Why Buy Sunoco Now?

| About: Sunoco LP (SUN)

Sunoco (NYSE:SUN) June 14, 2009, $26.43
52-week range: $21.30 (Oct. 10, 2008) - $49.44 (Sep. 12, 2008)
Dividend = $0.30 quarterly = 4.54% current yield

Sunoco is a major refiner and retailer of gasoline in 26 Eastern and Midwestern states. They also sell petrochemicals and metallurgical coke for the steel industry.

2009 is likely to show a huge drop in profitability from the boom years 2005 – 2008 when EPS came in between $6.91 and $7.59. Estimates for 2009 and 2010 are now centered on $2.80 and 3.80 respectively as crack spreads and margins are well below peak levels. Recessionary conditions are impacting total driving miles as well. Net profit margins will probably come in around 1.1% versus the 2.5% - 3.0% levels seen as recently as 2004 to 2006.

Why be interested now? The share price appears to already reflect the bad news. At today’s quote of $26.43 the multiple is < 9.5x this year’s and < 7x 2010’s cyclically low expectations. As oil prices rise and crack spreads widen Sunoco should see improved earnings. Value Line sees $7.30 /share in normalized earnings power by 2012 – 2014. That would be similar to what SUN posted in each of the four years 2005 – 2008 when the share price generally hovered between $60 and $80.

The dividend provides a current yield of 4.54% and looks sustainable at about a 43% payout ratio. Value Line gives Sunoco an ‘A’ for financial strength. Morningstar considers ‘fair value’ to be $41 under present day conditions.

Knowing that the second half quarterly comparisons will be very negative I’m not counting on a big surge in the near term. It doesn’t take a lot of imagination, though, to picture SUN exceeding $30 again even if things don’t improve greatly.

Here’s how I’m playing Sunoco right now…

If Sunoco rises by 9.8% to at least $30 by the January 2011 expiration date:

The $30 calls will be exercised.
You will sell your shares for $30,000.
The $30 puts will expire worthless.
You will likely have collected $1800 in dividends.
You will have no further option obligations.
You will own no shares and hold $31,800 cash.

That’s a best-case scenario total return of $18,570 / $13,230 or a cash-on-cash return of 140% - achieved in about 19 months on shares that only needed to rise by 9.8% from the trade’s inception price.

What’s the risk?

If Sunoco shares stay below $30 through Jan. 2011:

The $30 calls will expire worthless.
The $30 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $30,000 cash.
You will likely have collected $1800 in dividends.
You will have no further option obligations.

You will end up with 2000 shares of SUN and $1800 cash.

What’s the break-even on the whole trade?

On the first 1000 shares it’s the $26.43 purchase price less the $4.10 /share cal premium = $22.33 /share.

On the ‘put’ shares it’s the $30 strike price less the $9.10 /share put premium = $20.90 /share.

Your net cost would be the average of those:

$22.33 + $20.90 / 2 = $21.615 /share.

You would own 2000 shares @ $21.62 for a total outlay of $43,230 less the $1800 received from dividends = $41,430.

$41,430/2000 = $20.715 /share net break-even.

Sunoco shares could fall by as much as (-21.6%) without causing a loss on the trade.

What’s the static return?

If SUN shares finish on January 2011’s expiration date exactly where we started…

You’d own 2000 SUN @$26.43 /share plus the $1,800 in yield.

2000 x $26.43 = $52,860 liquidation value of shares.

$52,860 + $1,800 = $54,660 net value for your total cumulative outlay of $41,430

If the shares do absolutely nothing you’d see a total return of $54,660 - $41,430 = $13,230

$13,230 / $41,430 = 31.9% for 19 months or about 20% annualized on shares that did not move.

Disclosure: Author is long SUN shares and short SUN options.