Limited Time to Lock In This 11% Yield
Turnaround Situation Yields 11%
If you’re looking for big yields, one area of the market provides a rich hunting ground: turnarounds.
Regular readers have heard us mention these before. Turnarounds involve buying companies that have fallen on hard times, identifying the problem, and working a plan to reengage the business.
Of course, these issues come with more risk. But for those that call it right, you can lock in oversized yields. Not to mention that turnarounds often result in tidy capital gains.
Case in point today is Sunoco LP (NYSE:SUN), which yields almost 11%.
Sunoco operates two businesses. On the wholesale side, the partnership delivers gasoline to some 8,000 or so stations across the country. The retail side, on the other hand, owns and operates gas stations, as well as the accompanying convenience stores.
Over the past few years, management has spent billions of dollars on acquisitions. While these deals grew the size and scale of operations, it also left a big debt load. Analysts downgraded shares, worried that executives might have to slash the distribution.
That could change soon. In April, Sunoco agreed to sell most of its retail locations in a $3.3-billion cash deal. Investors loved the idea, sending units up 28% following the announcement. And for the partnership, the deal has three upsides.
Proceeds will put a big dent in the debt load, for starters. Today, Sunoco has around $6.00 of debt for every dollar of earnings generated before interest, taxes, depreciation, and amortization. For context, rival names keep this number around $2.00 or $3.00.
Management wants to get this metric down to a more reasonable $4.50. This will cut the amount of money paid out in interest. It will also give the top brass more breathing room, boosting the safety of the distribution.
Second, the extra cash will be used to fund a big buyback program. Management wants to repurchase some of the units owned by Energy Transfer Partners LP (NYSE:ETP) from the previous deals. Executives plan to buy back over $300.0 million of preferred shares held by its parent, Energy Transfer Equity LP (NYSE:ETE) too.
For unitholders, this increases their stake in a wonderful business. With the company pie divided up into fewer slices, owners get a bigger piece of future profits. And, with less in the way of preferred dividends to pay out, Sunoco will have more funds left over for common unitholders.
Finally, the deal will transform Sunoco into an almost pure gasoline distributor. Convenience stores suffer from the dreaded “V” word: volatility. Analysts hate wild profit swings at the best of times, but it becomes a big problem when you have a heavy debt load. And, while drivers may need to buy gas during a downturn, they definitely don’t need to stock up on overpriced sodas and snacks.
Gasoline distribution, in contrast, cranks outs predictable cash flow. Deals get done through long-term supply agreements. Investors can easily forecast profits years in advance.
Chart courtesy of StockCharts.com
So Sunoco sounds like a slam dunk, right? Time to back up the truck, lock down that 11% yield, and put in your two weeks notice at work?
Not so fast, bud.
Convenience store sales made up more than a third of the partnership’s profits last year. Jettisoning this business will leave a big hole to fill.
Paying off debt can only do so much. If everything goes according to plan, Sunoco will generate $1.10 for every dollar paid out in distributions. By comparison, top-tier companies like Enterprise Products Partners L.P. (NYSE:EPD) and Magellan Midstream Partners, L.P. (NYSE:MMP) tend to keep distribution coverage ratios above $1.20 or $1.30.
For now, executives have little wiggle room. If management can run out the clock, they should be able to work off the debt while paying out distributions to unitholders. Investors getting in today may be buying a once-in-a-lifetime bargain.
But if anything goes wrong, this turnaround situation could turn ugly in a hurry.