SunCoke Energy Partners: Surprisingly, The 14.1% Yield Is Sustainable

| About: SunCoke Energy (SXCP)
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By Nick McCullum

High dividend yields can be both a blessing and a curse for income investors.

On the one hand, investors have the opportunity to use high dividend stocks to generate sustainable and life-changing dividend income from their investment portfolios. On the other hand, a high dividend yield may indicate that a company's dividend payments are unsustainable. High yields can also be caused by market pessimism regarding a company's future. Finding the source of this pessimism and evaluating its validity can be very difficult.

SunCoke Energy Partners (NYSE:SXCP) certainly falls in one of these categories. The company's 14.1% dividend yield makes it a member of the short list of stocks with 5%+ dividend yields.

SunCoke's exceptionally high dividend yield actually make it one the highest yielding stocks on that list.

However, investors should always be concerned with the sustainability of a double-digit dividend yield. In order for a company to pay such a high dividend it must be either:

  1. Tremendously undervalued
  2. Distributing more cash than it is earning

For this reason, a company like SunCoke Energy Partners deserves thorough due diligence before making an investment.

With that in mind, this article will analyze the investment prospects of SunCoke Energy Partners in detail.

Business Overview

Suncoke Energy Partners is a master limited partnership that manufactures coke, an input for blast steel manufacturing. The company also has a smaller segment that handles and distributes coal.

SunCoke Energy Partners' general partner is owned by SunCoke Energy (NYSE:SXC), which also has a 54% limited partner interest (meaning it owns 54% of the publicly-traded SXCP common units).

In addition to its general & limited partner interests, SunCoke Energy owns 100% of SunCoke Energy Partners' incentive distribution rights (IDRs), which gives the general partnership an increasing share of distributable cash flow as the MLP grows.

Incentive distributions rights encourage growth at the partnership level but generate additional costs for the MLP and mean that not all of SunCoke Energy Partner's growth accrues directly to SXCP unitholders.

SunCoke Energy collaborates with SunCoke Energy Partners on many operating initiatives, generally in the cokemaking segment. Typically, SunCoke Energy Partners will own the majority (~98%) of their joint initiatives while SunCoke Energy will own only a small portion.

The following diagram gives a comprehensive overview of SunCoke's legal and corporate structure. Note three major cokemaking collaboration deals (Middletown, Haverhill, and Granite City) where SunCoke Energy Partners is the majority owner and SunCoke Energy owns the remainder.

Source: SunCoke Energy Partners Investor Presentation, slide 8

As mentioned, SunCoke Energy Partners operates in two core segments:

  • Cokemaking
  • Coal Logistics

The company's cokemaking business is far more important to the overall SunCoke Energy Partners enterprise, contributing 89% of first quarter revenues this year. SunCoke Energy Partners is the largest independent coke producer in North America and serves all 3 major blast furnace steel producers.

While smaller than its cokemaking counterpart, SunCoke Energy Partners' Coal Logistics business is still quite large, with 40 million tons of total throughput capacity.

Additional information and certain key statistics about each operating segment can be seen below.

Source: SunCoke Energy Partners Investor Presentation, slide 6

SunCoke Energy Partners has a relatively short corporate history that can be traced back to 2011 when SunCoke Energy (the general partner, not the master limited partnership) was spun-off from Sunoco Inc.

In January of 2013, SunCoke Energy Partners had its initial public offering and initially controlled 65% of the Haverhill and Middletown cokemaking locations.

Over time, the partnership's growth has been driven by its expansion into the coal logistics business and dropdown transactions (where SunCoke Energy sells assets to SunCoke Energy Partners).

Source: SunCoke Energy Partners Investor Presentation, slide 7

Today, SunCoke Energy Partners operates a strategically diversified network of assets in the domestic United States.

The company also has assets in Brazil and operates a joint venture in India.

SunCoke Energy Partners' domestic asset base can be seen below.

Source: SunCoke Energy Partners Investor Presentation, slide 9

Current Events

On Oct. 31, 2016, SunCoke Energy announced a proposal to acquire all of the outstanding units of SunCoke Energy Partners that it did not already own. Because of the close relationship of the two entities, the financial markets seemed to count this transaction as a certainty.

Under the terms of the original proposal, SXCP shareholders would receive 1.65 shares of SXP for each unit of SXCP they already owned.

The implied price was $17.80, or a 5% premium to the company's most recent close prior to the announcement.

Here's what the Chief Executive Officer of SunCoke Energy had to say about the potential transaction:

We believe this proposed transaction enhances value for both SXC shareholders and SXCP unitholders. The merger of SXC and SXCP will result in significant cash flow accretion to SXC shareholders, generate meaningful cash flow synergies for the combined organization, and create greater financial flexibility to initiate a dividend, further de-lever the balance sheet and pursue a broader set of growth opportunities where we may have product or customer adjacencies. The combination of these financial and strategic benefits will create a stronger combined company and will maximize value for both investor bases. - Fritz Henderson, Chairman, President, and CEO of SunCoke Energy

In SunCoke Energy's first quarter earnings release, the company terminated this offer. Here's what the company's CEO had to say on the matter:

While we continue to believe strongly in the merits of a simplified structure, we were focused on taking a disciplined approach and ultimately it became clear we would not reach an agreement with the Conflicts Committee on a value, through the exchange ratio, for the unaffiliated LP units.

So, to sum up, the entities were unable to agree on a fair value for the transaction and it is canceled for the time being. Additional details can be seen below.

Source: SunCoke Energy Partners First Quarter Earnings Presentation, slide 3

SunCoke Energy Partners still expects a strong fiscal 2017, though investors should be aware that this transaction is no longer a possibility for the foreseeable future.

Growth Prospects

SunCoke Energy Partners' growth prospects are derived from company's continued expansion into coal logistics. As we've seen, the company's cokemaking currently dwarfs its coal logistics segment in terms of revenues.

SunCoke Energy Partners sees a more even distribution between cokemaking and coal logistics in the company's future.

Source: SunCoke Energy Partners Investor Presentation, slide 10

SunCoke Logistics currently pays out most of its cash flows as distribution payments. Thus, the company will need to issue additional limited partnership units or debt to acquire new assets.

With that in mind, it's important to note that SunCoke is currently moderately leveraged relative to other MLPs. This gives it some 'dry powder' in the form of the potential to issue new debt if attractive buying opportunities are presented.

Competitive Advantage and Recession Performance

SunCoke Energy Partners main competitive advantage come from being the largest cokemaking manufacturer in the United States. This gives the partnership economies of scale and reduces its fixed costs of production.

Unlike many commodity companies, the company reports relatively stable EBITDA through the commodity cycle. This can be seen below.

Source: SunCoke Energy Partners Investor Presentation, slide 16

The company also benefits immensely from the structure of this revenue stream.

SunCoke Energy Partners operates under long-term, take-or-pay contracts with blast furnace steel manufacturers, which means that its counterparties are required to purchase the manufactured coke or pay a significant fee.

This gives the company revenue stability over long periods of time.

Source: SunCoke Energy Partners Investor Presentation, slide 15

SunCoke Energy Partners' double-digit dividend yield means that investors should rightly be concerned about the sustainability of the company's dividend as well as its performance during future economic downturns.

It should be noted that the company has plenty of financial flexibility right now. At the end of the most recent quarter, the partnership reported consolidated cash of $46.2 million as well as availability on its revolving credit line of $76 million.

This gives the partnership current available liquidity of ~$122 million, slightly above its target of $120 million.

Source: SunCoke Energy Partners First Quarter Earnings Presentation, slide 9

SunCoke Energy Partners also has a lower debt level than many of its peers in the MLP space.

The company has a current gross leverage ratio of 3.78x and expects to lower this ratio to its long-term target of 3.5x over time.

Source: SunCoke Energy Partners First Quarter Earnings Presentation, slide 10

For dividend investors, the most important metric for assessing the safety of SunCoke Energy Parters is its distribution coverage ratio.

As discussed in the introduction, many companies paying double-digit dividend yields are paying out more than their earnings as dividends.

Remarkably, SunCoke Energy Partners had a distribution coverage ratio of 1.26x in the most recent quarter. While this might seem high when compared to common stocks, it is actually quite good for a master limited partnership.

Source: SunCoke Energy Partners First Quarter Earnings Presentation, slide 5

Looking ahead, SunCoke Energy Partners is expected its distribution coverage ratio to decline slightly in fiscal 2017, though the company's distribution will remain covered and the MLP is not at risk of a dividend cut.

Source: SunCoke Energy Partners First Quarter Earnings Presentation, slide 11

To sum up, SunCoke Energy Partners distribution is covered and is expected to remain well-covered for the remainder of fiscal 2017. This is remarkable given the company's high dividend yield.

Valuation and Expected Total Returns

SunCoke Energy Partners' future shareholder returns will be primarily composed of distribution payments and valuation changes.

As a master limited partnership that operates cokemaking and coal logistic assets, SunCoke Partners incurs significant non-cash depreciation and amortization charges that artificially impair the company's GAAP earnings.

The traditional price-to-earnings ratio is not very useful for MLPs because of this accounting phenomenon.

An alternative valuation technique is to compare an MLP's current dividend yield to its historical dividend yield.

If the current dividend yield is lower than average, the partnership is overvalued; on the other hand, if the current dividend yield is higher than average, the partnership is undervalued.

SunCoke Energy Partners currently pays a quarterly distribution of $0.594 which yields 14.1% on the company's current stock price of $16.85.

The following diagram compares the MLP's current dividend yield to its average dividend yield since inception.

Source: YCharts

SunCoke Energy Partners' current dividend yield of 14.1% is actually below its long-term historical average of 15.3%.

Accordingly, the company may be slightly overvalued, though it still has a very high probability of delivering double-digit total returns thanks to its exceptionally high dividend yield.

What stands out about SunCoke Energy Partners is its unique combination of income and safety. There are very few companies right now that pay a sustainable double-digit dividend yield.

In fact, SunCoke Energy Partners has maintained a distribution coverage ratio above 1.25x since its IPO. This means that for every $1.00 of distributions, there has been $1.25 in distributable cash flow (on average).

Source: SunCoke Energy Partners Investor Presentation, slide 31

With that said, the shareholders of SunCoke Energy Partners have a very high probability of achieving double-digit total returns thanks to the company's sustainable 14.1% dividend yield.

Final Thoughts

SunCoke Energy Parters has a unique value proposition right now:

  • 14.1% dividend yield
  • 1.26x distribution coverage ratio in the most recent quarter and >1.25x since inception

Many companies have either a double-digit dividend yield or a solid distribution coverage ratio. Very rarely do we encounter a company with both.

Thus, SunCoke Energy Partners is a buy for investors looking to meaningfully boost the current income of their investment portfolios.

Investors should keep in mind that SunCoke Energy Partners is a small-cap stock with a market capitalization of just $750 million. Small cap stocks have additional risks when compared to their large cap counterparts, including less information availability and higher volatility.