Sunoco, Inc. SUN [NYSE]

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1 ? Sunoco, Inc. SUN [NYSE] High oil prices and a weak consumer environment should translate into lower margins for Sunoco. heavy sour crude discounts will remain strong; consequently, the financial performance of Sunoco s refining operations should lag that of its competitors, which are more leveraged to refining heavy sour crude oil. by Justin Perucki, CFA Senior Stock Analyst Analysts covering this company do not own its stock. Report updated on April 18, Data and Rating updated as of June 27, Currency amounts expressed with "$" are in U.S. dollars () unless otherwise denoted. Stock Price Thesis Apr. 18, 2008 With refining capacity of about 910,000 barrels per day, Sunoco is the second-largest independent refiner in the United States. Sunoco has enjoyed robust margins and returns on capital over the past five years, but competitive pressures are now beginning to build. Furthermore, due to the location of most of its capacity (the East Coast) and its relatively simple refineries, Sunoco is at a structural disadvantage to its peers. Refining is a difficult business. Unlike upstream producers, refiners lack the cooperative pricing environment supported by OPEC; refiners actually have little pricing power. Refiners also have little control over input costs (primarily oil). These competitive issues are exacerbated by the fact that most of Sunoco s refining capacity is on the East Coast, which is susceptible to imports from the Midwest, Gulf Coast, and Europe when refined product prices get too high on a relative basis. To improve on its competitive position, Sunoco has adopted a couple of strategies to help it keep its costs and selling prices as low as possible. First, the company focuses both its refining and marketing operations in the Northeastern and Midwestern United States, minimizing its transportation costs. Second, the firm sells gasoline, Sunoco-branded products, and convenience items at its retail outlets. By controlling the retailing effort of most of its end products, Sunoco is able to sell its finished products at the most competitive prices. Given the infrastructure in place at its refineries, Sunoco is unable to add a significant amount of heavy sour crude conversion capacity like many of its peers. Because heavy sour crude oil sells at significant discounts to light sweet oil, the most profitable refineries are the ones capable of processing large amounts of sour crude. Certain types of heavy sour crude oil have recently sold at discounts as high as $15 to $20 per barrel to light sweet oil. We think After several years of outsized profits, Sunoco is facing pressure from recent alternative fuel mandates, expansions at existing U.S. refineries, and the build-out of export refineries in the Middle East. In addition, new automobile fuel-efficiency standards and persistently high gasoline prices should lead consumers to purchase more fuel-efficient cars over time. While we don t think that as significant a glut of refining capacity will materialize as there was during the 1980s and 1990s, we do believe that over the next several years, capacity constraints will be relieved. Consequently, we anticipate that refining margins will fall from their record levels in Valuation We re maintaining our fair value of $64 per share. Increased refining capacity, higher use of ethanol, and a weakening consumer lead us to believe that refining margins in 2008 will be lower than in However, we think the longer-term profit outlook is brighter than what the firm experienced three to five years ago. Sunoco is one of the few firms electing to defer some of its longer-dated capital projects because of high construction and engineering costs. The projects haven t been canceled, but their expected start date is unclear. We think this is a wise move, as projects currently under construction across the industry continue to be plagued by cost overruns. The firm s unfunded postretirement obligations reduce our fair value estimate by about $4. Sunoco has done a nice job of increasing shareholder value through the repurchasing of common stock. Furthermore, it pays the highest dividend among independent refiners. Our fair value estimate is extremely sensitive to our assumptions about gross refining margins. If we increase our gross refining margins 10%, our fair value estimate increases to $76, all else being equal. A 10% decrease in our assumptions translates into a fair value estimate of $52, all else being equal. This report was produced by an Independent Research Provider selected by the Independent Consultant as required under the Global Research Analyst Settlement.

2 Sunoco, Inc. SUN [NYSE] Close Competitors Currency(Mil) Market Cap TTM Sales Oper Income Net Income Sunoco, Inc. ExxonMobil Corporation BP PLC Marathon Oil Corporation Morningstar data as of June 27, ,380 48,236 1, , ,183 75,029 42, , ,438 38,051 21,169 36,261 70,305 6,614 3,970 Risk Sunoco profits from the spread between the price of its oil feedstock and its finished products, like gasoline and diesel fuel. If oil feedstock prices increase dramatically, Sunoco may not be able to pass on the added costs through its finished products; consequently, profits shrink. Like others in the refining business, Sunoco faces risk from increased environmental and government regulation. The company must also routinely defend itself in litigation regarding pollution and health-related issues. in North America. Sunoco will experience lower refining gross margins than many of its peers because it has minimal heavy sour crude conversion capacity. Like many older companies in the United States, Sunoco has legacy costs such as its pension plan. Independent Sunoco competes with larger, integrated rivals that are better equipped to handle fluctuations in the price of crude oil feedstock and industry cycles. A simultaneous increase in industrywide capacity and slowdown in economic activity would put significant pressure on refining margins. Financial Overview Growth: Because much of Sunoco s revenue comes from refining and marketing, most of its growth will be driven by commodity prices for oil and gasoline. Bulls Say Sunoco s refining facilities are close to its retail outlets, helping reduce transportation costs. Refining capacity has been stagnant for the last two decades, benefiting independent refiners like Sunoco. Sunoco commands more than one third of the refining capacity in its primary market--the Northeastern U.S. Although limited by its existing infrastructure, Sunoco is retrofitting its refineries to handle a greater amount of poor-quality crudes, which sell at a discount to light sweet crude. Sunoco continues to repurchase outstanding shares. Since the beginning of 1999, shares outstanding have fallen more than 30%. Bears Say Despite its large presence in the Northeast, Sunoco possesses only a fraction of the total refining capacity Profitability: Sunoco s profitability hinges on the price spread between its oil feedstock and finished goods. Because the prices of its feedstock and finished products are tied to commodities, Sunoco s profits can be quite volatile. Net margins historically average in the low-single digits. Financial Health: Sunoco is the second-largest independent refiner, but it lacks the financial strength of the industry s integrated giants. At year end, debt/total capital was nearly 40%. Company Overview Profile: Philadelphia-based Sunoco engages in oil refining, chemical production, and cokemaking. At the end of 2007, Sunoco s total refining capacity was about 910,000 barrels of oil per day. The firm holds a 43% interest in Sunoco Logistics Partners LP, a partnership that owns pipelines and terminals connecting Sunoco s refineries. Sunoco

3 Sunoco, Inc. SUN [NYSE] markets gasoline through 4,528 retail outlets in 25 states. Strategy: Sunoco refines lighter crude feedstock, which is more expensive to purchase but cheaper to process. By concentrating its effort in the Northeast and Midwest regions of the U.S., Sunoco thinks it can achieve local pricing advantages. Its geographic focus in both refining and marketing cuts down on transportation costs. Sunoco uses its retail outlets to sell its numerous finished products. Management: John Drosdick has been chairman, president, and CEO of Sunoco since He is also chairman of Sunoco Partners, the general partner of Sunoco Logistics Partners LP. Drosdick is an industry veteran with more than 35 years of experience, having spent the bulk of his time at Exxon. Sunoco s executive compensation is about average compared to that of peers. In 2007, Drosdick brought home $15 million in cash compensation and stock awards. Bonuses are primarily based on return on invested capital relative to the firm s peers and an operating income target. Management s stake in the firm is relatively small--about 1% of the outstanding shares at the end of Although we d like to see greater management participation in the stock, Sunoco s executives own a fair stake, considering the age and size of the firm. Overall, Sunoco has good stewardship practices.

4 Sunoco, Inc. SUN [NYSE] Analyst Notes Apr. 15, 2008 Sunoco under Review We re placing Sunoco under review while we re-evaluate our assumptions. Jan. 08, 2008 Sunoco under Review We are placing Sunoco under review while we re-evaluate our assumptions. Disclaimers & Disclosures No Morningstar employees are officers or directors of this company. Morningstar Inc. does not own more than 1% of the shares of this company. Analysts covering this company do not own its stock. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.

5 Morningstar Stock Report All pricing data thru Fiscal year-end: December Sunoco, Inc. SUN Sales Mil Mkt Cap Mil Industry Sector $48,236 $4,380 Oil/Gas Energy Products Philadelphia-based Sunoco engages in oil refining, chemical production, and cokemaking. At the end of 2007, Sunoco s total refining capacity was about 910,000 barrels of oil per day. The firm holds a 43% interest in Sunoco Logistics Partners LP, a partnership that owns pipelines and terminals connecting Sunoco s refineries. Sunoco markets gasoline through 4,528 retail outlets in 25 states. Ten Penn Center 1801 Market Street Philadelphia, PA Phone: Website: Growth Rates Compound Annual Grade: 1 Yr 3 Yr 5 Yr 10 Yr Revenue % Operating Income % Earnings/Share % Dividends % Book Value/Share % Stock Total Return % /- Industry /- Market Profitability Analysis Grade: A Current 5 Yr Avg Ind Mkt Return on Equity % Return on Assets % Fixed Asset Turns Inventory Turns Revenue/Employee $K * Gross Margin % Operating Margin % Net Margin % Free Cash Flow/Rev % R&D/Rev % Financial Position Grade: C $Mil $Mil Cash Inventories Receivables Current Assets Fixed Assets Intangibles.. Total Assets Payables Short-Term Debt 4 3 Current Liabilities Long-Term Debt Total Liabilities Total Equity Valuation Analysis *3Yr Avg data is displayed in place of 5Yr Avg Current 5 Yr Avg Ind Mkt Price/Earnings Forward P/E Price/Cash Flow Price/Free Cash Flow Dividend Yield % Price/Book Price/Sales PEG Ratio Morningstar Rating Last Price Fair Value Uncertainty Economic Moat Stewardship Grade QQQQQ Buy $37.48 $64.00 High None B YTD : Trading Volume Million 1.0 Annual Price High Low Recent Splits Price Volatility Monthly High/Low Rel Strength to S&P week High/Low $ Year High/Low $ Bear-Market Rank 8 (10=worst) Stock Performance TTM Financials Revenue $Mil Gross Margin % Oper Income $Mil Operating Margin % Total Return % +/- Market +/- Industry Dividend Yield % Market Cap $Mil Net Income $Mil Earnings Per Share $ Dividends $ Shares Mil Book Value Per Share $ Oper Cash Flow $Mil Cap Spending $Mil Free Cash Flow $Mil TTM Profitability Return on Assets % Return on Equity % Net Margin % Asset Turnover Financial Leverage Financial Health Working Capital $Mil Long-Term Debt $Mil Total Equity $Mil Debt/Equity TTM Valuation Price/Earnings P/E vs. Market Price/Sales Price/Book Price/Cash Flow Quarterly Results Revenue $Mil Jun 07 Sep 07 Dec 07 Mar 08 Most Recent Period Prior Year Period Rev Growth % Jun 07 Sep 07 Dec 07 Mar 08 Most Recent Period Prior Year Period Earnings Per Share $ Jun 07 Sep 07 Dec 07 Mar 08 Most Recent Period Prior Year Period Industry Peers by Market Cap Major Fund Holders Mkt Cap $Mil Rev $Mil P/E ROE% Sunoco, Inc ExxonMobil Corporati BP PLC % of shares Ivy Global Natural Resources A 2.50 T. Rowe Price Capital Appreciation 1.11 T. Rowe Price Value Morningstar, Inc. All Rights Reserved. Intended for U.S. residents only. Data as originally reported. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only,

6 Morningstar s Approach to Rating Stocks Our Key Investing Concepts Economic Moat Discounted Cash Flow Discount Rate Fair Value Uncertainty Margin of Safety Consider Buying/Consider Selling Stewardship Grades At Morningstar, we evaluate stocks as pieces of a business, not as pieces of paper. We think that purchasing shares of superior businesses at discounts to their intrinsic value and allowing them to compound their value over long periods of time is the surest way to create wealth in the stock market. We rate stocks 1 through 5 stars, with 5 the best and 1 the worst. Our star rating is based on our analyst s estimate of how much a company s business is worth per share. Our analysts arrive at this "fair value estimate" by forecasting how much excess cash--or "free cash flow"--the firm will generate in the future, and then adjusting the total for timing and risk. Cash generated next year is worth more than cash generated several years down the road, and cash from a stable and consistently profitable business is worth more than cash from a cyclical or unsteady business. Stocks trading at meaningful discounts to our fair value estimates will receive high star ratings. For high-quality businesses, we require a smaller discount than for mediocre ones, for a simple reason: We have more confidence in our cash-flow forecasts for strong companies, and thus in our value estimates. If a stock s market price is significantly above our fair value estimate, it will receive a low star rating, no matter how wonderful we think the business is. Even the best company is a bad deal if an investor overpays for its shares. Our fair value estimates don t change very often, but market prices do. So, a stock may gain or lose stars based just on movement in the share price. If we think a stock s fair value is $50, and the shares decline to $40 without much change in the value of the business, the star rating will go up. Our estimate of what the business is worth hasn t changed, but the shares are more attractive as an investment at $40 than they were at $50. Because we focus on the long-term value of businesses, rather than short-term movements in stock prices, at times we may appear out of step with the overall stock market. When stocks are high, relatively few will receive our highest rating of 5 stars. But when the market tumbles, many more will likely garner 5 stars. Although you might expect to see more 5-star stocks as the market rises, we find assets more attractive when they re cheap. We calculate our star ratings nightly after the markets close, and issue them the following business day, which is why the rating date on our reports will always be the previous business day. We update the text of our reports as new information becomes available, usually about once or twice per quarter. That is why you ll see two dates on every Morningstar stock report. Of course, we monitor market events and all of our stocks every business day, so our ratings always reflect our analyst s current opinion. Economic Moat This is our assessment of a firm s ability to earn returns consistently above its cost of capital in the future, usually by virtue of some competitive advantage. Competition tends to drive down such economic profits, but companies Morningstar Research Methodology for Valuing Companies Competitive Economic Company Fair Value Uncertainty Analysis Moat Rating Valuation Estimate Assessment Q Q Q Q Q Analyst conducts The depth of the Analyst considers DCF model leads to An uncertainty company and industry firm s competitive company financial the firm s Fair Value assessment research: advantage is rated: statements and Estimate, which establishes the competitive position anchors the rating margin of Management None to forecast future framework. safety required for interviews Narrow cash flows. the stock rating. Conference calls Wide Trade-show visits Assumptions are Competitor, supplier, input into a disdistributor, and counted cash-flow customer interviews model. Q QQ QQQ QQQQ QQQQQ The current stock price relative to fair value, adjusted for uncertainty, determines the rating.

7 Morningstar s Approach to Rating Stocks (continued) that can earn them for an extended time by creating a competitive advantage possess an economic moat. We see these companies as superior investments. We re big fans of companies that are low-cost producers, create high switching costs for their customers, or have strong brands or long-lasting patents, because all of these characteristics allow companies to protect their competitive position. For example, Tiffany is far more profitable than a run-of-the-mill jewelry chain because it has a strong brand that creates a moat around its business, allowing it to charge more than competitors. Discounted Cash Flow This is a method for valuing companies that involves projecting the amount of cash a business will generate in the future, subtracting the amount of cash that the company will need to reinvest in its business, and using the result to calculate the worth of the firm. We use this technique to value nearly all of the companies we cover. Discount Rate We use this number to adjust the value of our forecasted cash flows for the risk that they may not materialize. For a profitable company in a steady line of business, we ll use a lower discount rate, also known as "cost of capital," than for a firm in a cyclical business with fierce competition, since there s less risk clouding the firm s future. Fair Value This is the output of our discounted cash-flow valuation models, and is our per-share estimate of a company s intrinsic worth. We adjust our fair values for off-balance sheet liabilities or assets that a firm might have--for example, we deduct from a company s fair value if it has issued a lot of stock options or has an under-funded pension plan. Our fair value estimate differs from a "target price" in two ways. First, it s an estimate of what the business is worth, whereas a price target typically reflects what other investors may pay for the stock. Second, it s a long-term estimate, whereas price targets generally focus on the next two to 12 months. Uncertainty To generate the Morningstar Uncertainty Rating, analysts consider factors such as sales predictability, operating leverage, and financial leverage. Analysts then classify their ability to bound the fair value estimate for the stock into one of several uncertainty levels: Low, Medium, High, Very High, or Extreme. The greater the level of uncertainty, the greater the discount to fair value required before a stock can earn 5 stars, and the greater the premium to fair value before a stock earns a 1-star rating. Margin of Safety This is the discount to fair value we would require before recommending a stock. We think it s always prudent to buy stocks for less than they re worth.the margin of safety is like an insurance policy that protects investors from bad news or overly optimistic fair value estimates. We require larger margins of safety for less predictable stocks, and smaller margins of safety for more predictable stocks. Consider Buying/Consider Selling The consider buying price is the price at which a stock would be rated 5 stars, and thus the point at which we would consider the stock an extremely attractive purchase. Conversely, consider selling is the price at which a stock would have a 1 star rating, at which point we d consider the stock overvalued, with low expected returns relative to its risk. Stewardship Grades We evaluate the commitment to shareholders demonstrated by each firm s board and management team by assessing transparency, shareholder friendliness, incentives, and ownership. We aim to identify firms that provide investors with insufficient or potentially misleading financial information, seek to limit the power of minority shareholders, allow management to abuse its position, or which have management incentives that are not aligned with the interests of long-term shareholders. The grades are assigned on an absolute scale--not relative to peers--and can be interpreted as follows: A means "Excellent," B means "Good," C means "Fair," D means "Poor," and F means "Very Poor."