Description

“Can investing really be this easy?”  That was the question posed to me by a colleague of mine after I informed him that the IPO of SunCoke Energy Partners, L.P. (SXCP) had priced at the low end of its range ($19) and had subsequently fallen to an approximately 9% yield by the close of its first day of trading (1/18/12).  With long term take or pay contracts, strong sponsor support (SXCP’s GP is SunCoke Energy [SXC]) including a 5-year revenue guarantee, a long dropdown runway from SXC and the potential to be the beneficiary of the creation of a whole new segment within the MLP sector, SXCP is mispriced for the amount of risk an investor is taking in owning the partnership. 

I believe that within three years that SXCP will be midway through its third target distribution, which would amount to $2.27 in annual distributions and will be trading at an 8% yield, implying a unit price of $28.37.  While waiting, investors will be rewarded with in excess of $5.60 in distributions implying $15.7 of upside from the partnership’s current unit price of $18.25 which works out to a +28% annual return for investors over the next three years.  Substantial (think 6% yield at the end of year 3 or an additional +$10 per unit) upside exists if the partnership’s general partner is able to roll up the domestic coke making industry via the purchase of captive coke plant from the steel companies.  Given the unique nature of these assets, the market appears to be pricing SXCP similar to coal MLPs and is failing to understand the low risk nature of the partnership’s cash flows and drop down opportunities.  A significant revaluation of the partnership is likely to occur with the passage of time, the initiation of sell-side coverage and the announcement of the first drop down.

An investment in SXCP at its current price represents a solid single and potentially double whose significant downside protection allows for a rather large position for those familiar with MLPs.

Partnership Overview:

SXCP is a master limited partnership whose general partner (SXC) was previously one of the few independent coke producers in the United States.  SXCP owns a 65% interest in three coke plants that have the following characteristics:

The partnership’s coke production contracts are long term in nature and are all fixed fee based take-or-pay contracts that require SXCP to deliver certain volumetric commitments.  The cost of coal, maintenance capital expenditures, increases in operating costs, taxes (excluding income) and transportation expenses pass through to the partnership’s customers with SXCP receiving a fixed fee in exchange.  SXCP’s coke plants have been integrated deeply with the steel plants that they serve and the partnership talks at length about its ability, with its technology, to operate its coke plants cheaper and more efficiently for its partners than if its partners were to build and operate their own plants.  This is a business whose characteristics make it a perfect candidate for an MLP.

SXC has significant coke assets remaining following the IPO of SXCP and the drop down of 65% interests in its two Haverhill and Middletown facilities.  Over the next two years, I expect SXC to drop down its remaining 35% interest in these three facilities, which will help SXCP to increase the partnership’s distribution substantially.  Beyond these three dropdowns, which amount to an additional 570K in annual coke production capacity, there is just over 1M in annual coke production capacity currently at SXCP.  In addition to the Haverhill and Middletown facilities, SXC has an additional 2.6M tons of annual domestic coke production capacity that can be dropped down as well.  SXC will drop these assets down in order to generate significant incentive distribution rights and cash flows which SXC will use to fund greenfield projects in the US, Brazil and India. SXC will drop these assets down because: 1) IDR cash flows are more highly valued by the marketplace. 2) There is a need for new coke plants because the US is structurally short coke (we import 3.5M tons of coke that becomes brittle and less valuable the further/longer coke is transported). 3) SXC has made numerous international investments in India and Brazil, which I expect, will continue to be a use of proceeds from the drop downs. 

SXC’s remaining domestic coke plants are as follows:

Assuming that SXC initially drops down the three plants that it only has a 35% interest in, SXCP has a clear trajectory towards distributing in excess of $2 a year.  The table below attempts to look at what future drop downs would look like, assuming $60M of EBITDA net to SXC’s 35% interest in the three coke plants.  It is important to note that I am assuming that the first wave of drop downs will be financed with 50% equity; given the minimal net debt (somewhere around 50M at SXCP), it is possible that this number will be lower. 

SXCP Credit Enhancements:

The primary risk associated with SXCP lies in its close relationship with AK Steel.  This relationship is reflected in the fact that 66% of SXCP’s coke production is associated with AK Steel contracts vs. 12% for SXC.  While this credit risk is not ideal given AK Steel’s small size and levered nature, I believe that this relationship is not a deal killer due to the following: 1) AK Steel recently raised just under $600M in debt and equity. 2) Total liquidity at AK Steel post offering is now at approximately $1.2B. 3) Any restructuring will likely be financial and not structural as AK Steel is still generating a healthy amount of EBITDA. 

SXC sought to address SXCP’s counterparty risk with AK Steel by structuring SXCP’s IPO documents in such a manner as to provide substantial enhancements to SXCP’s common unit holder distribution coverage.  SXC, which has a fraction of the AK Steel exposure that SXCP has, has effectively guaranteed to cover any defaults by SXCP’s customers for the next five years.  SXC’s financial position following the IPO of SXCP has also been strengthened tremendously; the company’s current debt to EBITDA of just over 2.0x will likely come down further as drop downs to SXCP progress.  For example, the drop down of the various 35% interests contemplated above would provide SXC with a substantial net cash position and the financial health to make good on the company’s five year contract guarantee to the partnership, should it ever be needed.    

In addition, 15.7M of SXCP’s 31.4M units are subordinated units held by SXC.  Based on SXCP’s forecast for the next year, these subordinated units will be receiving the minimum quarterly distribution ($0.4125) that the common unit holders are entitled to, this amounts to an additional $25.9M in coverage for the common unit holders.  For reference purposes, SXCP’s common units will only be receiving $22.3M in aggregate quarterly distributions over the next year.  When SXCP’s aggregate distribution on its subordinated units is coupled with the partnership’s estimate  that it will still generate additional undistributed coverage it is likely that the distribution to the common units has in excess of $33M of coverage (on a 22.3M distribution) - all in addition to SXC’s five year guarantee of SXCP’s contracts. 

Conclusion:

SXCP is a layup/single/extra point MLP LP IPO with substantial coverage, clear growth trajectory and unlike many other LPs the opportunity to participate in the consolidation of an industry as SXCP is the only MLP pursing coke plants.  In pricing SXCP at a 9% yield the market is effectively valuing SXCP as if it has no dropdowns and is facing secular headwinds (e.g. propane MLPs) – both of these factors are clearly not the case.  The existing assets of SXC should get SXCP close to is 50/50 splits and provides a clear distribution growth runway for SXCP.  The possibility that SXCP will become a purchaser of coke plants from cash strapped steel companies for much lower multiples than what traditional midstream MLPs pay for acquisitions acts as a free option for unit holders at the partnership’s current price.     

Catalyst