SUNOCO INC SUN
May 30, 2011 - 12:33am EST by
skimmer610
2011 2012
Price: 40.00 EPS $0.00 $0.00
Shares Out. (in M): 121 P/E 0.0x 0.0x
Market Cap (in $M): 4,836 P/FCF 0.0x 0.0x
Net Debt (in $M): 54 EBIT 0 0
TEV ($): 4,890 TEV/EBIT 0.0x 0.0x

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Description

Note: if charts are difficult to read, write-up can be accessed in PDF form at: https://docs.google.com/viewer?a=v&pid=explorer&chrome=true&srcid=0B8JQBxIp5NxKYmRiYjJjODEtM2JiYy00NjgxLWE2MmYtN2YwMjA4OWJiNzMx&hl=en_US&authkey=CN6Dh-cE

 

 

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:

 

For 2010, SXL distributions to the GP were $46mm. However, in February of 2010, SUN received ≈$200mm in cash from SXL pursuant to an agreement modifying the GP incentive distribution rights. Presented below is a table of the previous and amended IDRs.
  Cancelled IDRs   New IDRs
               
    Marginal     Marginal
    Percentage Interest in     Percentage Interest in
    Distributions     Distributions
  Total  Quarterly       Total  Quarterly    
  Distribution Target General LP   Distribution Target General LP
  Amount Partner Unitholders   Amount Partner Unitholders
               
Minimum Quarterly Distribution $0.450 2% 98%        
               
First Target Distribution up to $ 0.500 2% 98%     No change
Second Target Distribution above $ 0.500            
up to $ 0.575 15% 85%        
Third Target Distribution above $ 0.575       above $ 0.575    
up to $ 0.700 25% 75%   up to $1.5825 37% 63%
Thereafter above $ 0.700 50% 50%   above $1.5825 50% 50%
 

In terms of valuing the GP: simply - I believe the SUN's GP interest in SXL is very valuable. Mature GP's - i.e. those already in the 50% split level - trade in the market at low-to-mid twenty times current year IDRs (i.e. even those held in C-Crop entities). The SXL GP is not in its 50% split level. Accordingly, I believe it should trade at a higher multiple than GP interests that have already reached their 50% split.

 

Given the size of SXL, relatively modest acquisitions translate into material growth. The GP stake, of course, has substantial leverage to that growth. I believe the valuation of the GP interest ought to take account of that growth potential.

 

The analysis below analyzes current and future GP distributions based on the above splits and based on assumptions around future growth of LP distributions. The primary assumptions driving the NPV calculation are the following:

 

  • 1) LP distributions grow at 6.0% through 2019
  • 2) The terminal growth rate for LP distributions is 2%
  • 3) Discount rate used is 8% - I believe that is conservative insofar as al higher quality MLPs trade at yields meaningfully lower than 8%

 

Note: The calculation for the GP's payment for each tier is not a straight multiplication of the GP's IDR with the LP's distribution. Rather, the calculation is as follows:

 

(LP Distributions / LP Marginal Percentage Interest in Distributions) * GP IDR

 

Based on the analysis above and because the GP interest has not yet reached 50% splits, I believe SUN's GP stake in SXL deserves a very high multiple on the current distribution level. It is also worth noting that were we to apply a 6% discount rate to the GP cash flows - quite possibly too low but still above the levels at which high quality MLPs, SXL included, currently trade - the value of the GP interest is ≈$2.1bn.
            Total      
  LP Distributions Per Unit       GP      
  Quarterly Annual     GP Payment Payments      
GP Distribution Based on Current LP Distributions Distribution Distribution LP GP per LP Unit ($mm)      
Tier 1  $           0.575  $            2.30 98.0% 2.0%  $           0.047  $              1.6      
Tier 2  $           0.620  $            2.48 63.0% 37.0%  $           1.457  $            48.2      
Tier 3                  
Total  $           1.195  $           4.780      $           1.503  $            49.8      
                   
                   
LP Distribution 2002 2003 2004 2005 2006 2007 2008 2009 2010
Total  $           1.648  $           2.050  $           2.395  $           2.650  $           3.125  $           3.383  $           3.785  $           4.297  $           4.605
Y/Y change   24.4% 16.8% 10.6% 17.9% 8.2% 11.9% 13.5% 7.2%
                   
LP Distribution 2011 2012 2013 2014 2015 2016 2017 2018 2019
Total  $           4.881  $           5.174  $           5.485  $           5.814  $           6.163  $           6.532  $           6.924  $           7.340  $           7.780
Y/Y change 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%
                   
GP Distributions per LP Unit                  
Tier 1  $           0.047  $           0.047  $           0.047  $           0.047  $           0.047  $           0.047  $           0.047  $           0.047  $           0.047
Tier 2  $           1.516  $           1.688  $           1.870  $           2.064  $           2.268  $           2.349  $           2.349  $           2.349  $           2.349
Tier 3  $               -     $               -     $               -     $               -     $               -     $           0.136  $           0.367  $           0.611  $           0.869
Total  $           1.563  $           1.735  $           1.917  $           2.111  $           2.315  $           2.533  $           2.763  $           3.007  $           3.265
Assumed LP Units                33.1 33.1 33.1 33.1 33.1 33.1 33.1 33.1 33.1
Total Distributions to GP ($mm)  $            51.7  $            57.4  $            63.5  $            69.9  $            76.6  $            83.8  $            91.4  $            99.5  $           108.1
                   
Discount rate 7.0%                
Terminal growth rate 2.0%                
Terminal value  $        1,175.8                
NPV + Terminal Value  $        1,663.6                

 

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:

Store Base 2008 2009 2010
Direct Outlets:      
Company-Owned or Leased:      
Company Operated:      
Traditional                75               49               51
APlus®Convenience Stores               451             346             337
Total Company Operated               526             395             388
       
Dealer Operated:      
Traditional               199             160             150
APlus®Convenience Stores               230             223             229
Ultra Service Centers®               122             112             103
Total Dealer Operated               551             495             482
Total Company-Owned or Leased            1,077             890             870
       
Dealer Owned               578             509             507
       
Total Direct Outlets            1,655          1,399          1,377
       
Distributor Outlets            3,065          3,312          3,544
       
Total units            4,720          4,711          4,921

 

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:

                  Average Median
Retail Marketing 2003 2004 2005 2006 2007 2008 2009 2010 Ex. 2008 Ex. 2008
                     
EBITDA  $           244  $         217  $         155  $         233  $         221  $         439  $         241  $         269  $         226  $         233
D&A                99             106             105             105             108             110               95               93  $         102  $         105
EBIT  $           145  $         111  $           50  $         128  $         113  $         329  $         146  $         176  $         124  $         128
Tax rate 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0%
NOPAT  $             88  $           68  $           31  $           78  $           69  $         201  $           89  $         107  $           76  $           78
                     
Maintenance CapEx               (80)              (80)              (80)              (80)              (80)              (80)              (80)              (80)              (80)              (80)
Unlevered FCF  $           107  $           94  $           56  $         103  $           97  $         231  $         104  $         120  $           97  $         103

 

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:

R&S Assets Status Complexity Capacity Multiple Value
Toledo, OH - base price Sold              9.7           170.0  $       242.6  $       400.0
Toledo, OH - with earnout Sold              9.7           170.0  $       318.4  $       525.0
Tulsa, OK Sold             10.4             85.0  $         73.5  $         65.0
           
Eagle Point, NJ Shutdown              8.4           150.0  NA   NA 
           
Marcus Hook, PA Operating              8.2           175.0  $       125.0  $       179.4
Philadelphia, PA Operating              7.7           330.0  $       125.0  $       317.6
Total value of remaining capacity          $       497.0

 

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:

Excess inventory - LIFO vs. book - as of 12/31/10  $   3,119
Less: Inventory attributable to SXL         (200)
Less: Inventory gain associated with Toledo         (600)
Less: Crude payables      (1,600)
Net excess inventory  $      719
Assumed basis         (200)
LIFO gain  $      519
Tax rate 37.5%
After-tax LIFO gain  $      324

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:

Excess inventory - LIFO vs. book - as of 12/31/10  $   3,119
Less: Inventory attributable to SXL         (200)
Less: Inventory gain associated with Toledo         (600)
Less: Crude payables      (1,600)
Plus: Crude receivables          850
Net excess inventory  $   1,569
Assumed basis         (200)
LIFO gain  $   1,369
Tax rate 37.5%
After-tax LIFO gain  $      856

 

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:

SunCoke 2007 2008 2009 2010
EBITDA  $        34  $     160  $     226  $     225
Less: Depreciation            20           25           33           49
Less: Income tax             3           46           73           63
Plus: Tax credits            18           16           19           19
Plus: Granite City one-time tax credit              -             -           41             -
Net income  $        29  $     105  $     180  $     132
         
Capital Spending         (221)        (312)        (229)        (223)
Maintenance CapEx           (45)          (45)          (50)          (50)
Maintenance level FCF  $          4  $       85  $     163  $     131
 

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.

 

 

Guidance 2011 2012
EBITDA  $      165  $     200  $     280  $     320  $     340
Net income(1)  $        90  $     115  $     160  $     180  $     200
Coal price(2)  $      165  $     165  $     175  $     175  $     175
D&A            55           55           65           65           65
Maintenance CapEx           (50)          (50)          (50)          (50)          (50)
Maintenance level FCF  $        95  $     120  $     175  $     195  $     215
           
Coal production (tons mm)           1.3          1.3          1.7          1.7          2.0
EBITDA / ton  $        65  $       65  $       60  $       60  $       60
Implied coke EBITDA  $        81  $     116  $     178  $     218  $     220
Coal EBITDA  $        85  $       85  $     102  $     102  $     120
           
(1) Excludes any potential financing costs associated with separation of SunCoke.
(2) Uses a coal price assumption of $175 per ton. No coal purchases or sales have been contracted yet for 2012.

  

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.

Based on 2012E EBITDA      
Coke EBITDA  $      178  $     218  $     220
Coke multiple 7.0x 8.0x 9.0x
Coke value  $   1,246  $   1,744  $   1,980
       
Coal EBITDA  $      102  $     102  $     120
Coal multiple 4.5x 5.3x 6.0x
Coal value  $      459  $     536  $     720
       
SCE value  $   1,705  $   2,280  $   2,700
Blended EBITDA multiple 6.1x 7.1x 7.9x

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.

In MLP Structure 2012  
EBITDA          178         218         220  
Maintenance CapEx           (25)          (25)          (25)  
Interest expense(1)           (33)          (33)          (33)  
Distributable cash flow  $      121  $     161  $     163  
(1) Assumes $500mm of debt at 6.5% average rate        
         
     $     121  $     161  $     163
  6.0%  $   2,008  $   2,675  $   2,708
  7.0%  $   1,721  $   2,293  $   2,321
  8.0%  $   1,506  $   2,006  $   2,031

 

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:

Less Conservative = Scenario 2  
Sunoco net debt / (cash) - as of 12/31/10              (671)
Cash from sale of Frankford plant               (85)
CapEx for completion of Middletown               100
Tax liability associated with Toledo sale               175
Pro-forma net debt / (cash)  $          (481)
Non-controlling interest - excluding portion attributable to SXL                52
Retirement benefit liabilities               483
Total adjustments to enterprise value  $             54

Capital Structure   Valuation
           
Stock price  $        40.00   Retail Marketing - EBITDA
Diluted shares outstanding            120.9    $           220  $           240  $           260
Market cap  $        4,836 5.0x  $        1,100  $        1,200  $        1,300
Total adjustments to enterprise value  $             54 6.0x  $        1,320  $        1,440  $        1,560
Enterprise value  $        4,890 7.0x  $        1,540  $        1,680  $        1,820
           
SunCoke      $        1,705  $        2,280  $        2,700
           
Chemicals      $           100  $           125  $           150
           
Logistics          
           
LP stake      $           838  $           838  $           838
           
GP stake      $        1,250  $        1,600  $        2,000
           
Combined Value      $        2,088  $        2,438  $        2,838
Tax rate     35.0% 35.0% 35.0%
Combined Value      $        1,357  $        1,585  $        1,845
As a multiple of 2012 received DCF     12.5x 14.6x 17.0x
           
Refining          
           
Marcus Hook          
Complexity                   8.2               8.2               8.2
Capacity                175.0            175.0            175.0
Multiple      $               -  $           125  $           250
Value      $               -  $           179  $           359
Philadelphia, PA          
Complexity                   7.7               7.7               7.7
Capacity                330.0            330.0            330.0
Multiple      $               -  $           125  $           250
Value      $               -  $           318  $           635
Total      $               -  $           497  $           994
           
Value of Inventories      $           300  $           300  $           300
           
Coporate          
Operating loss      $            (50)  $            (50)  $            (50)
Multiple     5.0x 6.0x 7.0x
Value      $          (250)  $          (300)  $          (350)
           
      Enterprise Value
       $        4,312  $        5,686  $        6,939
       $        4,532  $        5,926  $        7,199
       $        4,752  $        6,166  $        7,459
           
      Equity Value / share
       $        35.22  $        46.59  $        56.95
       $        37.04  $        48.57  $        59.10
       $        38.86  $        50.56  $        61.25

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

Potential Sources of Upside Low High
Earnout from sale of Toledo refinery               125               125
Terminaling Eagle Point and dropdown to SXL                50               200
Higher multiple or tax free transaction of SXL LP or GP               250               500
SCE MLP conversion (or embedded option thereof)               400               700
Total  $           825  $        1,525
Per share  $          6.82  $        12.61

 

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:

Stock price  $       40.00  $       40.00  $       40.00
Diluted shares outstanding           120.9           120.9           120.9
Market cap  $       4,836  $       4,836  $       4,836
       
SUN net debt / (cash)  $         (481)  $         (481)  $         (481)
       
SUN proceeds from SCE IPO      
EV of SCE  $       1,705  $       2,280  $       2,700
Less: SCE assumed debt (see below)  $         (300)  $         (600)  $         (900)
Equity value  $       1,405  $       1,680  $       1,800
Value of 20%  $          281  $          336  $          360
Net (cash) to SUN  $         (281)  $         (336)  $         (360)
       
SUN proceeds from SCE dividend      
SCE - 2012 EBITDA  $          300  $          300  $          300
Leverage multiple 1.0x 2.0x 3.0x
SCE leverage  $          300  $          600  $          900
Net (cash) to SUN  $         (300)  $         (600)  $         (900)
       
SUN PF net debt / (cash)  $      (1,062)  $      (1,417)  $      (1,741)
Per share  $         8.78  $       11.72  $       14.40
       
Legacy SUN:      
EBITDA from Retail Marketing  $          240  $          240  $          240
Cash distributions from SXL LP and GP  $          100  $          100  $          100
SUN cash flows to support debt  $          340  $          340  $          340
Leverage multiple 0.0x 1.0x 2.0x
SCE leverage  $              -  $          340  $          680
Per share  $              -  $         2.81  $         5.62
       
SUN - total possible dividend  $         8.78  $       14.53  $       20.02

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).

SUN - current market cap  $       4,890  $       4,890  $       4,890
SUN net debt / (cash)  $         (481)  $         (481)  $         (481)
SUN - EV (simple)  $       4,409  $       4,409  $       4,409
Less: SUN proceeds from SCE IPO  $         (281)  $         (336)  $         (360)
Less: SUN proceeds from SCE dividend  $         (300)  $         (600)  $         (900)
SUN - EV (simple)  $       3,828  $       3,473  $       3,149
       
EV of SCE  $       1,705  $       2,280  $       2,700
Less: SCE assumed debt  $         (300)  $         (600)  $         (900)
Equity value  $       1,405  $       1,680  $       1,800
Value of 80%  $       1,124  $       1,344  $       1,440
       
SUN - PF residual EV  $       2,704  $       2,130  $       1,709
SUN - PF net debt / (cash)  $      (1,062)  $      (1,417)  $      (1,741)
SUN - PF equity value  $       3,766  $       3,546  $       3,450
SUN - PF equity value / share  $       31.15  $       29.33  $       28.54
SUN - PF net debt / (cash) per share  $         8.78  $       11.72  $       14.40
SUN - PF net debt / (cash) per share as % of share price 28.2% 40.0% 50.5%
       
Less: sale of Haverhill Chemical plant  $         (100)  $         (125)  $         (150)
Less: value of Eagle Point terminal (drop down)  $           (50)  $         (100)  $         (200)
Less: value of crude inventories  $         (300)  $         (300)  $         (300)
SUN - adjusted PF residual EV  $       2,254  $       1,605  $       1,059
SUN - 2012 EBITDA from Retail Marketing and SXL LP and GP  $          330  $          350  $          370
EV / EBITDA 6.8x 4.6x 2.9x

 

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
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