Description

Thesis Overview: SunCoke Energy (SXC) was spun off from Sunoco in 2011 and has since stayed under the radar due to what we believe is a misperception of the company’s business model. While analysts have grouped SXC with steel and coal companies, long term take-or-pay contracts with cost pass-through provisions protect SXC from market volatility (akin to a toll collector). Unlike steel companies whose utilization rates dropped to 50% in 2009 and are currently grappling with widespread oversupply, SXC has continued producing per its agreements and growing its manufacturing capabilities. We believe SXC offers both steelmakers and equity investors a compelling and valuable proposition. SXC has modest debt, generates a tremendous amount of cash, and management has invested in SXC since the spin. At 10x 2012 run rate Ebitda – maint. Capex (their Middletown, OH facility comes on line mid-2012), we derive a target price over $25.

Value to Customers: For steelmakers, SXC provides a steady supply of coke used in blast furnaces to convert iron ore to iron. Its leading hardware and process technologies offer low emissions, operational flexibility, and low electricity consumption, and it remains the only company that has produced a new Greenfield coke plant in the United States over the past 25 years. SXC builds coke-making facilities near its customers’ steel operations in which it produces higher yielding coke under 20 year take-or-pay contracts at a lower cost than that available in the merchant market.

The majority of existing coke producers uses utility by-product ovens, which generate higher levels of toxic gas, liquid and solid waste materials. SXC’s lower emission heat recovery ovens even produce electricity it sells to steelmakers.

Steelmakers also have the option of using natural gas in their blast furnaces; SXC management expects steel producers to continue to blend natural gas in their furnaces to reduce expenses when coal prices rise. However, natural gas cannot supplant coke unless the steelmaker constructs an entirely new facility designed for natural gas. Industry commentary suggests many steelmakers are unwilling to risk sufficient capital to build a Greenfield plant and recognize SXC’s coke is both superior and lower cost than imported or self-produced coke.

Value to Investors:  SXC offers investors exposure to highly-structured contracts that provide recurring cash flows and significant incremental, low-risk earnings growth as new plants come online. SXC’s business model mitigates downside risk in an uncertain macro environment. Take-or-pay contracts provide cash flow security with targeted volume ranges and earnings levels set at contract inception and seek to pass coal, transportation, and certain operating expenses directly onto customers. The company also retains additional upside given its ownership of coal assets. Contracts allow SXC to pass-through coal costs, but if SXC can acquire its own coal more cheaply than that available in the open market, it profits the difference. We do not view SXC as a coal company given coal will only contribute ~10% of EBITDA, though we do believe earnings may receive a boost from improved coal operations in the coming years.

Growth Opportunity: We expect strong growth in 2012 due primarily with bringing on their new Middletown Ohio facility and the absence of start-up and other one-time costs incurred in 2011.  For 2013 we expect more modest 10-15% EBITDA growth (primarily a full year of Middletown) and thereafter see further earnings upside from 1) a 1.1mm ton domestic multi-customer plant coming online in 2015; 2) replacement of retiring aging coke plants in the US, and 3) international coke-making facilities.

SXC plans to bring online a new multi-customer facility in 2015 that will be twice the size of the latest plant, Middletown, with lower capital costs per ton. Improvements in technology and benefits of scale should drive EBITDA margins well above the $50/ton average for domestic coke plants and add at least $60mm in recurring EBITDA.

SXC should benefit from the eventual retirement of much of North America’s existing coke-making capacity. While plants in Brazil, Russia, Poland, India, and other developing countries are ~15-20 years old, the average age of coke plants in the US, Japan, and Canada is between 30 and 40 years. As plants are decommissioned, steelmakers will be forced to either increase their dependence on imported materials or contract/construct new domestic capacity. Over the last several years, steel producers have preferred to outsource the supply of coke to SXC via long-term agreements, and since 2005, SXC has constructed and contracted ~2.3mm tons of annual production. SXC expects 3mm tons of North America coal-making capacity will be in need of replacement; US Steel will likely undertake production for 1.5mm of capacity, leaving 1.5mm to be filled by imports or SXC capacity.

Finally, SXC can expand its international footprint with little capital risk.  For example, according to management, the Indian market is structurally short both coke and power; SXC supplies both at highly competitive prices, making India a natural fit for future SXC growth. 

Risks: The primary investment risks include failure of a major customer (SXC currently has only three primary customers, MT, AKS, and X, with MT accounting for 70% of sales), a high adoption rate for coke substitutes that would lower the demand for metallurgical coke, prolonged downturn in North American steel production, and operational issues. Longer term, we do expect steelmakers to continue using increasing amounts of natural gas in their blast furnaces, though even aggressive expectations do not jeopardize SXC earnings in a material way over the coming decades.

Valuation: We expect the company to generate a significant amount of cash this year (at least $200mm before growth investments) and to use that cash in a shareholder-friendly manner. Peer companies which we believe have earnings characteristics similar to those of SXC such as Air Products and Praxair trade between 13 and 18x EBITDA less Maintenance CapEx. Over time, investors have rewarded these companies for characteristics that closely mirror those of SXC: long term contracted high margin earnings with growth potential. 

Based on $300mm of EBITDA (2012 guidance plus Middletown for a full year of opereations)  less maintenance capex of $60mm valued at 10x yields a target price of $27, presenting significant upside. On an EPS basis, SXC should report $1.50 this year and $2.00 in 2013.  Investors get “for free” the 2015 facility and any international expansion. Finally, the company has announced it is considering converting the coke operations to an MLP structure, which would provide even further upside.

Catalyst