Description

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Overview

We believe shares of SunCoke Energy (“SXC” or the “Company”) offer investors an attractive investment opportunity with over 100% upside due to its stable cash flows and durable business model.  This write-up is much longer than is typical, as we believe that is necessary given the complexity of the situation and several misconceptions associated with the business.  The opportunity in SXC exists because of extreme, but transitory, negative sentiment, stemming from both macro and Company-specific factors that have obscured the underlying enterprise value inherent in the Company’s long-term take-or-pay contracts with its customers and strong industry position as the preferred provider for coke.  SXC is often lumped in with steel companies, coal companies, and even oil and it seems few investors are willing to do the work necessary to gain conviction in an investment that admittedly has some “hair”.  While we have heard many “sky is falling” statements ranging from no domestic steel capacity in the future to an immediate loss of MLP status, the truth is far different.  SXC stock has fallen 60% YTD, and its sister MLP SunCoke Energy Partners LP (SXCP) has fallen 61%.  This has happened despite the Company executing on additional asset dropdowns, a 100% increase in SXC’s dividend to a 8% yield at today’s price, an accretive deal in coal logistics at SXCP, additional stock repurchases at SXC, the launch of unit repurchase program at SXCP, and continued dividend growth at SXCP.  In short, although we acknowledge some Company missteps that we discuss later, the fundamentals are far different than the stock price performance, and we believe investors will be handsomely rewarded from an investment in SXC.

SunCoke’s primary business is that of an outsourced coke supplier to domestic steel manufacturers.  Its assets are housed in a complicated structure in an industry with a challenging cyclical backdrop.  We do not dispute the current pain within the domestic steel market, but we believe an examination of the Company’s fundamentals clearly shows that the intrinsic value of its assets lies far above where they are marked in the market today.  SXC had previously garnered attention in the investment community as an event stock pursuing a dropdown strategy into its underlying MLP, SXCP, of which SXC owns the GP and 53% of the LP units (translating to a total economic interest of 55% inclusive of the GP’s 2% stake before IDRs).  However, the process stalled late last year as widening yields at SXCP rendered its cost of capital less competitive in purchasing assets from SXC and the dropdown math proved elusive. So far in 2015, things have gone from bad to worse.  This year SunCoke has suffered from myriad factors, including customer credit concerns, MLP regulatory issues, and a failed activist effort from a former large shareholder, to name a few.  The toll has left SXC and SXCP trading like a business left for dead.  SXCP units currently yield 23% and trade at 7x EBITDA less capex with net debt to EBITDA of 3.6x while SXC trades at 8x unlevered 2016E cash flow.  As we have alluded to above, the one constant for SunCoke throughout this volatility has been its contracted cash flow, which provides the Company with multiple options to reward shareholders willing to see through unwarranted commodity correlation.  Aside from operational improvements at its Indiana Harbor facility and continued growth in GP cash flows as the MLP executes on accretive unit repurchases, growth in SXC’s core business is off the table.  The focus from here will be on accretive capital allocation that should ultimately reward patient shareholders.  To their credit, SunCoke’s management has been transparent in its strategy, stating that SXCP was intended as a financing vehicle, but can no longer serve as such given its current cost of capital.  At this point, we believe management is well aware of its options set.  At current levels, we believe SXC provides a strong margin of safety, with compelling upside potential of over 100% through intelligent capital allocation and the potential for an obvious catalyst in the next 3 – 12 months.

The companies’ balance sheets require adjusting for the acquisitions completed after the second quarter close:

Business Overview

SunCoke offers customers an outsourced model for coke processing.  Its value proposition to customers is as follows: it will put up the capital, design and build the plant, assume maintenance costs and stringent environmental compliance, and commit to deliver highly efficient production.  In return, SXC receives a long-duration fixed fee per ton contract priced to earn an adequate return on invested capital with direct costs (i.e. raw material, operating, and transportation) passed through to the customer.  These plants are long-lived assets, typically operating 40+ years. It has 5 plants of varying size and age that supply to the big three US blast furnace operators.  In addition, SunCoke has two small international coke assets, of which only Brazil contributes to earnings.  Basic detail on its coke plants and contracts is as follows (note that Haverhill’s tonnage is split between two customers):

SunCoke was originally spun out of the former Sunoco, Inc. in January 2012 (Sunoco has since been acquired by ETP). SunCoke then IPO’d SXCP in January 2013 as a growth platform to leverage its contracted base business into other industrial processing assets.  At inception, SXCP contained 65% ownership interests in Haverhill and Middletown.  Upon expiry of its tax-sharing agreement with Sunoco in early 2014, SXC began dropping additional coke assets into SXCP.  To date, SXC has executed three drops, including the remaining interests in Haverhill and Middletown and Granite City in two separate transactions.  In addition, SXCP acquired two small coal logistics businesses in 2013 and recently a larger coal export facility in the Gulf.  SXC consolidates SXCP’s earnings within its financials, but excluding SXC’s stake in SXCP, the direct ownership of assets is as follows:

Industry Overview

Coke is the primary feedstock for blast furnaces (BFs), which are the ovens of integrated steel-making.  It is made by cooking metallurgical coal in stacked ovens (called coke “batteries”) at extreme temperatures in the absence of oxygen to drive off impurities, leaving what is essentially pure carbon.  Each ton of coke produced requires approximately 1.4 tons of met coal. There are two methods to produce coke: traditional by-product or heat recovery.  The by-product method condenses the volatile matter released in the cooking process to then be resold into chemical markets whereas the heat recovery method combusts the waste to create steam or electricity for sale.  SunCoke employs the latter because of its superior environmental performance, a quality that is highly value by its customers given the EPA’s constant pressure around anything in the coal industry.  SunCoke is the undisputed technological leader in coke.  It is the only North American producer to utilize heat recovery technology and its ovens’ performance is used by the EPA as the basis for establishing Maximum Achievable Control Technology (“MACT”) standards under the Clean Air Act.  Moreover, it has constructed the only greenfield coke-making facilities in the U.S. in the last 25 years.

Domestic coke demand is estimated between 14 – 17 million tons per year.  Captive supply by steelmakers accounts for the majority, with SunCoke the largest outsourced option at 25% of the total and gaining share over time.  Coke imports can serve as a short term option to be blended with other high quality coke but are not a viable long-term option for domestic producers (discussed later).

The global market for coke is approximately 700M tons a year.  Of that, China represents the lion’s share of both supply and demand and serves as the primary exporter.  However, the seaborne market is small at only ~20M tons because coke is by nature a localized product for two primary reasons.  1) Coke’s fragile chemical form is subject to degradation in shipping, and quality variables such as chemical purity, porosity and particle size are critical for optimal blast furnace operation.         2) Blast furnaces are expensive to maintain and run around the clock, requiring domestic producers to secure reliable, high quality coke supply relationships at batteries located nearby their furnaces.  Sourcing contacts at large blast furnaces that we have spoken to have verified that large imports of coke are not a reliable source, with many simply saying they would go to SXC if they needed more coke in the future.

This point is further supported by the ITC’s (International Trade Commission) own independent industry analysis of coke imports.  In 2003, the ITC ruled on final appeal that domestic coke did not qualify for trade protection.  While this may seem like a negative, essentially, the ITC ruled that issues with coke imports make them less relevant to the domestic market.  Structural limits hurt imports’ ability to compete in a meaningful way and that the domestic market is advantaged.  A link to the full report is in Appendix A, but we found the following quotes from the report supportive of our view:

“A third factor is that blast furnace coke has a low value to weight ratio. Freight costs are therefore a significant factor in total delivered costs. Domestic producers tend to market their coke close to where it is produced. Most domestic producers are located in Illinois, Indiana, Ohio, Pennsylvania and Michigan, and a significant percentage of domestic production is internally consumed by steel producers at adjacent or nearby steel mills.”

“Blast furnace coke crumbles whenever it is being transported or handled, creating particles of coke called coke breeze. A higher percentage of breeze in a shipment, caused, for example, by the coke being on the ground, can result in a decreased price for the shipment, either because the purchaser discounts the shipment or because the breeze is screened out. Therefore, blast furnace coke producers seek to minimize crumbling or degradation of the blast furnace coke prior to use, by minimizing handling, moving or transporting the coke. Since placing the coke on the ground involves handling and degradation, blast furnace coke producers endeavor to avoid holding inventories. Moreover, in general, blast furnace coke is sold directly to end users and not through distributors.”

Within the domestic steel market, blast furnaces have been losing share to electric arc furnaces (EAFs).  This has pressured domestic blast furnace production and led to consolidation among suppliers to where there are currently only four North American operators (AK Steel, US Steel, ArcelorMittal, and Essar Algoma - see Appendix B for plant detail).  Production from BFs has undoubtedly lost share, but nonetheless BF volumes are projected to remain flat or grow. BFs remain the only option to supply high quality steel demand for high-value applications such within the auto market.  For example, automotive applications account for more than 50% of AKS’ volume versus 13% at Steel Dynamics and 11% at Nucor, the two largest EAF producers.  Steel demand from the automotive market is approximately 16M tons of the ~110M tons consumed domestically.  In a draconian scenario, if you assume this represents the only market segment where BFs will remain competitive this would imply annual coke demand of roughly 7-8M tons/yr.  In such a scenario, SXC tonnage would represent half the market. Given the age distribution of competitor plants (discussed below), SXC’s younger assets would be the logical surviving capacity within the industry if the market were to trend towards such drastic capacity removal over the next 5-10 years.

Imports are a huge issue for domestic steelmakers.  They have taken share and undercut indexed pricing to which supply contracts are tied.  However, similar to coke production, key markets serviced by BFs today are structurally localized. Domestic automakers require custom precision on advanced steel grades and JIT delivery that cannot be serviced by imports, which are largely bought by service centers.  It would be a huge issue for major automakers and the U.S. economy if all blast furnaces in North America were shuttered tomorrow.  In fairness, if one has a view that all domestic automotive production will move overseas, SXC is likely not an investment for him or her.  We think it is highly unlikely this would occur in the short-term (or at all), given the unionized labor, the fixed-cost infrastructure, and protectionism/national security reasons. The key distinction we are making is that the issue for SXC’s customers has not been demand, which benefit from strong non-residential construction and automotive markets; it has been price.  We believe trade cases that should be settled in the next several months should offer important protection to domestic BFs producers.  For more detail on these trade cases please see Appendix C.

SunCoke’s positioning within its market is strengthened by the aging state of customers’ captive supply options.  As depicted in the chart below, a large portion of current supply is from legacy by-product plants that are nearing the end of their useful lives and would require large refurbishment capex to extend.  This trend is evident by recent closures of coke batteries (see Appendix D for detail).  The following statement by US Steel’s CEO announcing such a closure on the 3Q13 call is supportive of SXC’s value proposition: “We're ceasing operations at 2 of our oldest highest cost and maintenance and capital-intensive coke batteries at Gary Works, resulting in an improvement in our average coke costs and eliminating future maintenance spending and capital investments needed to sustain operations at these batteries.”  SXC’s assets are younger, environmentally advantaged and more efficient.  In fact, one could argue that the current environment has made SXC’s assets more valuable considering the cost of capital has increased dramatically for its blast furnace customers, especially for expensive coke plants.

In conclusion, despite its association with oversupplied deflating commodities, SunCoke’s fundamentals are strong.  The Company is the biggest player in an industry with large barriers to entry, with the youngest and most efficient assets supplying customers that require domestic sourcing to ensure their blast furnaces produce the highest grades of steel.  We think there will continue to be demand for SXC’s assets long after contracts expire as other industry assets age and even in the event of potential further turbulence in the domestic steel industry.  Essentially, at today’s valuation you get this terminal value for free.

Where Things Went Wrong

Within this industry backdrop, it is understandable why the Company believed the long-term coke contracts coupled with its tax-advantaged status could have provided SXC with a competitive cost of capital with which to fund growth via its MLP. The reality has been the quite the opposite.  Despite no direct commodity exposure, SXC has consistently exhibited strong correlation with the heavily commodity-linked stocks of its steel customers.  This has undermined SXCP’s viability as an MLP since day 1 (and begs the question if it should be public at all).  The following chart shows SXC’s share price indexed against a basket of its customers stocks (AK Steel, US Steel, and ArcelorMittal at equal weighting) dating back to the end of 2013 (R² = 0.88).

This correlation is unwarranted.  SunCoke’s contracts and business model provide insulation from direct commodity exposure and its take-or-pay contracts should provide stable cash flows even during downturns.  We have at times encountered pushback from other investors quoting SunCoke as a “high cost supplier” in an oversupplied market.  This assessment misses the point. SunCoke is not a supplier in the traditional sense like that of a coal company.  The underlying cost of the coke it produces from a customer’s perspective flexes with the market.  For example, if metallurgical coal prices decline, it is not as if SXC just became less competitive versus a global benchmark.  Rather, the benefit of lower met coal prices is passed on to its steel customers.  Falling iron ore prices can be similarly viewed, as lower iron ore represents lower raw material costs for blast furnaces.  Paradoxically, both trends depress shares despite representing economic benefits within SXC’s market.  SXC is essentially extracting a processing/handling fee that provides an adequate return on capital for the plants they have built for their customers.  Absent paying this fee, over time domestic blast furnace operators would have to construct their own new plants or continue investing capital into an aging fleet of coke batteries with a finite life.  There is a reason the domestic steel producers have opted to close their own batteries and contract with SunCoke and we think that is pretty clear.

Nonetheless, the correlation is overwhelmingly strong despite management’s attempts to fight it.  Exacerbating factors include the fact that SunCoke has no direct comps in the market, the business was already considered unconventional within the MLP space, and SXCP units have minimal liquidity.  During 2014, a large hedge fund liquidation also significantly impacted the yield at SXCP.  Unfortunately, for MLP/GP structures, significant changes in yield can quickly become a self-fulfilling prophecy, much like a run on a bank.  2015 has been an incredibly challenging year for domestic steel producers due to elevated dumping from Chinese exporters into the domestic market. Adverse foreign currency trends and declining demand from the oil and gas sector have hurt too.  The cumulative damage to SunCoke’s valuation has been extreme.  Units now yield above 20%.  At this point, SXC and SXCP thoroughly qualify as orphaned stocks in a broken MLP structure.

Why Does This Opportunity Exist (i.e., Why Does Everyone Hate This?)

The stock has gone straight down this year despite increasing distributions and returning capital.  Nobody seems to care.  Even the largest shareholders have been disgruntled and this seems very much like it has been washed out.  The following is what we view as the comprehensive list of diligence items necessary to gain conviction.  This is a long list and it is understandable why few are willing to do the work.

1) AK Steel Concerns

SXC has a concentrated customer base. This is a fact, but credit risk is also most relevant to one customer, AK Steel (AKS), which is burdened by overleverage and a large underfunded pension.  AKS will struggle to generate cash at prevailing steel prices.  However, it has ample liquidity and its first bond maturity is not until December 2018.  If creditor protection is the only option for AKS eventually, there is no reason management would need to or want to file for a few years.

There are reasons to be hopeful for AKS.  First, trade cases should tighten the market and boost profitability next year.  Also, its fixed payments schedule is much improved.  After injecting hundreds of millions of dollars into its underfunded pension and Magnetation JV over the past few years, the spigot is now turned off.  Magnetation is in Chapter 11 and management has stated it has zero intention of contributing more capital.  Its pension guidance is for $25M invested this year and zero for 2016 and 2017.  Lastly, because AKS is a major supplier to the NA auto market, we feel there is something to be said about customers not wanting to see further consolidation in their supplier base (from 3 to 2).

Those issues aside, we believe owning SXC does not require investors to take a specific view on AKS. This stands in contrast to consensus.  We have read that some investors claim the Company should trade with AKS’ unsecured bonds. This argument is off base for two reasons.  First, it simply fails to recognize that AKS only represents roughly 1/5 of SXC’s consolidated EBITDA, so valuing full cash flows on this metric is overly punitive.  Second, and more importantly, when assessing credit quality, SXC’s importance to AKS obviously matters.  We strongly believe SunCoke would be designated as a critical vendor if AKS were forced to file for bankruptcy, as their plants simply cannot operate without SXC’s coke delivery.  SXC’s coke plants are tied to AK Steel’s blast furnace assets, which remain profitable even in this depressed environment.  In any bankruptcy process, the value of a reorganized AK Steel is dependent on the continued operation of its assets.  There is recent precedent for this belief. The ongoing US Steel Canada bankruptcy process featured an urgent motion approved by the court to secure coke supply to preserve asset value (see Appendix E for case).  We believe AKS, should it be forced into Chapter 11, has a capital structure problem, and not a coke supply (cost) issue.

SunCoke’s plant at Middletown is strategically collocated with the furnace, delivering coke via a conveyor belt and thereby representing the best and logical supply option for the life of the furnace.  The Middletown blast furnace feeds AKS’ collocated hot strip mill.  This mill is AK Steel’s largest and most valuable asset, servicing many of the most desirable, high-quality tiers of the domestic automotive steel market.  It is also where AKS just built its new R&D center.

The other AKS furnace SXC has historically supplied is Ashland.  The Middletown blast furnace does not have the melt capacity to fill the strip mill (known as “melt short”), and as a result Ashland (located nearby) exists to supply slabs to that strip mill via direct daily rail. Haverhill II is the Company’s only contract with a cancelation clause.  This clause requires that AKS permanently retires its Ashland furnace AND “has not acquired or begun construction of a new blast furnace in the U.S. to replace, in whole or in part, the Ashland Plant’s iron production capacity” (as stated in SXC’s 10-K).  Ashland is not a well-regarded furnace among industry participants so a shutdown scenario is possible.  However, SXC is protected by the second clause because AKS has since acquired the larger Dearborn (MI) furnace from Severstal in 2014.  In a scenario where AKS shutters Ashland, this acquired capacity provision provides SXC leverage with AKS to secure its Haverhill II tonnage. Moreover, even in a scenario in which AKS had to file and Ashland were shuttered by the new owner of the reorganized assets, the Company believes its Haverhill II contract is already very competitive (on price/quality/proximity) versus the other coke supply relationships at Dearborn inherited from Severstal.  These include a contract from DTE that expires one year prior to Haverhill II and captive supply from a plant in West Virginia.  It is our understanding that this inherited DTE supply is from a very old, less competitive plant, lending credence to the view that AKS would eventually reject that contract and keep the contract they actually willfully negotiated (Haverhill II).  In all scenarios, the Haverhill II supply should remain. Notably, SXC is already shipping tonnage from Haverhill II to Dearborn on a swap agreement, as it is viewed as logistically superior supply.  In terms of when Ashland could be shuttered, AKS invested $49M to reline the bottom section (called the “hearth”) of the furnace in 4Q14.  AKS had not done a reline in 30 years and guided that another reline would not be necessary until 2019.  Such recent investment dollars imply shuttering Ashland was not in their near-term plan.

2) General Steel Issues

The market hates steel.  Taking a view on global steel is not necessary for investing in SXC, but given the correlation we figure it is worth reviewing three large themes weighing on steel stocks:

• ·         China blow-up risk and imports:  First off, domestic supply is preferred versus imports within the high-value market segments that blast furnaces serve.  As mentioned, many auto contracts are JIT.  For example, if AKS contracts to supply all the steel necessary for the fender of a Camry, they will provide as much steel as needed for the number of Camrys sold, flexing production with market demand.  Trade cases have also been filed across a range of steel grades.  All three were approved by the ITC and the Commerce Department is expected to rule on penalty levels early next year with retroactive measures in effect.  These trade cases are not expected to cure the market of import pricing pressure overnight.  However, they should yield material financial benefits to domestic steelmakers and represent an important symbolic trend of protecting a strategic domestic industry.  Moreover, we have seen recent comments suggesting there would somehow be no domestic steel capacity going forward.  We think these comments are nonsensical.  For national security reasons alone, we will never cease to have a domestic steel industry.

• ·         Electric arc furnaces displacing blast furnaces:  It is true that EAFs benefit from non-union labor and better capacity management by more easily turning production off and on versus blast furnaces.  However, because EAFs utilize scrap metal, they do not reach the high purity levels required for advanced grades of steel.  Therefore, blast furnaces will maintain relevance within the market.  As already shown, blast furnace tons in the U.S. have been relatively steady over the last several years and industry contacts we have spoken to have verified that EAFs will not replace blast furnace capacity any time soon.

• ·         Aluminum displacing steel within auto market:  The news that Ford was switching its F150 frame to aluminum created a lot of hype post-announcement in 2012.  Aluminum usage in cars has grown, but the reality is that steel remains the logical economic option for carmakers.  Aluminum is far more expensive, especially considering the fully-baked costs in switching the existing supply chain and aftermarket.  Its usage is tied to meeting onerous EPA mandates (CAFE standards), which are subject to change from political regime to regime.  Even so, innovation within advanced grade steels can stem potential future share loss.

3) Take-or-Pay Contracts…Except When Bad Stuff Happens

Twice this year SunCoke has traded down because of rumors of capacity shutdowns at customers’ furnaces.  Both turned out to be erroneous, but highlighted how skittish investors are regarding the enforceability of its contracts.  Ironically, the follow-up from customers provided a critical stress test to the SXC thesis and actually affirmed what we believe.

• ·         In March, U.S. Steel announced that it was idling its Granite City blast furnace. Although SXC’s stock immediately dropped 10%, the response from both parties was that U.S. Steel would continue to pay the $40M obligation to SXC, as is the nature of a take-or-pay agreement.  SXC would work with U.S. Steel to divert the tonnage to another facility, but without any cost burden passed along to SXC.  U.S. Steel ultimately decided against idling Granite City. One furnace remained producing while they installed a new caster at the other.  These capex dollars (~$40M) affirm U.S. Steel’s commitment to Granite City longer term.

• ·         In July there were rumors that ArcelorMittal planned to rationalize capacity at Indiana Harbor.  In response, the CEO of ArcelorMittal USA posted a statement on his blog including the following: “What I want to assure you is that we have no intention of reducing our blast furnace capacity in the United States.”  Also the rumor was specifically regarding Indiana Harbor’s West facility.  SunCoke supplies the #7 East furnace, which is the largest in North America and clearly a strategic asset to ArcelorMittal.  Indiana Harbor is strategically located close to customers with good access to raw materials.  Discussions with industry insiders confirmed this view, with the only critique of Indiana Harbor being that “it’s a bit coke short.”

• ·         As we have already demonstrated, the Company is the preferred supplier of coke to domestic blast furnaces for many reasons.  To the extent contracts needed to be re-negotiated, we believe this is truly only a risk to the extent SXC’s contracts are priced materially above market.  Instead, contracts are priced with customers to ensure SXC generates a fair, but not excessive, return on capital.  In cases where SXC has incurred more capital expenditures on plant refurbishments in the past, their customers have actually worked with the Company to increase the rates for their contracts to compensate them for this capital.  In short, while any contract can be renegotiated, is there really any benefit if SXC’s contracts are priced at market rates, and if there is no credible alternative source?  We believe only the Middletown facility’s contract, which is collocated at a highly regarded blast furnace, is “above market” by approximately $14mm in EBITDA per year.  With that said, it would be difficult to compete with SunCoke’s installed capacity because of the freight savings due to collocation, the fact that Middletown is one of the newer more technologically advanced facilities around and the high build cost of new supply.

• ·         Many of SXC’s facilities are strategically located near their customers.  This makes it less likely customers choose to switch coke providers and gives SXC incremental security for stable production.  A map of SXC’s facilities relative to their customers is provided in the Appendix B.

4) MLP Regulations

Another unwelcomed development was concern over SunCoke’s MLP status.  In early June, a fear-mongering Seeking Alpha article was published that contends SXCP is at imminent risk to lose its MLP status.  To keep this brief, the author grossly mischaracterized the risk to SXCP of the ongoing IRS MLP review.  We think this is a non-issue despite the toll it has taken on the equity.  In a worst case scenario, SXCP could lose its qualification 10 years from whenever the updated rules are published (if they are published).  Our base case remains that SXCP qualifies clearly. The Company and certain shareholders have submitted comments.  The initial IRS proposal was a draft document intended to be amended. SunCoke’s legal counsel maintains they qualify even if the rules were published as drafted.  We highly doubt that the intent of the proposal is to single out the one publicly trading coking coal provider, but instead to ensure all sorts of random things will not get MLP status. Ironically, the fact that SXC did not have a PLR for its coke assets is because they so clearly did qualify. Instead of a PLR they received a “will level” opinion from their counsel at Vinson & Elkins.  In other less clear instances SXC did seek a PLR, such as for iron ore concentration and pelletization for which they received a PLR in 2014 when considering that vertical. Lastly, does this trade like an MLP anyway?  We would be worried about this issue if we thought this was a lower than normal cost of capital because it is an MLP; at a 23% yield we do not think it matters.  In the event we are wrong and SXCP only gets a 10-year grandfathering, the theoretical impact would be the NPV of taxes beginning 10 years from now, which ends up being a de minimis amount.

5) Recent Convent Marine Terminal (CMT) Acquisition

It is unclear to us if the market viewed this deal as a negative considering the stock ran up as much as 15% post-announcement.  However, while we are on the topic of things people could hate, we figured we’d review it anyway.  The CMT facility is an export facility located on the Louisiana Gulf Coast selling thermal coal from the Illinois Basin (ILB) into the seaborne market primarily to European utilities. SXCP paid 6.9x EBITDA for the asset which was sold by an entity controlled by Chris Cline, founder of Foresight Energy (FELP). The terminal includes a take-or-pay contract through 2022 for ten million tons split between Foresight Energy and Murray Energy, the largest privately held US coal company. We think the deal was good, but not great. We like that the Cline took MLP units struck at $17.00 with a multi-year lockup and provided seller financing, and we like that the cash flows through the end of the take-or-pay contracts essentially pay for the deal, allowing SXC to retain any terminal value (no pun intended).  The asset fits with SXCP’s existing terminal business, but it clearly does not help industry taint issues.  The challenges facing the thermal coal markets are well known, but within that landscape the Illinois Basin is well positioned to survive.  Longwall production yields competitive cost per ton on high BTU coal.  High sulfur content used to be a drawback to ILB coal but the widespread installation of scrubbers by power plants removed this issue.  The facility had recently undergone a large capex project. Both customers have a B+ credit rating. Debt to EBITDA at Foresight is ~4x and it should remain cash generative for the foreseeable future.  Our diligence suggests the facility has unique access to both rail and panamax vessels for the region, unlike a neighboring facility in the region.

6) A Broken Structure With No Dry Powder

Pro forma for the Convent deal, SXCP’s leverage has reached the upper end of management’s comfort range and new unit issuance is out of the question.  Therefore, it is out of dry power for growth acquisitions, and without growth the IDRs at the GP are much less valuable.  Management plans to raise additional high yield at SXCP to term out the revolver, in which case SXCP would still have comfortable liquidity to pursue bolt-on acquisitions.  However, with such a high yield for SXCP’s units, it’s hard to imagine that strategy moving the needle. We believe management is aware that the current structure is an unsustainable home for these assets and will pursue options to remedy the situation. If the market will not reward SXCP for growing distributions then it should not do so.  We are glad to see management redirecting cash flow at SXCP into unit repurchases, which grows distributable cash flow per unit going forward, improves distribution coverage, and benefits SXC. We think the current unleveraged free cash flow valuation more than makes up for the current structural issue.  Ironically, the broken structure today might actually be the catalyst the forces value realization in the near term.  With nothing left to do, we think the options for management are fairly obvious, and we discuss a few potential pathways later.  Absent a material tightening of the SXCP yield, we would prefer for the equity to be leveraged prior to the catalyst of a potential sale.

Historical Financials

Although the financials can be confusing, there are several things worth noting that should make EBITDA and distributable cash flow even stronger going forward:

• ·         Indiana Harbor:  The Company recently completed a large refurbishment project at its Indiana Harbor facility.  Once fully ramped, Indiana Harbor is expect to contribute $40M in EBITDA (on a gross basis, of which SXC owns 85% and DTE owns 15%).  This facility contributed $16M in gross EBITDA in 2014 with guidance for $30M at the midpoint in 2015. However, the plant has underperformed targeted levels so far this year, and the Company admits they simply haven’t executed on the turnaround as quickly as they would have liked.  Updated guidance for 2015 contribution and expectations for 2016 have not been given.  Optimizing performance is a key focus moving forward as it is the Company’s largest plant by tonnage, feeding North America’s largest blast furnace.

• ·         Capex:  While capex has been elevated lately, much of the capex is due to one-time environmental remediation at the Company’s Granite City facility.  Ongoing capex needs for the core coke operations amount to just $30 - $35mm per year, as many ordinary course maintenance costs and repairs are simply passed through with the Company’s contracts.  We would expect to see this more normal capex run-rate at some point during 2016.  Although the Company’s capex disclosure makes this clear (and it is broken out above), we know that few investors are going past the cash flow statement in assessing dividend sustainability or coverage at SXCP.  Additional environmental requirements at SXC’s plants should be limited to Indiana Harbor, which has an outstanding Notice of Violation to settle with the EPA.  However, the Company believes the recent capital invested at the plant will address the majority of any potential issues from here.

• ·         Legacy Coal:  Unfortunately, the Company was unable to sell its money-losing Jewell coal operation.  While this was definitely a setback, plans are underway to streamline losses from roughly $20mm this year to $12.5mm next year.  This number is expected to decline to close to zero over time as operations are eventually shuttered.

• ·         Coke Operations:  Generally, the Company has delivered strong operating performance at its coke plants, frequently running above nameplate capacity. SunCoke’s contracts stipulate production minimums, coal–to-coke yields, and operating cost components subject to pass-through or inflation adjustment provisions.  The last major operating issue was at Indiana Harbor in 2011 when ground instability issues led to a production shortage of 122k tons.  SunCoke was obligated to make third party purchases below its selling price in order to meet this shortfall.  This issue led to its engineering study and subsequent capex program at Indiana Harbor.  Alternatively, if SXC produces above the design basis of its plants it can pursue spot sales for excess tonnage.  Solid operating performance in 2013 enabled a spot sale of 50k tons to Essar Algoma.

Valuation

The following is the run-rate earnings power for SunCoke’s assets, hopefully achievable in 2016 depending on the speed at which Indiana Harbor is brought to full profitability. This can be pieced together from various presentations and we have reviewed it with the Company. This assumes a fully ramped Indiana Harbor.

The traditional way to value SunCoke is using a sum of the parts within the MLP structure. We present this case below at variable yields. This contemplates SXCP limits distributions to the $2.42 level guided for 2016 pre-acquisition announcement last quarter. This would translate to roughly $150M in total DCF and a 1.25x coverage ratio, leaving ample flexibility to increase distributions and/or justifying a lower yield given the enhanced coverage.  It is worth noting that as the Company continues to buyback LP units, every $10mm in repurchases at SXCP is accretion of roughly $.02/unit at SXCP.

Even at very modest yields for what we believe is a very stable MLP, there is substantial upside in the common shares of SXC.

The issue with SXCP is of course that there are no direct comps and this is largely a stranded MLP.  Another approach would be to value SXCP as though it was an unsecured creditor of its largest customers, an outcome that would yield a substantially higher price. If one were to utilize a weighted-average of the current unsecured bond yields at customers, the yield implied would be approximately 13%.  For reasons discussed previously, we actually believe SXCP should trade tighter, given its role as a critical vendor and because they are a crucial supplier for ongoing operations.  While we certainly believe it will help for SXCP to continue purchasing their own units, even at a 12% yield, SXCP is hardly a financing vehicle.  We also believe a potential outcome for this situation is a collapsed structure where SXC simply bids for third party units in SXCP.  Such a transaction would remove complexity and improve liquidity at the expense of losing the MLP’s tax benefits, but at a yield of 23% we do not believe it is priced to include these benefits anyway. The following analysis shows what that might look like. Such a transaction should be considered attractive to SXC considering it would be taking back units below issuance levels.

In this consolidated structure SXC could payout a generous dividend and redirect remaining cash flow to share repurchases, organic growth, or deleverage.  We hardly think an unleveraged FCF multiple of ~14x or a leveraged FCF multiple of 10x is expensive for long-term contracted assets, and it is worth noting that this multiple would yield more than 129% upside relative to today’s price. More striking is the fact that at today’s price SXC trades at just 4x FCFE in the collapsed structure.  Below, we show the same transaction assuming SXC issues equity to fund the transaction.

We certainly do not expect that management would pursue this new issuance option in such a transaction.  It would be a blatant admission of error considering the Company has been repurchasing shares well above today’s prices.  However, we include the analysis just to demonstrate that even in such a case SXC shares are cheap.

Framing the Downside

Despite many positives during the year, SXC and SXCP securities have continued to trade lower.  The important question to ask then is what the fundamental (and not mark-to-market) downside really is.  SXCP has grown distributions for 9 straight quarters. Prior to the recent acquisitions, SXCP was targeting a coverage ratio of 1.10x. Within that calculation, the Company removes a noncash replacement accrual, so the actual cash coverage ratio is higher. That target was in place before the recent acquisitions. The existing distribution guidance target is $2.42/unit annualized exiting this year. This implies ~$113M in gross DCF assuming a 1.10x coverage ratio, or the upper range of 2015 DCF guidance pre-acquisitions. DCF accretion from the CMT acquisition was guided at $0.20/LP unit, which translates into ~$30M in gross DCF after netting out capex and new interest expense. Adding DCF contribution from the second Granite City drop should sum to roughly $150M in total DCF in 2016. Assuming management maintains the $2.42/unit distribution level, we estimate the implied coverage ratio at 1.24x. So by looking purely at contracted cash flows, SXCP should be able to comfortably meet this distribution.  Importantly, this does not give SXCP credit for any unit purchases completed as part of its recently announced $50mm unit repurchase plan.  As an aside, if one believes there is no terminal value in these assets, coverage is actually better because there is nothing to replace in the future, and the replacement capex accrual should be eliminated.