Description

SunCoke Energy Partners (Ticker: SXCP)

A write-up on SunCoke Energy Partners (SXCP) was previously published in January 2013 describing the business and the MLP GP/LP relationship.  SXCP is a Master Limited Partnership (MLP) formed by SunCoke Energy (SXC) and currently operates two coking coal facilities under long-term take-or-pay contracts with third party customers (importantly without any commodity price risk) and coal handling facilities with indirect commodity risk.  Since the middle of August, its shares have fallen 23% (or 20% adjusted for its quarterly distribution) for reasons we believe are completely unwarranted.  We are recommending taking a long position in the stock as we think the current valuation with an 8.4% dividend yield and 50% upside over the next two years with very limited downside is quite compelling. 

Recent Trading Activity

Even though SXCP does not have other publicly-traded comparable MLPs, its stock price collapsed in the broader MLP sell-off (the Alerian MLP Index sold off 10% from its peak (adjusted for dividends) through mid-October due to fears of the impact of the oil price decline) and the coal sector implosion (shares of the Russell 3000 Coal index were down from early August through mid-October by nearly 30%). We believe the SXCP price decline is entirely undeserved because the company has no exposure to either coal or oil prices.  Since mid-October, SXCP shares have continued to languish while the Alerian MLP index is back to its mid-August level (adjusted for dividends) and the Russell 3000 Coal index has halved its losses.  Due to its illiquidity, SXCP’s share price also likely suffered from one of its largest holders shutting down its operations. 

Plan for Drop-Downs

SunCoke Energy (SXC, the parent company to SXCP) continues to prepare for the contribution of its three other coking coal facilities to SXCP over the next two years assuring SXCP of an 8-10% CAGR in distribution growth through 2016 to $2.40-$2.53 per share from the current annualized distribution of $2.11 per share. 

In Q2, management noted it had the capacity to raise its distribution by 5%, so we anticipate the Q4 distribution to be at least $2.16 per share (annualized).  Also, management has already suggested that the next drop-down will be its Granite City plant and is actively preparing for the drop-down.  We believe this will be announced when management gives its 2015 guidance in December.  Given SXCP’s low stock price, management fully understands that selling equity at the current price is not attractive.  In addition, SXCP has an additional 0.7-0.8x of debt capacity and management is open to using it to make the next drop-down fully debt financed.  Management also noted that like its first drop-down, it can drop-down only a portion of Granite City for the next drop-down.  Assuming 50% of Granite City is dropped down using all debt, we believe this would add at least $0.10/share of accretion.  So the PF distributable cash flow by the end of 2014 should be $2.26/share implying shares are actually currently yielding 9%. 

Management’s 2016 distribution guidance is dependent on stock prices for SXCP that are higher than today’s stock price.  The low end of the range can be reached with equity prices in the high $20s and the high end of the range requires higher equity prices than that.  We think management also has some flexibility to lower the price of the drop-downs making them more accretive to SXCP given that this increases the value of the IDRs for the GP, which is owned by SXC.  There is a delicate balance here, but management’s interest is making SXC a pure-play GP (ie dropping all of its assets down to SXCP) to enhance its value so it needs to successfully complete the drop-downs for that to occur.   This further underscores why management is keenly focused on increasing SXCP’s share price as soon as possible.      

Also, management announced this past quarter that it would be able to drop-down its Brazilian assets with $18MM of EBITDA and $15MM of cash flow, which will be additionally accretive to its 2016 guidance. 

Valuation

Today, SXCP trades at an 8.4% dividend yield based on its current distribution. MLPs with similar distribution growth profiles and much less predictable and stable cash flows, trade at yields between 5-6.5%.  Even at a 6-7% yield on the $2.40-$2.53/share 2016 guidance, the stock should trade at $34-42 representing 36-68% upside. 

New Kentucky South Shore Coke Plant

SXC has also made substantial progress toward the construction of a new coking coal facility, which contractually effectively must be sold to SXCP thereby assuring a longer runway of distribution growth and at least another $0.20/share of accretion assuming it is dropped down when the high GP/LP splits are reached.  SXC has received all of the permits it needs for its new coke plant and currently is discussing contracting the plant with potential customers.  The Company has said it will begin construction after it receives contracts for 60-70% of its capacity. We believe the Company will secure contracts for the plant by the spring or summer of 2015, will begin construction in 2015, will begin coke production in 2017/2018 and will drop-down the plant to SXCP in 2018.   There are four potential customers for the plant (AK Steel, Arcelor, US Steel, and Essar Algoma).  AK Steel will likely decide their coke needs given their recent purchase of its Severstal plant over the next three months.  Arcelor is currently evaluating buying a US Steel coke plant from US Steel’s Canadian subsidiary’s bankruptcy, which should be determined between now and the spring of next year, after which it will be in a position to sign a contract with SXC.  US Steel has said its coke production is in balance, but it could still be a small customer.  And if Essar Algoma gets recapitalized, it could potentially be a customer.  Our confidence that the plant will get built is further bolstered by the fact that the economics of buying coke from SXC is compelling compared with importing it from China, the marginal producer of coke today.  Finally, the additional accretion from the new coke plant will help compress SXCP’s current yield as it becomes clear to the market that the plant will be built.  

M&A

SXCP completed two M&A transactions last year, but has made no progress on M&A in 2014.  This has certainly been a disappointment, but represents a significant source of upside for shareholders.  The Company has made multiple bids for other companies particularly in the coal industry, but believes it has not found success due to the lack of willingness of sellers to part with their assets.  We do think it is commendable that management has been disciplined with M&A.  And given the continued troubled state of the coal industry, we believe there will be more willing sellers in the future making M&A more fruitful.  In addition, management is going to look at M&A in other types of material handling businesses outside of the coal industry, which should also be fertile ground.  And management is in particular evaluating other private equity owned material handling businesses where the owners may be more motivated sellers.  Management understands M&A would be very helpful to show the additional growth potential for SXCP beyond SXC’s future drop-downs and recognizes this would bolster the case for a lower yield for SXCP today. 

DRI Opportunity

The Company has determined that income from a DRI plant would qualify for being contributed to an MLP.  The market for DRI is very customer specific, so it is not clear whether SXC will be able to contract for the construction of a DRI plant.  The Company has been in discussions with one customer recently, so it is possible that a DRI plant could be built.  Like the new coke plant, this has the dual benefit of being accretive for SXCP and the future accretion helping compress SXCP’s current yield. 

MLP Share Buybacks

As noted, management recognizes the clear need to increase SXCP’s share price as fast as possible.  They acknowledged that the MLP could buy back its shares to increase its per share distribution.  While liquidity remains a challenge for SXCP likely making this not the first choice for most investors, it demonstrates management’s willingness to explore all possible options for increasing the Company’s share price. 

Recent Earnings

Notwithstanding the share price decline, SXCP reported a solid Q3 performance on October 24th and management reiterated its full year-guidance. This was not surprising as the majority of Company’s business is contracted and highly predictable.

Downside Protection

At a 9% yield pro forma for the next drop-down (as described above), we believe there’s very limited down-side here.  SXC’s coking coal facilities have useful lives of at least 30-40 years and management has demonstrated the value of their existing facilities to their customers through the recent renewal of the contract for the Indiana Harbor facility.  When the contract on the facility was renewed, the price charged actually increased as the Company will be paid for the additional capital it is investing in the facility on top of the previous contract’s price.  Therefore we believe the future distributions for the MLP will be sustained far past the current decade-plus life of SXC’s take-or-pay contracts. 

In addition, management and the board understand that the steel industry going forward needs SunCoke’s facilities but not necessarily SunCoke the corporation.  And as such, we believe they will be commercial if an interested buyer, particularly a larger GP/LP enterprise that could use the accretion from the SunCoke system, expresses interest. Therefore if both SXC and SXCP’s share prices continue to trade at these levels, we believe selling the SunCoke ecosystem is a viable path for management to ensure shareholder value is created. 

Overall, we find SXCP to be a very attractive risk-reward at this price and believe that the technical pressures that have brought this stock to this point will soon be alleviated by solid execution. 

Risks

Risks to SXCP include a material deterioration in the outlook for the North American steel industry that would result in a delay in the construction of its new coking coal facility or in a severe scenario, would cause result in a decrease in coke demand testing the company’s take-or-pay contracts.  In addition, material delays in the ability of SXC to drop-down its assets to SXCP or a significant widening of yields for the MLP industry could dilute returns.

Catalyst

Management is planning to issue 2015 guidance in December 2015 and we believe will likely announce the partial drop-down of SXC’s Granite City facility.  The only reason we think this would not occur is if management is successful in pursuing an M&A transaction or is close to announcing a transaction.