Description

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At current levels, an investment in Sunoco (NYSE: SUN) presents a compelling risk/reward profile with a 2H 2011 catalyst that ought to unlock material value in the shares. I believe that on a SOTP basis, SUN's share price implies very conservative valuations for the company's various businesses and assets. Accordingly, I believe the risk of permanent capital impairment in low, and there is a high probability of a 30%-50% return over the next 12-18 months.

I believe the 2011 IPO (and eventual spin) of SunCoke Energy (SCE) will highlight the substantial value of that business. Additionally, I believe that removing that asset from SUN will simplify the legacy SUN structure and thereby enable the market to more appropriately value the components of the business. Critically, through the divestment of certain refining and chemical assets and the growth of its retail and logistics business, legacy SUN is in the process of transforming itself into a company focused on logistics, terminals, pipelines and retail. The transformation will increase the attractiveness of the legacy SUN assets as they will be increasingly less associated with the refining business.

In addition to SCE, there could be multiple other catalysts over the next 12-18 months as SUN divests or restructures certain assets. SUN management has been very open about the fact they are willing to sell any and all of their assets (SCE included) at the right price - and recent sales testify to that. Indeed, SUN may be a company in slow motion liquidation and asset sales at levels above where the market is giving SUN credit will unlock shareholder value.

Assuming SCE is spun-out with reasonable leverage, SCE will likely upstream to SUN $500-$700mm in cash.  Including cash currently on the balance sheet, SUN could have ≈$12.00+ in net-cash per share with very few opportunities to deploy that cash. A special dividend, therefore, seems likely.

Why the opportunity exists: foremost, I believe SUN is mispriced because market participants overwhelmingly associate SUN with its troubled refining operations. Sell-side analysts pay an inappropriate and disproportionate amount of attention to this part of SUN's business. However, in almost any scenario the portion of SUN's value attributable to refining is minimal, and management's strategy will further reduce the significance of the segment.

I believe a number of other factors contribute to SUN's mispricing and thereby provide an opportunity in the stock:

• 1) SOTP value - the disparate businesses held by SUN each require distinct analysis and the company is not correctly valued on a standard EV/EBITDA or P/E basis.
• 2) Unlevered balance sheet - on a consolidated basis, SUN appears to have a meaningful net debt position - however, after deconsolidating the portion of debt related to SUN's ownership of Sunoco Logistics (NYSE: SXL), SUN emerges with a net cash position.
• 3) Undervaluation of SCE - the market is unlikely to apply an appropriate multiple to the high quality earnings stream of SCE while it remains under consolidated SUN. Additionally, management has likely provided conservative 2012 EBTIDA guidance for SCE.
• 4) Undervaluation of GP in SXL - the market is likely undervaluing SUN's GP interest in SXL.
• 5) Undervaluation of LIFO inventories - the market is likely not giving SUN credit for the market value of its crude and refined products inventory in excess of their reported book value.

Business Overview:

SUN is organized into five business units:

• 1) Logistics - conducted through Sunoco Logistics Partners L.P. (NYSE: SXL), in which SUN owns a 29% stake of the LP interest and the entirety of the 2% GP interest.
• 2) Retail marketing - retail sale of gasoline and middle distillates and the operation of convenience stores in 23 states.
• 3) Chemicals - manufactures, distributes and markets commodity and intermediate petrochemicals.
• 4) Refining & Supply - owns and operates two refineries which are located in Marcus Hook, PA and Philadelphia, PA.
• 5) SunCoke Energy - owns and operates four metallurgical coke plants in the US; also owns and operates metallurgical coal mines located in VA and WV.

Logistics:

SUN's logistics business is conducted through Sunoco Logistics Partners L.P. (NYSE: SXL). SXL operates refined product and crude oil pipelines and terminal and conducts crude oil and refined products acquisitions marketing activities in various regions of the US.

SUN owns 29% of the LP interest (9.9mm units) and the 100% of the GP interest in SXL.

I am not going to delve deeply into SXL. The short of it is this: the vast majority of SXL's earnings stream is fee based in nature and I believe SXL's assets are high quality. Whether the whole the MLP group deserves to trade at the yield it current does is debatable, but on a relative basis I believe SXL is fairly valued.

The LP units are publicly traded and thus valued at market prices.

With regards to the GP interest:

To value the combined LP and GP stake: simplistically, we could fully tax the market value of the LP units and fully tax the DCF value of the GP stake. However, that approach appears to understate the value of the LP and GP stake. Conceivably - and not wholly unlikely - SUN could spin-off the retail marketing and refining divisions, leaving legacy SUN as a C-Corp holding only the LP and GP stakes in SXL. Based on comparable multiples for C-Corp entities holding LP and GP units in MLPs, a least an 18x DCF multiple appears reasonable. I estimate SUN will collect ≈$100mm in cash flow from the LP and GP stakes in 2011 and ≈$110mm in 2012.

Retail Marketing:

The Retail Marketing business consists of the retail sales of gasoline and middle distillates and the operation of convenience stores in 23 states. In total, SUN operates 4,921 retail outlets, primarily in the

East Coast and Midwest United States.

The retail business is really three businesses:

• 1) Retail fuel business - SUN operates retail fuel stations itself, as well as distributes fuel to affiliated parties
• 2) Convenience store business - many of SUN owned & operated stores include attached convenience stores
• 3) Real estate business - SUN leases company owned properties to affiliated dealers

SUN itself owns and operates only 388 of locations of the entire store base. Another 482 stores are leased by SUN to independent dealers. By in large, SUN's retail business involves the distribution of fuel to distributor outlets - sites that sell Sunoco fuel but locations which SUN does not own, lease or operate:

This is not a great business, but it is a decent one that generates relatively stable earnings on an annualized basis. SUN management claims that Retail Marketing has generated mid-teens ROIC over the last ten years. As of YE 2010, SUN's net investment in Retail Marketing was $709mm, with total assets of $1,114mm - thus, the mid-teens ROIC appears validated.

Presented below are basic earnings numbers for SUN's Retail Marketing since 2003:

I have excluded 2008 from the calculation of normalized earnings because SUN benefited massively that year from the sharp decline in oil during 3Q and 4Q. The most basic rule of thumb in fuel retailing is this - the direction of the trend is what matters. Retail fuel prices lag the wholesale markets: accordingly, as crude and refined product prices climb, retail prices cannot keep pace and margins contract; conversely, as crude and refined product prices fall, retail prices do not decline as quickly and margins expand.

I believe 5.0x-7.0x normalized EBTIDA of $220mm-$260mm is reasonable for this business.

There is substantial embedded real estate value in the Retail Marketing business. Of the 870 company owned locations (both company operated and leased), SUN owns the land and buildings on 650-700 of them. I believe market value per location averages $1mm-$1.5mm, implying value of $675mm-$1bn. I believe real estate provides a floor value, but 5.0-7.0x  EBITDA is a more reasonable valuation for the business. 

Chemicals:

SUN's chemicals business manufactures, distributes and markets commodity and intermediate petrochemicals. SUN produces aromatic derivatives including phenol, acetone, biphenol-A, and other phenol derivates.

On May 18, 2011 SUN announced that it had sold its 1bn lb/yr phenol and acetone manufacturing facility in Philadelphia, PA (Frankford facility) to Honeywell for $85mm ($25mm for the facility and $60mm for the inventory).

The Frankford plant came attached with an unfavorable contract that severely reduced plant profitability. Of the 1.1bn lbs of Phenol capacity, SUN was obligated to supply 745mm lbs at phenol at cost. Effectively, therefore, SUN sold a 300mm lb facility for $25mm ($60mm balance allocated to inventory). Additionally, SUN and Honeywell had repeatedly been involved in lawsuits over the contracts, resulting in additional expenses incurred by SUN. There is no question SUN was trying to put the hassle of the Frankford facility behind them. So based on the Frankford sale, a $100mm+ seems a reasonable estimate for the Haverhill plant.

Refining and Supply:

SUN owns and operates two refineries which are located in Marcus Hook, PA and Philadelphia, PA.

SUN management has a decidedly bearish view of the US refining industry, and of Northeast refining in particular. SUN management sees little hope for an industry recovery, and expects margin pressure to persist. Accordingly, SUN has been selling and shutting down certain refining assets in order to maximize profitability and focuses resources towards growing the company's retail marketing and logistics businesses:

• - Tulsa, OK Refinery - transaction closed 2Q09
• - Westville, NJ Refinery (Eagle Point) - shut down 4Q09
• - Toledo, OH Refinery - transaction closed 1Q11

SUN's refining assets have two sources of value:

• 1) Actual refining assets - I believe these are worth anywhere from $0 to $1bn+
• 2) Inventory - I believe that on an after tax basis, SUN's inventory is represents at least $300mm in value

Transactions:

Tulsa - sale closed June 1, 2009; sale price for refinery was $65mm; implied price per complexity barrel was $73.50

Toledo - sale closed March 2, 2011; sale price for refinery was $400mm, plus possible earnout of $125mm; implied price per complexity barrel was $242-$318.

Presented below is a snapshot of SUN's sold, shutdown, and operating refining capacity - assuming $125 per complexity barrel of operating capacity, SUN's refining assets are worth ≈$500mm:

Comps:

I'd recommend Barclay's reports as a good source for comp valuations for refiners. The report adjusts EV for a variety of items to arrive at a clean EV/complexity barrel. Based on the recent numbers, Barclays has SUN trading at ($119) on an EV/complexity barrel basis; the group as a whole (including SUN) trades at a median valuation range of $673 on an EV/complexity barrel basis. SUN's assets deserve a lower valuation given their geographic locations in the NE. However, NE assets such as Valero's Paulsboro asset have transacted at recently at north of $200/complexity barrel.

Inventory:

SUN accounts for its inventory according to LIFO accounting. Accordingly, due to the prolonged increase in prices of petroleum and related products, the market value of SUN's inventory is dramatically in excess of the value stated on SUN's books.

From SUN's 10K: "The current replacement cost of all such inventories, including inventories classified as assets held for sale, exceeded their carrying value at December 31, 2010 by $3,119 million. Inventories valued at LIFO, which consist primarily of crude oil and petroleum and chemical products, are readily marketable at their current replacement values."

As IR presents it, the embedded value of the inventory is ≈$300mm:

However, I believe that IR's calculation is conservative insofar as it does not offset the crude payables with the crude receivables; if we did that we get to a significantly higher value:

Foremost, SCE plans on returning their NE refining assets to sustained profitability. Should that not prove possible, SUN will convert the assets into crude terminals that can be dropped into SXL, likely receiving LP units (or cash) in return and driving he value of their GP stake.

Related, I believe that SUN will - in the near term - convert their Eagle Point refinery (currently shut down) into a crude storage terminal. Presently, it's difficult to establish the value of the Eagle Point refinery as a terminal asset. Simplistically, the value should be ≈10x EBITDA, with EBITDA = capacity * utilization * price. However, SUN will not disclose EP's capacity. My $50mm-$200mm valuation is based on discussion with SS analysts - and therefore is not entirely reliable.

Coke - SunCoke Energy:

SunCoke Energy (SCE) manufactures high-quality coke for use in the production of blast furnace steel.

In the United States, SCE's facilities have the capacity to manufacture approximately 3.67mm tons annually of high-quality metallurgical-grade coke.

SunCoke is also the operator of, and has an equity interest in, a 1.7 million tons-per-year cokemaking facility in Vitoria, Brazil.

SCE is characterized by long term take-or-pay (ToP) contracts with leverage to improving metallurgical coal prices. As a standalone company, SCE will be headed by Fritz Henderson, CEO of GM between March and December 2009.

Essentially all of the production from SCE's four US plants is sold pursuant to long-term take or pay contracts with the following customers:

Indiana Harbor - ArcelorMittal through 2013

Jewell - ArcelorMittal through 2020

Haverhill - 50% to ArcelorMittal through 2020; 50% to AK Steel through 2022 (early termination provision beginning in November 2014)

Gateway - US Steel through 2024

Additionally, the technology and operating fees, as well as preferred dividends pertaining to the Brazilian cokemaking operation are payable to SCE under LT contracts (through 2021) with a project company in which a Brazilian subsidiary of ArcelorMittal is the major shareholder.

SCE also owns and operates metallurgical coal mines located in Virginia and West Virginia. In 2010, 82% of SCE's metallurgical coal production was converted into coke at the Jewell plant and 18% was converted into coke at the Indiana Harbor, Haverhill and Gateway plants.

In April 2010, SCE commenced a project to expand its coal production by approximately 500K tons per year, from 1.2mm to 1.7mm tons. Additionally, in January 2010, SCE announced the acquisition of Virginia based Harold Keene Coal Co., Inc. for ≈$40mm. Harold Keene currently produced 250K-300K tons of coal annually. Accordingly, by late 2012 CE will be producing two million tons on an annualized basis.

Middletown:

In March 2008, SunCoke Energy entered into a coke purchase agreement and related energy sales agreement with AK Steel under which SunCoke Energy will build, own and operate the Middletown cokemaking facility and associated cogeneration power plant adjacent to AK Steel's Middletown, OH steelmaking facility. The project will cost $415mm in total. Through March 31, 2011, expenditures related to Middletown totaled $310mm.

The Middletown plan will produce approximately 550,000 tons of coke annually and AK Steel has agreed to a 20 year take-or-pay agreement for all of the coke (as well as electrical power - 44 megawatts) produced from the facility.

Middletown will be completed in late 2011 and will contribute fully to EBITDA in 2012.

ArcelorMittal Litigation:

In July 2009, ArcelorMittal initiated legal proceedings challenging the prices charged to ArcelorMittal under the Jewell coke purchase agreement. In August 2010, ArcelorMittal presented SCE with additional bases for challenging the prices charged for coke produced at the Jewell facility as well as its Haverhill facility and also presented its notice of intent to arbitrate outstanding issues relating to the Indiana Harbor facility.

In January 2011, SCE and ArcelorMittal reached settlements around these issues. Effective January 2, 2011 amended agreement became effective whereby the fixed coal cost adjustment factor in the Jewell agreement was eliminated and the operating cost and fixed fee components payable to SCE were increased under both agreements. Critically, the parties also agreed that volumes under both contracts will remain ToP through the end of the contracts in December 2020.

In February 2011, SCE and ArcelorMittal entered into a settlement to resolve the Indiana Habor arbitration claims. 

Presented below are summary results for SCE - 2007-2010:

As presented (see below), 2011 EBITDA guidance is meaningfully weaker than 2009/2010 - a number of factors contribute to that:

• - Negatively impacted by: decrease in contract with ArcelorMittal, pursuant to the aforementioned
• - Negatively impacted by: transition & stand-alone costs starting in 2011
• - Positively impacted by: full year of Gateway operations in 2011

The substantial step up in EBITDA for 2012 vs. 2011 is a function of:

• - Full year of Middletown operations
• - Jewell coal mining expansion
• - $10/ton higher coal price assumptions for 2012 vs. 2011

I think management is likely sandbagging SCE 2012 EBITDA guidance - I highlight three points:

• 1) Indiana Harbor Contract - this contract is currently losing money because SCE not meeting their minimum production requirements at the facility. To the extent these can be reserved by 2012, there could be meaningful upside to SCE's 2012 EBTIDA guidance.
• 2) Coal price sensitivity - by 2012, SCE's coal price sensitivity will mean that a $10/ton move in coal prices impacts EBITDA by ≈$20mm. SCE is currently assuming $175/ton coal price for 2012 - however, SCE does not have that capacity under contract. Currently, metallurgical coal settlements are meaningfully north of $200/ton. If prices hold, there should be substantial upside to SCE's 2012 EBITDA guidance.
• 3) Transition & stand-alone costs - SCE appears to be assuming ≈$60mm in corporate unallocated standalone costs. That number appears on the high end. For 2010, SUN recognized total Corporate Expenses of $109mm. Therefore, assuming $60mm to SCE seems excessive. Moreover, to the extent that we ding SUN on a SOTP basis for the impact of corporate, we should keep in mind to not fully ding them twice.
• 4) As previously mentioned, management had stated that their goal was 2mm tons of production by late 2012. However, at recent meetings, management has indicated that their production target for YE 2012 might be higher.

SCE has growth opportunities. Management has stated a goal of doubling production in this business over the next ten years (between 2004 and 2011, SCE's production tripled). More specifically, on the 1Q11 call, management disclosed that they are in the process of permitting/planning a 1.1mm ton plant in Kentucky. Additionally, there could be significant international growth opportunities.

Based on the SCE S-1 and discussions with the company, I believe that all in mining costs for SCE were ≈$100/ton (including DD&A) for 2010. I assume that number moves up to ≈$115/ton by 2012. Within SUN's guidance for 2012, SUN will not disclose the breakdown of coke vs. coal EBITDA, nor the assumed coal production levels. That said, existing 2012 SCE guidance assumes managements goal of reaching run-rate coal production of 2mm tons by late 2012.

The analysis below attempts to estimate the contribution of coke vs. coal EBITDA in 2011 and 2012 EBITDA guidance. The upside $340mm EBITDA figure assumes the higher run-rate coal production.

Given the contracted nature of SCE's earnings stream and the potential for growth, I believe 7.0x-9.0x EBITDA multiple for the coke business is appropriate. I believe 4.5x-6.0x multiple for the coal business is appropriate.

After the spin occurs, I believe that SCE management will take a close look at putting their US coking assets in a MLP structure. Such a conversion would significantly lift the value of SCE. Even if SCE does not in fact pursue that strategy, there is embedded value in the option itself.

As for their US coal assets, I believe it is likely that SCE will look to sell the assets after the company successfully increases production. The US metallurgical coal industry has already undergone substantial consolidation. Assuming a 5.0x-7.0x EBITDA multiple (on 2012E numbers), SCE's coal business could sell for $500mm-$800mm.

Consolidated Valuation:

Balance Sheet:

The table below presents the adjustments a 'trued up' version of SUN's net debt (cash) position as well as other relevant liabilities that ought to be added to get to enterprise value:

I think there are various sources of upside to the model above - specifically:

Additionally, other sources of potential upside include:

• - Greater than assumed value in crude inventories
• - Lower pension liability (partly a function of SUN stock price)
• - Significantly higher than assumed coal price in 2012 and beyond

Lastly, I believe appropriate capital structure for SCE and SUN will also help to generate additional shareholders value. As the analysis below presents, following the SCE IPO and spin, SUN should have between $9 and $20 per share in net cash to distribute to SUN shareholders:

The analysis below presents what legacy SUN will look like, following the SCE IPO and spin. Note - the analysis assumes zero value for refining (outside of $300mm for inventories). The major upshot is that the reaming SUN will be trading at 2.9x-6.8x combined Retail Marketing and SXL (EBTIDA (LP and GP received DCF).

Risks:

• - Continued issues at refineries resulting in further shutdowns
• - Continued issues at Indiana Harbor coke facility
• - Poor allocation of excess cash on BS
• - Macro issues that severely impact steel industry (SCE) and/or result in meaningful drop in gasoline consumption (Refining and Retail Marketing)

Catalysts:

• - SCE IPO and spin
• - Sale of remaining chemical asset
• - Conversion of Eagle Point to terminal and dropdown to MLP
• - Profitability at refineries and sale of assets
• - Special dividend or large share buyback

Catalyst

• - SCE IPO and spin
• - Sale of remaining chemical asset
• - Conversion of Eagle Point to terminal and dropdown to MLP
• - Profitability at refineries and sale of assets
• - Special dividend or large share buyback