SXC - SunCoke Energy

[Picasso]

Hedge fund hotel? Check.

China macro worries? Check.

SUNE/TERP style yieldco blowup? Check.

ZINC style operational issues? Check.

Commodity related? Check.

 

And I think Game of Thrones has some words commentary regarding the next few months:

 

"Winter is coming" - House of Stark

 

Short story: spin from Sunoco in 2011, SXCP is the MLP, SXC is the GP, SXCP is takes drop downs from SXC.  Lots of consolidation in the SXC financials so it's best to understand SXCP first.  They have concentration around several cokemaking facilities and a newly acquire export terminal with somewhat long-term take-or-pay contracts.  The steel industry is blowing up so there's a lot of worry that you're going to see renegotiated rates or no-takey-no-payey.  I think that risk is overblown at this point but who knows. 

 

Right now SXCP has the capacity to pay around $100 million to unitholders.  That's about a 20% yield on the current share price of $11.  SXC owns around 56% of SXCP and IDR's plus some other goodies, some of which were written down to zero (or will be).  SXC will be "debt free" at the end of the year but it's only worth as much as their stake in SXCP so considering SXCP debt, you've got about $1 billion of total debt rated BB-. 

 

All things considered, I think SXCP should probably be a lot higher.  It's going to take a little time before we see X, AKS and MT go under assuming that happens.  Not sure it warrants a 20% yield on intermediate duration contracts.

 

I could also see someone making a bid to boost their distributable cash flow.  There's probably some GP/MLP out there starving for a last fix to keep the dividend going.  Anyway not key to the thesis but it's probably one of the outcomes here.

 

Not long yet but it looks interesting.  Basically getting killed on all sides while going into a difficult winter season.  I could see hedge fund redemptions taking this lower and then assuming no one told me why this business is doomed to fail, it could make for a really good long.

[Green King]

SXC will be "debt free" at the end of the year but it's only worth as much as their stake in SXCP so considering SXCP debt, you've got about $1 billion of total debt rated BB-

Care to explain why ?

[Picasso]

The debt is attributable to SXCP but gets consolidated on the SXC financials. There's a very small amount of SXC parent debt that will be retired by the end of the year.

[Picasso]

Been looking more into the counter party risk and I think there's probably more risk here than I initially considered.  Crazy what a difference a year makes when it comes to anything commodity related.

 

This is probably telling regarding sentiment:  http://www.zerohedge.com/news/2015-11-10/son-billionaire-steel-magnate-plunges-his-death-amid-demise-uk-industry

 

Bonds for AKS, X, MT are trading like it's 2008.  SXCP should probably trade at yields similar to the counter party bonds. 

[Picasso]

Alright so SXCP is now trading at yields over 30%.  At this point it seems nutty considering the take-or-pay contracts and comparable yields on steel maker bonds.  They (X,AKS, etc) will be limping along for a while, but I think long enough to get substantial parts of my investment back just on the existing contracted cash flows for the next few years.

 

I've started going long both SXC and SXCP.  I like that SXC is buying up shares as well. 

[Picasso]

I really like the risk reward here.  Market value of SXCP is around $325 million which leaves a $33 million stub for the rest of SXC's business.  Overall SXCP looks massively undervalued and so does SXC.  I've made this my biggest position and will probably add more. 

[awindenberger]

I really like the risk reward here.  Market value of SXCP is around $325 million which leaves a $33 million stub for the rest of SXC's business.  Overall SXCP looks massively undervalued and so does SXC.  I've made this my biggest position and will probably add more.

 

A reader on Seeking Alpha suggested that I take a look at SXCP just yesterday. How knowledgeable are you about the coal/coke/steel industry? Assuming the worst, that the Steel companies stop paying, how likely is it that the company could find other customers for the coke?

[Picasso]

I've spent the past few weeks going into as much of the gritty details of the steel industry as I can muster.  There are probably investors who are much more familiar with it, but this is how I look at your concern.

 

SXC and SXCP's creditors are spread out between ArcelorMittal, US Steel, and AK Steel.  SXCP also has some credit exposure to Murray/Foresight, but that's not a big concern for me right now.  Anyway, of those three steel names the worst is AKS.  X is now a not-so-close second and MT is a distant third. 

 

If AKS goes belly up, it will improve things for X and MT from a capacity standpoint.  What is the probability that all three go belly up at the same time?  That has to be an extremely low probability event.  You'll see stress from the AKS contracts in a year or two (potentially) but X and MT have several years worth of liquidity.  It should also be noted that AKS, MT and X don't have cost issues because of the coke from SunCoke, they have other larger cost issues and supply being uneconomically dumped from China.  If they decided to stop paying SunCoke simultaneously, they would also need to source coke in the future (capital intensive when their cost of capital is very high right now) or completely shutter blast furances in the United States.  From everything I've read, it's unlikely to see a complete removal of blast furnaces in favor of other methods.  So the contracts to SunCoke are the last things that a steel producer will want to default on unless the cost of the contracts are well above market or blast furnaces disappear. 

 

If all three stop paying then yeah the coke isn't worth anything.  But then neither are 90% of the capital structures behind AKS, X, MT.  It's a bit of a reflexive thing: if they want to source their own coke, it's going to take a lot of capital they can't afford.  If steel producers cost of capital goes down then we won't be discussing this risk and people will be comfortable with the contracts.

 

The contracts also extend out into a fairly good duration (it's not like they come due in the next few years) so the amount of cash that holders of SXCP and SXC can collect until we see what happens or who goes under is likely in excess of the current share price. 

 

I mean SXCP is trading for $6.50 with the capacity to pay $2 of dividends even if AKS doesn't honor its contract.  That's pricing in a very significant probability of significant distress which I don't see happening anytime soon. 

 

So to answer your question: it's not really important to ask what happens to an asset if their customers no longer want it.  That would make SXC/SXCP worthless.  That's not a realistic outcome here unless you think all three go under simultaneously.  So the real question is, what's the probability all three go under?  Based on where their customers bonds are trading and current liquidity levels even with $400 or less HRC, that's as close to a zero percent probability as I can estimate.

[topofeaturellc]

Blast furnace production probably goes to zero in our life times.  Especially if cheap gas makes DRI more economically appealing.

[awindenberger]

Blast furnace production probably goes to zero in our life times.  Especially if cheap gas makes DRI more economically appealing.

What is DRI?

[awindenberger]

So to answer your question: it's not really important to ask what happens to an asset if their customers no longer want it.  That would make SXC/SXCP worthless.  That's not a realistic outcome here unless you think all three go under simultaneously.  So the real question is, what's the probability all three go under?  Based on where their customers bonds are trading and current liquidity levels even with $400 or less HRC, that's as close to a zero percent probability as I can estimate.

 

Thanks for the thoughts. Its interesting to me how so many different leveraged energy companies are seeing intense declines; SunCoke, the SUNE complex, Kinder Morgan now.

 

Suncoke def looks like an interesting speculation. The question is, will the price go even lower into mid-December as we see more tax-loss selling.

[topofeaturellc]

Direct Reduction Iron. Basically you use natural gas instead of coal/coke to reduce the iron oxide into pig iron.  It's less capital intense and cheap gas + cheap Brazilian pellets have a cost advantage over landlocked met coal and expensive great lakes iron ore.

 

The other problem the NA blast furnace guys have is competing with stld and nue is difficult when scrap prices are lower than what is implied by their cost of ore.

[topofeaturellc]

That said the DRI thing is a long term issue.  Global steel prices + scrap relationship is what's killing aks,x,mt today.

[Picasso]

Mangrove now owns 10% of SXC, up from 3% as of last September.  They were involved with the HLSS/Ocwen servicing drama if anyone remembers.  I like their investing style (not cloning them here, just notice they're also in the trade) and think there might be some activism from their end.  At a minimum the C-corp should be rolled back with the LP.

 

Just some quick back of the envelope.  SXCP does about $240 million of EBITDA, SXC does about $10 million of EBITDA excluding SXCP but they have a plant which is in the middle of improvements which should add $30 million of EBITDA.  If we exclude that improvement for now, a 7x multiple on $250 million of EBITDA puts the whole complex at about $1.75 billion.  It trades around 5x EV/EBITDA right now.

 

There's about $1 billion of debt leaving $700 million of value for the equity and unit holders not including whatever cash gets spit out in the meantime (used for dividends, debt and equity/unit repurchases).  There's 23 million units of SXCP not including the SXC stake and 65 million SXC shares.  Based on current market prices that's a total of about $300 million.  There's over $100 million of free cash coming in every year and the equity/units should be worth closer to $750 million if you think it's worth 7x (which I do). 

 

There's no reason to have an MLP in these market conditions when the complex trades at a 33% free cash flow yield.  I think part of the problem here is the illiquidity in the junk bond market which has impacted the integrated steel producers.  Not that they have great fundamentals, but their spreads gapped out very recently despite having manageable debt levels. 

 

Anyway, some bad stuff can happen (Murray/FELP credit issues, AKS going under) and it looks well accounted for.  KMI (which investors here think is bombed out, I'm not so sure because it's so loved) is trading for 10x EV/EBITDA and this is at 5x.  It's pretty much at the point where every turn on that multiple doubles the value of the equity.  But same goes for the downside if you think it should trade under 5x.

 

I mentioned early on that it was being affected by everything people hate in this market.  Now add junk bond illiquidity to the mix.  I'm probably a masochist, but I like that.  Especially at year end.

 

Oh and the investor day is in a couple days.  I'll be there in case anyone else wanted to join me afterwards for a beer.

[awindenberger]

Looks like SXC is going to cut their dividend for the time being and provide support to help maintain SXCPs dividend and lower their debt. Very interesting.

 

See both news items here: http://finance.yahoo.com/q?s=sxcp

[Picasso]

Not a bad day for the stock and units. If anyone has questions, I have some notes from the investor day. I really like this idea.

[awindenberger]

Not a bad day for the stock and units. If anyone has questions, I have some notes from the investor day. I really like this idea.

I took a small position in SXCP at the open yesterday. Might add more if we see a retracement.

[KJP]

If anyone has questions, I have some notes from the investor day. I really like this idea.

 

At current prices, do you prefer SXC or SXCP and how do you think about the relative risks of the two companies? 

 

Do you have an estimate of SXC 2016 cash flow in light of the IDR giveback and potential corporate cost holiday?  Also, how would 2016 buybacks at SXC be funded?

 

If the steel industry can stabilize, what would SXC standalone look like in 2017-18 with no IDR giveback, no corporate cost holiday and stabilization of Indiana Harbor (even if not at 1.2Mt)?

 

Thanks for your thoughts.

[Picasso]

At current prices, do you prefer SXC or SXCP and how do you think about the relative risks of the two companies? 

 

SXC should have a lower risk profile.  They own 25.4 million shares of SXCP with no net debt; at $7/share on SXCP that is worth $178MM versus a market cap of $234MM.  You're paying a difference of $56MM for a few assets which independently should produce around $40MM of EBITDA by 2017/2018.  So you're effectively getting a business that should be worth around the current market at almost no cost.  That assumes SXCP should be worth $7 even though it is most likely more valuable.

 

SXCP will trip covenants at 4.5x debt/EBITDA and they sit at 4x right now without any further debt repurchases.  The debt is trading around $60 so they've been in the market buying up those bonds fairly aggressively.  This quarter they repurchased $43MM of bonds for $33MM of cash, so as long as that is in play I think they can lose a contract and stay within the debt covenants fairly easily. 

 

There is an omnibus agreement that runs out at the end of 2017 where SXC covers the AKS contracts.  Management said that was something they needed to prepare for, if it happens, which caused that dividend cut at SXC.  So in theory you might have better downside support by owning SXCP versus SXC, but remember that SXC is collecting 55% of the distributions from SXCP so there shouldn't be a large liability here.  It would simply help SXCP maintain EBITDA while it delevers in that situation.

 

I like both so I own both.  Longer term there is a lot more upside to SXC (IDR's already in the high splits, further drop downs, potential to lever up, repurchase a lot of shares, minimal capex) but they've made it clear that they plan to support the asset which is currently the vast majority of their market value. 

 

Do you have an estimate of SXC 2016 cash flow in light of the IDR giveback and potential corporate cost holiday?  Also, how would 2016 buybacks at SXC be funded?

SXC will bring in around $50MM of free cash in 2016 when excluding the IDR giveback and cost holiday.  The IDR's are alongside the LP units which are providing most of SXC's cash.  There should be some improvement at Indiana Harbor which can add around $10 million of free cash for 2016 but it's been one of those crappy projects that has been underwhelming for a while.  Buybacks will likely be minimal at this point since they need to hold cash in case there are issues with AKS/Murray/Foresight in 2016/2017.  Omnibus related or not they need to protect the value of SXCP.  SXC can be levered 3.5x EBITDA but they would rather remain more liquid and flexible here.

 

If the steel industry can stabilize, what would SXC standalone look like in 2017-18 with no IDR giveback, no corporate cost holiday and stabilization of Indiana Harbor (even if not at 1.2Mt)?

Indiana Harbor should be able to easily exceed $30MM of EBITDA by that time.  Jewel and Brazil are basically covering the other expenses so that's the only asset that is driving performance at SXC above what happens at SXCP.  So there's a few things here.

 

1) In a stabilized steel environment SXCP is likely worth 8-10x EBITDA *unless* there is no terminal value for their facilities because blast furnaces go the way of the dinosaur.  I don't think that will be the case for a while so let's ignore the "unless" for now.  At 8x $210MM of EBITDA that leaves a unit value of $780MM (subtracting $900MM of debt) which on 48 million units gives us a value of $16 for SXCP.  SXC's stake would be worth $406MM plus the value of the IDR's.

2) Indiana Harbor can probably be dropped down into SXCP at that time.  Let's say they get to $30MM of EBITDA, that would also add $240MM to the asset pile.

3) Any cash that accumulates into 2017/2018 which can vary on how much is used for debt repurchases.

 

If SXC is conservatively opportunistic then they can probably end up with 60 million shares on value in the $750MM range assuming no major contract breaks.  That's worth around $12.50 versus $3.50 today.  I played around with the numbers a bit for some breaks at AKS/Murray/Foresight and ended up with a price range between $3-4 for SXC and $7-9 for SXCP.  At current prices I think you are fully pricing in potential problems.  There will be over $100MM of FCF between both SXC and SXCP for 2016 when you exclude overlap.  It's possible you might get down to $60MM of FCF in a really bad situation. 

[Picasso]

Another way to think about the downside/upside:

 

You can buy SXCP for $6.80 and get back $2.38 of dividends in 2016.  That would leave you with a $4.42 basis at the start of 2017.  On 48 million units you would have an enterprise value around $1.11 billion.  So if all kinds of bad things start happening in 2017 you are not paying a heck of a lot when they should produce $210MM of EBITDA at SXCP in 2016.  If bad stuff happens in 2018 then your basis is now $2.04 and SXCP will have the ability to get debt down to $700MM.  That would give SXCP an enterprise value of $798MM on say some terrible $150MM of EBITDA.  That's still around a 5x EV/EBITDA multiple and it's unlikely to trip any covenants. 

 

Since SXC is going to need to improve the value of SXCP, and that comes in the form of maintaining their distribution, owning SXCP gives some piece of mind in that you are rapidly lowering your basis over time which pulls out most of the terminal value risk that we see in stocks with dubious futures.  There is also a massive amount of debt reduction going on since SXCP is able to cover distributions at 1.4-1.5x with the givebacks and cost holidays.  Management also specifically stated they will change the distribution when they have a customer stop paying.  They don't need to cut the dividend because it isn't being covered and we don't have any customer default yet, so there should be some comfort to owning SXCP.  AKS has to give two years notice starting in 2016, they do not have any major liquidity events until 2018, and they source 80% of their coke from SunCoke.  So we'll see if AKS pulls out a nasty trump card in 2016 but it seems like a silly move to me.

 

SXC is going to be a tracking stock for SXCP until we get a rerating of SXCP and there is clear improvement at Indiana Harbor.  Then we can start looking at other capital allocation decisions at SXC which can drive a lot more long-term value than one can get by owning SXCP.

 

I hope that help explains how I frame some of the risks of owning each. 

[KJP]

Thanks for taking the time to provide your thoughts.  I agree that SXC has higher long-term upside, while the near-term distributions from SXCP provide more protection if the worst case comes to pass in a few years. 

 

At the end of the day, it seems that all that has to be true at these prices is that (1) there will still be significant blast furnace steel production in the US in 5-10 years (regardless of who owns those furnaces), and (2) SunCoke's facilities can most efficiently provide the coke those blast furnaces need. 

[KJP]

Another way to think about the downside/upside:

 

You can buy SXCP for $6.80 and get back $2.38 of dividends in 2016.  That would leave you with a $4.42 basis at the start of 2017.  On 48 million units you would have an enterprise value around $1.11 billion.  So if all kinds of bad things start happening in 2017 you are not paying a heck of a lot when they should produce $210MM of EBITDA at SXCP in 2016.  If bad stuff happens in 2018 then your basis is now $2.04 and SXCP will have the ability to get debt down to $700MM.  That would give SXCP an enterprise value of $798MM on say some terrible $150MM of EBITDA.  That's still around a 5x EV/EBITDA multiple and it's unlikely to trip any covenants. 

 

Since SXC is going to need to improve the value of SXCP, and that comes in the form of maintaining their distribution, owning SXCP gives some piece of mind in that you are rapidly lowering your basis over time which pulls out most of the terminal value risk that we see in stocks with dubious futures.  There is also a massive amount of debt reduction going on since SXCP is able to cover distributions at 1.4-1.5x with the givebacks and cost holidays.  Management also specifically stated they will change the distribution when they have a customer stop paying.  They don't need to cut the dividend because it isn't being covered and we don't have any customer default yet, so there should be some comfort to owning SXCP.  AKS has to give two years notice starting in 2016, they do not have any major liquidity events until 2018, and they source 80% of their coke from SunCoke.  So we'll see if AKS pulls out a nasty trump card in 2016 but it seems like a silly move to me.

 

SXC is going to be a tracking stock for SXCP until we get a rerating of SXCP and there is clear improvement at Indiana Harbor.  Then we can start looking at other capital allocation decisions at SXC which can drive a lot more long-term value than one can get by owning SXCP.

 

I hope that help explains how I frame some of the risks of owning each.

 

Your thinking makes sense to me.

 

I listened to parts of the investor day and heard the question about whether AKS would send the letter in 2016 just to start the process and gain leverage in negotiations.  It wouldn't surprise me to see that.

[Picasso]

SunCoke has had almost every possible bad thing happen to it.  I could see AKS try their hand at renegotiating in 2016 and management waking up to the news unfazed and simply calling it another crappy day at SunCoke & Co.  From what I understand, they can't just give notice and change their mind in two years.  The question seemed to imply they could do that but Henderson didn't correct it so maybe that is the case.  I'll probably email IR to clarify that. 

 

If AKS needs to reduce capacity and they already source 80% of their coke from SunCoke then I don't see the advantage to trying to negotiate for more volume at less price.  It would have to be for the same or less volume at less price which is a tough negotiation without being in bankruptcy.  So would they try that move when they don't have a full advantage?  Or would they just try it out and see how far it takes them?  It's a tough one to figure out but entirely possible given enough desperation from AKS.  SunCoke knows the needs of AKS pretty well so I'm not sure how this will play out when the other poker player knows the cards from the bluffer.

[Picasso]

Mangrove now owns 10% of SXC, up from 3% as of last September.  They were involved with the HLSS/Ocwen servicing drama if anyone remembers.  I like their investing style (not cloning them here, just notice they're also in the trade) and think there might be some activism from their end.  At a minimum the C-corp should be rolled back with the LP.

 

Mangrove filed a 13D with the intent to go activist.  Looks like they paid an average of $5.96 so definitely still trading well under their basis. 

 

http://d1lge852tjjqow.cloudfront.net/CIK-0001514705/70ce42ad-f0e6-4638-a613-cfce1ff92979.pdf

[KJP]

Mangrove now owns 10% of SXC, up from 3% as of last September.  They were involved with the HLSS/Ocwen servicing drama if anyone remembers.  I like their investing style (not cloning them here, just notice they're also in the trade) and think there might be some activism from their end.  At a minimum the C-corp should be rolled back with the LP.

 

Mangrove filed a 13D with the intent to go activist.  Looks like they paid an average of $5.96 so definitely still trading well under their basis. 

 

http://d1lge852tjjqow.cloudfront.net/CIK-0001514705/70ce42ad-f0e6-4638-a613-cfce1ff92979.pdf

 

SunCoke keeps getting cheaper.  Have you looked at Crestwood Equity Partner (CEQP)?  It seems like it's right up your alley.