Sunoco Logistics Partners: Is Wall Street Wrong to Hate This High-Yield Dividend Stock?

Source: Sunoco Logistics Partners

Every long-term income investor knows that the best way to achieve market crushing returns is to "be greedy when others are fearful". Unfortunately when it comes to the worst oil crash in 50 years, which has caused most energy stocks to trade at extremely undervalued levels, determining which investments are worth your hard earned money can be challenging.

Take for example Sunoco Logistics Partners (NYSE: SXL), which has been punished worst than most of its peers over the last year.

SXL data by YCharts

Is this a classic case of market irrationality mispricing a good business? Or perhaps an important warning that something is wrong with Sunoco Logistics' business model?

To help long-term income investors decide whether or not this high-yield midstream MLP deserves a place in your diversified income portfolio let's look at three key questions dividend investors need to ask to determine just how good of an investment Sunoco Logistics makes over the next five to ten years.  

Just how undervalued is it?

Sources: Yahoo Finance, Fastgraphs

Indeed from a yield perspective Sunoco Logistics Partners seems extremely attractively priced. The same can be said about its price/operating cash flow considering its fast growth rate. For instance, management just announced a its 43rd consecutive quarterly distribution increase, 5% quarter over quarter and 20% year-over-year.

In fact, this is the 15th consecutive quarter of 20% year-over-year distribution growth, an impressive feat for any midstream MLP.

However, a high and fast growing yield can also be a double edged sword if a MLP isn't growing fast enough to sustain it in the long-term.

Does the payout profile justify the valuation?

Sources: earnings presentation, Fastgraphs

As you can see Sunoco Logistics Partners payout is highly sustainable, at least in the short-term. In addition analysts are projecting that its payout growth will actually accelerate through 2020. So that means Sunoco Logistics is an obvious buy right?

Not so fast. In order to determine whether the payout can achieve these optimistic growth rates, and more importantly remain sustainable in the long-term, Sunoco Logistics needs to be able to grow distributable cash flow at least as fast as its distribution.

However, for full year 2011 through 2014 the MLP only grew DCF -- which funds the distribution -- at a 17.9% CAGR, slower than its payout growth rate.What's worse for the first three quarters of 2015 DCF grew only 10.6%.

So unless Sunoco Logistics Partners has a major growth catalyst up its sleeve, such as a large backlog of organic growth projects or a giant drop down pipeline from its two sponsors and general partners, Energy Transfer Equity (NYSE: ETE) and Energy Transfer Partners (NYSE: ETP), its coverage ratio is likely to fall over time.

Source: Sunoco Logistics Partners.

While 2016 is likely to be another solid growth year for Sunoco Logistics, 2017 and beyond shows possible trouble ahead. With DCF growth already slowing, the only way for management to continue its aggressive payout growth strategy is to let the coverage ratio decline closer to 1.0, the bare minimum for a long-term sustainable distribution.

The problem with this strategy is that Sunoco Logistics would end up retaining precious little DCF to internally fund its growth efforts, thus relying completely on debt and equity markets for capital.

As for drop downs from Energy Transfer Equity and Energy Transfer Partners, while this is always a possibility, the fact is that Energy Transfer Equity owns no midstream assets itself and Energy Transfer Partners is struggling to maintain a coverage ratio of 1.0.

Thus, Energy Transfer Partners might not have any assets it can afford to drop down to Sunoco Logistics.

Does Sunoco's access to growth capital allow for future growth?

Sources: Morningstar, Gurufocus

Sunoco Logistics has historically relied on equity markets for two thirds of its capital needs. Yet with its unit price almost cut in half over the past year it will likely have to rely on debt to fund its planned $2.5 billion in capital expenditures in 2016.

The problem with this is that, as Sunoco Logistics' latest $1 billion senior debt offering shows, the interest rates it will have to pay due to its highly leveraged balance sheet are much higher than what its been paying up to now.

This will only raise its weighed average cost of capital which is already much higher than its return on invested capital meaning that future growth is likely to be even less profitable. This could further weaken the long-term growth and sustainability prospects of its distributions.

Bottom line:
Sunoco Logistics Partners' current payout is sustainable and its growth prospects for 2016 seem quiet good due to its five projects scheduled for completion.  However, given management's aggressive distribution growth policy my concern is that its coverage ratio will decline over time.

When combined with limited growth prospects in 2017 and beyond, profitability below its cost of capital, and a high debt load that is only likely to grow in 2016, I would say that the long-term risks justify the market's current valuation.