A Hold Rating for SunCoke Energy, Inc.
This analysis suggests a Hold rating for shares of SunCoke Energy, Inc. (NYSE:SXC), an independent Lisle, Illinois-based producer of metallurgical coke from its coke plants in the United States and Brazil.
The benefit of holding a position in SunCoke Energy comes from a portfolio of metallurgical coke assets that remain resilient despite dramatic commodity price declines, providing a solid foundation for a dividend increase that currently yields respectably (4.48% vs. S&P 500’s 1.57%). On September 1, 2023, the company will pay a quarterly dividend of $0.10 per common share, a 25% increase from the previous payout.
The market likes the core business and under its nudge, SunCoke Energy stock outperformed its larger peers by delivering superior performance in terms of total return (= price return + dividend yield) over the past year while met coke price plummeted. As a benchmark for the Met Coke price, this analysis uses Metallurgical Coke futures – [DCJc1], whose average price of Chinese yuan renminbi [CNY] 2,307.34/ton (approx. USD 322.22) in the second quarter of 2023 was down 41% year-on-year and 23% sequentially.
However, SunCoke Energy shares could trade lower in the coming weeks should a recession hit, as US real estate giant Fannie Mae and Fitch’s long-term US debt rating downgrade have recently pointed to, providing an opportunity to increase the position from a lower share price.
About SunCoke Energy, Inc.’s Robust Portfolio of Metallurgical Coke Operations in Times of Severe Headwinds
SunCoke sells the product to the steel industry under long-term take-or-pay agreements, primarily in the United States, as the US coke segment accounts for more than 90% of the company’s consolidated Adjusted EBITDA.
Through long-term take-or-pay agreements with major customers in the steel industry such as Cleveland-Cliffs Inc. (CLF), United States Steel Corporation (X) and ArcelorMittal S.A. (MT), SunCoke Energy effectively reduces the risk of deteriorating met coke market conditions: as market demand risk is fully neutralized. This has helped SunCoke Energy keep operating profitability within the industry average.
The benefit of shifting the risk of deteriorating market conditions to the buyer will become even more apparent in the coming months.
If the business cycle were to slide into a recession, with other operators involved in the decline in manufacturing activity, SunCoke Energy’s profitability, at least from this point of view, would have one less headwind to deal with and only worry about finding an effective instrument to hedge against market price risk.
Much of the metallurgical coke that SunCoke Energy will sell to its customers over the next several years will be under such take-or-pay contracts.
Last April, SunCoke signed an agreement with Cleveland-Cliffs Inc. to extend the terms of its supply of 1.2 million tons per year of metallurgical coke to Cleveland-Cliffs through 2035. This is just one contract in a much larger portfolio that, also taking into account this overview of Sun Coke’s U.S. Coke contracts, should result in more than 60% of the annual supply of metallurgical coke being delivered through take-or-pay agreements over the next several years. In addition, the information gathered indicates that more than 40% of the annual supply of metallurgical coke is already contracted until at least 2032.
Accordingly, if the deal between Cleveland-Cliffs (CLF) and the U.S. Steel (X) were to be implemented, it would correspondingly strengthen SunCoke Energy’s portfolio — that is, enhancing the protection it offers against the risk of falling met coke demand. There is a risk of further deterioration in the demand for metallurgical coke due to the sharp drop in factory activity, which is evidenced by a sustained series of negative data in the benchmark index. The lack of momentum in China’s economic recovery and the likely recession between Q4 2023 and Q1 2024 also weigh on the risk.
The recession is suggested by Fannie Mae’s reliable opinion in its role as a state guarantor of mortgage loans to low- and middle-income borrowers, who are by far the economic class of US households that make up the largest percentage of US consumption, which in turn accounts for more than 68% of US GDP.
As for the stability of China’s economy, it is currently being driven by payment problems in China’s property sector – a major buying industry of steel products from the world’s biggest steel consumer – as the debt crisis deepens and with it the outlook for global demand for metallurgical coke is undermined.
With regard to managing market pricing risk, from the second quarter of 2023, it appears that the company has opportunities to negotiate very favorable terms, even with generally very weak met coke prices.
Higher selling prices combined with higher met coke sales volumes led to excellent results in the second quarter of 2023, with Adjusted EBITDA and net income increasing by 3.8% and 13.3%, respectively, to $74 million and $20.4 million. Year over year, revenue increased 6.5% to $534.4 million.
In the US, revenue increased 7.1% year over year to $505.9 million on 3.6% higher sales volumes of 1.043 million tons of met coke, which means adjusted EBITDA increased 6.1% year over year to $68.2 million.
While Brazil Coke’s revenue and Adjusted EBITDA fell 8.3% and 41% year over year to $8.8 million and $2.3 million, respectively. However, this segment accounts for only a very small part of the company’s business.
The company is also engaged in logistics and through this segment provides various handling-blending services to steel producers, other coke and coal producers, and utilities, but in terms of consolidated adjusted EBITDA, this activity is still marginal compared to the company’s coke business.
The logistics segment also performed less well than in the prior-year quarter due to lower transfer cargo volumes and reported a 6.4% decline in adjusted EBITDA to $11.7 million on flat sales of $19.7 million. This trend is not surprising, however, as growth in the West is paying the consequences of the conflict in Ukraine, and tightening monetary policy to counter runaway inflation, while China’s economy fails to find the path to ultimate growth.
Looking ahead, the company aims to produce 4 million tons of metallurgical coke at its domestic facilities in 2023. The company also expects net income of $59 million to $76 million (vs. $100.7 million in 2022) and Adjusted EBITDA of $265 million (vs. $297.7 million in 2022).
Capital expenditures [CapEx] will increase to $95 million from $75.5 million in 2022 as the company works to expand met coke production. However, operating cash flow [OCF] is estimated to be between $200 million and $215 million, with the upper bound significantly above $208.9 million in 2022.
The company also expects it will likely pay between $12 million and $16 million in taxes.
So that means that free cash flow (= OCF – CapEx) should be about $127 million, or about $1.52 per common share, which covers the dividend by 3.8 times on an annualized basis and offers good odds that the distribution could be increased again, which represents value for the investors, all the more so if the recession were to set in.
The Balance Sheet
As of June 30, 2023, the balance sheet reported net debt of approximately $420 million (cash and equivalents of $78.2 million less total debt of $498.4 million).
The company is heavily leveraged but appears to manage that weight quite well, as reflected in the following interest coverage ratio of 4.71x, which is calculated as a 12-month operating income of $139.3 million divided by a 12-month interest expense of $29.6 million. Typically, investors consider a minimum acceptable level of 1.5x.
The Altman Z-Score provides a summary assessment of SunCoke Energy, Inc.’s financial condition, assigning it a score of 2.10 (scroll down to the Risk section of this webpage to view the ratio), meaning that SunCoke Energy’s balance sheet isn’t in clear waters from a solvency standpoint, but it doesn’t even face bankruptcy.
The Altman Z-Score measures the likelihood that a company will face bankruptcy problems. If the value is less than or equal to 1.8, the balance sheet is in distress zones, which means a high probability of bankruptcy within a few years. When the ratio is between 1.8 and 3, the balance sheet is in a gray area, which still implies a risk of bankruptcy, albeit tolerable. While a score of 3 or higher means that the risk of financial insolvency is extremely low or non-existent.
The Stock Valuation
Compared to the potential value of this stock for the above reasons, shares of SunCoke Energy, Inc. (SXC) were sold at $9.09 per share, representing a market capitalization of $747.11 million at close on Aug. 17, 2023.
Both technically and fundamentally, shares of SXC don’t really look expensive, but they’re about to get more attractively priced amid headwinds from a looming recession and struggling economy in China.
Shares are 12.6% above the middle point of $8.075 of the 52-week range of $5.72 to $10.43.
They are also above the 200-, 100- and 50-day simple moving averages as illustrated in the Seeking Alpha chart below, but the margin is not a huge gap.
Basically, SXC’s stock has a trailing 12-month EV/EBITDA of 4.24x versus the sector median of 8.80x, and it has a next 12-month EV/EBITDA of 4.48x versus the sector median of 8x.
Many of SunCoke Energy, Inc.’s peers are much, much more expensive, and the comparison is measured against an index that has an excellent reputation among investors as it enables the evaluation of coking coal stocks and other capital-intensive industries.
However, shares may still be getting more attractively priced as a 14-day relative strength indicator of 55.67x suggests there is room for a significant decline from current levels, while the aforementioned headwinds could be the kind of catalysts. However, without having to wait for the recession or the crisis in China’s real estate sector to grow in intensity, the policy of interest rate increases may be the reason for the expected price level.
Minutes from the July meeting of US Federal Reserve policymakers showed the possibility of further interest rate hikes, as most participants fear the rise in inflation may yet take place.
In a signal that another rate hike may be imminent, Yahoo Finance Morning Brief of Friday, Aug. 18 says:
“Yields across the Treasury curve continue to rise, with 10-year yields rising north of 4.3% at one point on Thursday as investors brace for continued action from the Federal Reserve as the economy remains surprisingly strong.”
Higher interest rates from the Fed not only increase the likelihood of a sharp downturn in the business cycle by affecting household and corporate balance sheets, but they are also not welcomed by equity investors because they reflect a lower present value of the equities as discount rates should be adjusted accordingly.
Headwinds from bearish sentiment among US-listed equity investors are expected to affect SunCoke Energy, Inc.’s (SXC) stock price by an order of magnitude based on a 24-month beta coefficient of 0.73x (scroll down to “Risk” on this website). The 24-month beta implies a less strong underperformance in SunCoke Energy, Inc.’s stock price amid a drop in market prices for US-listed stocks, but still significant.
In addition, a weakening demand for metallurgical coke is likely to lead to a lower price for the commodity, and shares of SunCoke Energy, Inc. could create great opportunities to buy dips based on a positive correlation that its US-listed share price has with the price of met coke.
The chart below from Investing.com shows that there is a positive correlation between the SunCoke Energy, Inc. (SXC) stock price and the met coke benchmark price (this analysis uses Metallurgical Coke Futures – [DCJc1]), as the CC- curve (light purple area) is almost completely above zero in the last 3 years.
SunCoke Energy, Inc. has significant value in its portfolio of resilient coke operations that allow the company to outperform even in deteriorating market conditions.
Ongoing headwinds from weaker demand for metallurgical coke and downward pressure on prices are expected to continue, further highlighting the resilience of SunCoke Energy’s business relative to its peers.
Because of these attributes, SunCoke Energy keeps its financial position under control while also increasing its dividend.
Investors should maintain their investments in SunCoke Energy and have the opportunity to increase their position in the coming weeks by taking advantage of a lower market price.