A Hold Rating on SunCoke Energy
This analysis suggests a “Hold” rating on shares of SunCoke Energy, Inc. (NYSE:SXC), an independent coke producer based in Lisle, Illinois.
This analysis confirms the “Hold” rating assigned to SunCoke Energy, Inc. in the previous analysis. The rating was given because thanks to the presence of a portfolio of robust coking operations the company can still perform well versus peers despite the risk of deteriorating market conditions amid recessionary threats. It was also predicted that over time, investors would have been able to take advantage of a lower market value of their shares to strengthen their position in SunCoke Energy stock, and that was the case in early November, before the nine-week winning streak in the US stock market.
About SunCoke Energy: Something Remarkable Recently Happened in the Portfolio of Long-Term Blast Furnace Customers
The company sells its mineral products in the North American market and the Brazilian market and also operates a logistics business segment. The company’s main source of income is the sale of coke to the steel industry under long-term take-or-pay agreements, particularly to the domestic market, as this accounts for about 90% of the income.
The company leverages a robust operating portfolio as the take-or-pay agreements provide SunCoke Energy with the following benefits:
- effective multi-year protection against the risk of lower coke needs if demand for steel products becomes weak, the consequences of which will be borne by the buyer.
- a striking number of contracts are concluded with top players in the global steel industry. These are operators like Cleveland-Cliffs Inc. (CLF), ArcelorMittal S.A. (MT) and now also Nippon Steel (OTCPK:NPSCY) of Japan, as SunCoke Energy’s original customer, United States Steel Corporation (X), is being acquired by the Japanese steel company. This deal was agreed on December 18, 2023, for a total consideration of $14.9 billion, or $55 per share of United States Steel Corporation, in an all-cash transaction. Although the merger is being closely watched by the U.S. Committee on Foreign Investment, people familiar with the matter believe the deal has a very good chance of being approved, reports Seeking Alpha. Furthermore, under the agreement signed last year, SunCoke will supply Cleveland-Cliffs Inc. with 1.2 million tons of metallurgical coke each year until 2035. The portfolio is much larger than just the renewal of the Cleveland-Cliffs agreement, as SunCoke Energy will supply more than 60% of annual metallurgical coke through multi-year take-or-pay agreements and with more than 40% of annual supply already contracted until at least 2032.
Macro Uncertainties May Pick Up: Hold the Stock for Now
SunCoke Energy operates in the coking coal industry with a well-rounded portfolio of coke sales contracts, while the outlook for US steel demand remains positive. The US government’s Infrastructure Investment and Jobs Act, bodes well for steel (which requires coking coal), as this legislation encourages investment in infrastructure projects such as bridges and railroads that require significant steel production.
However, this analysis recommends not going beyond the “Hold” rating, as the evolving macroeconomic situation affecting the coking coal industry makes increasing the stake in SunCoke a notably risky investment at this time.
The stock price will experience ups and downs in 2024 as this is a normal situation for it due to the volatility of the coking coal price in the commodity markets. However, this analysis sees a high probability that the stock price will be dominated by a downtrend in 2024 as industry profits, including SunCoke Energy, factor in further negative effects from delaying growth projects due to expensive borrowing as the Federal Reserve had to raise interest rates to combat increased inflation. Also, as a result of high borrowing costs, slow adjustment of wages, and the return of student loan obligations, the weakened spending capacity of US households during shopping is putting pressure on the consumption of steel products as well. On top of this, soon, the rise in unemployment may also have an impact on consumption, as the steady slowdown in the pace of job creation, echoed in the declining number of job vacancies, points to a slackening trend in the labor market.
Coking Coal Income Under Negative Pressure
As a benchmark, the chart below shows that SunCoke Energy’s direct competitors such as Ramaco Resources, Inc. (METC) (METCB), Alpha Metallurgical Resources, Inc. (AMR), Arch Resources, Inc. (ARCH), and American Resources Corporation (AREC) and Warrior Met Coal, Inc. (HCC) are all facing a significant decline in their ability to generate profits, as evidenced by the ongoing decline in EBITDA since 2022.
The EBITDA of SunCoke Energy, the main driver of the stock price, is expected to remain subject to a lower contribution margin across the portfolio that is not covered by long-term take-or-pay contracts for the sale of blast coke. This risk is exacerbated by the presence of a supply of steel products on the world market that exceeds the level of current demand, even as the latter appears robust. In addition, there are signs in the global market that the production of steel products will remain at an elevated level for some time due to large inventories in the steel industry. These clues come from China, where the world’s largest steel production takes place. Chinese inventories appear to have risen dramatically after the Chinese government suspended production controls to improve the margins of property developers whose balance sheets are heavily burdened by debt. Not only the crisis in the Chinese housing market but also China’s decision not to let the economic recovery take too much of the construction sector could affect coking coal’s near-term prospects through lower demand for ferrous metals.
The Uncertainties Will Weigh on SunCoke’s Stock Market, but Well into 2024
SunCoke Energy shares will also face some pressure (in line with the 24-month market beta of 0.72) due to recessionary headwinds for U.S.-listed stocks, but likely well into 2024.
But this analysis doesn’t suggest that SunCoke Energy shares should be sold now to make some profit on the investment, as the US coking coal producer’s shares still appear to be riding the waves of bullish sentiment sweeping through the market, fueled by the following factors: by some recovery in consumption due to Christmas shopping season and by the optimism generated in the markets ahead of the start of a series of interest rate cuts by the Fed. Therefore, SunCoke Energy shares are expected to continue with positive momentum before the earlier-mentioned uncertainties become more apparent in the stock market.
Once the resulting headwinds have ceased their depressing effect for the shares, it will also be possible to pursue more attractive entry points to re-position SunCoke Energy given the potential benefits ahead: these will primarily arise from a) the US Government’s Infrastructure Investment Act and Jobs; and b) US-China willingness to resolve some commercial and geopolitical issues that have cooled commodity markets somewhat recently.
However, since bullish sentiment is unlikely to truly abate at least until the first-rate cut expected at the Fed’s March 20 meeting by 2024, the average retail investor is probably best off assuming a “Hold” rating for the time being.
Further Reasons for the “Hold” Rating
A “Hold” rating seems most appropriate at this point, also considering the following possibility: as December’s consumer confidence recovery could prompt Federal Reserve policymakers to keep interest rates “higher for longer” than widely expected, the first rate cut could possibly be delayed.
Assuming that earnings are the primary driver of stock prices, as many on U.S.-listed exchanges claim, further bullish sentiment for stocks is likely to emerge as 2024 unfolds. Typically, analysts lower their earnings estimates early in the quarterly earnings season before most companies manage to beat analysts‘ quarterly earnings estimates. The Q4 earnings season results are published at the beginning of each year. Based on past trends, this appears to be a consolidated dynamic that is going to generate additional positive momentum.
Currently, share price levels don’t really provide a convenient way to add more SunCoke Energy shares to the portfolio. At this point in SunCoke Energy’s stock price cycle, there is a disconnect between the market value of the stock and what the stock has been able to deliver in terms of profitability.
While the twelve-month EBITDA margin (the most widely used profitability metric for capital-intensive companies) has fallen back to 2016 levels, the SunCoke Energy share price has managed to grow beyond its capabilities in the wake of the S&P 500’s nine-week winning streak from January 2 (the longest since 2004).
Thanks to the continued bullish sentiment, SunCoke Energy stock has performed exceptionally well, beating most of the operators in the industry. SunCoke Energy’s stock price is up 26.40% over the last 52 weeks, compared to +6.73% for the Materials Select Sector SPDR® Fund ETF (XLB).
SunCoke Energy’s Q3 2023 Activity Portfolio and Year-over-Year Trends
Hedging through long-term take-or-pay contracts helped the company withstand some volatility in the metallurgical coal market, but not completely. Market volatility impacted the company’s profitability – particularly EBITDA margin – in the third quarter of 2023 due to a lower contribution margin for non-contracted blast coke sales compared to the same quarter last year.
In the third quarter of 2023, Adjusted EBITDA of $65.4 million (down 21.9% year-over-year) on total revenues of $520.4 million (up 0.7% year-over-year thanks to higher coal prices on the company’s long-term, take-or-pay agreements) resulted in an EBITDA Margin of 12.57%, down 362 basis points year-over-year.
Domestic Coke’s adjusted EBITDA margin fell 280 basis points year-over-year to 12.91% in Q3-2023 as adjusted EBITDA fell 16.45% to $64 million while revenue increased 1.64% to $495.7 million.
Brazil Coke’s adjusted EBITDA margin fell 1,288 basis points year-over-year to 24.2% as adjusted EBITDA fell 33.3% to $2.2 million while revenue increased 2.2% to $9.1 million. Brazil Coke consists of a coking plant in Vitória, Brazil, operated by SunCoke Energy for the benefit of a subsidiary of ArcelorMittal.
Logistics’ adjusted EBITDA margin fell 712 basis points year-over-year to 39.62% as adjusted EBITDA fell 34.9% to $8.4 million while revenue (including inter-segment sales) decreased 23.2% to $21.2 million. The logistics segment provides various transshipment and blending services to steel producers, other coke and coal producers, and utilities, but as measured by consolidated adjusted EBITDA, this activity is still marginal compared to the company’s coke business. The conflict in Ukraine and other geopolitical tensions between the countries coupled with the difficult economic recovery in China, which continues to look for ways to return to growth, weighed on the segment’s sales and profitability. The Asia-Pacific Economic Cooperation (APEC) summit in San Francisco in mid-November 2023 showed clear signs of a thaw that will be crucial for resolving several issues and tensions between the two economic superpowers, the United States and China: for China, Taiwan issue and the US restrictions damaging high-tech exports, and, for Washington, the lack of a level playing field.
Stock Valuation: Stock price in the Top Half of the Cycle
As a result of the sharp rise in the past 2 months, shares of SunCoke Energy are trading very high compared to previous recent trends, as signaled by the following comparisons: At the time of writing, the stock price was $10.83, compared to the 200-day simple moving average of $8.84 and the 50-day SMA of $9.55. Combined with approximately 83.76 million shares outstanding, the current market valuation per unit results in a market cap of $907.12 million.
The stock’s market value has fluctuated between $6.71/share and $11.21/share over the past 52 weeks, meaning the stock is currently trading more than 20% above the interval midpoint of $8.96. The stock is trading in the very upper half of the stock price cycle and its 14-day relative strength indicator of 68.61, whose most common range is between 25 and 70, also suggests there is little room for additional upside potential.
SunCoke Energy Vs. Most Direct Peers, and the Investment Risk
These valuations lead to a trailing twelve-month Enterprise Value/EBITDA ratio of 4.95x, which compares favorably with the industry average of 9.17x. This ratio is highly regarded by investors in capital-intensive industries such as coking coal, but it comes with a notable risk: If purchased at current levels, SunCoke Energy shares do not have good growth prospects, even if apparently, they seem reasonably valued by the market.
However, compared to the trailing 12-month EV/EBITDA ratio of most direct competitors of Ramaco Resources, Inc. at 8.92x, Alpha Metallurgical Resources, Inc. at 4.45x, Arch Resources, Inc. at 3.90x, American Resources Corporation at -10.51x and Warrior Met Coal, Inc. at 4.32, the analysis highlights two aspects:
- First, SunCoke only beats Ramaco Resources, while the other coking coal stocks appear to be more attractively valued by the market, except AREC, which is negative.
- Second, SunCoke Energy’s enterprise value/EBITDA ratio has been around current levels, both in the higher stages of the stock price cycle and the lower stages. While the latter represented a small investment risk that was more than offset by the prospect of an upside, current price levels instead present a much greater risk that subsequent price increases will not provide a satisfactory market return from increasing the holding of SunCoke now.
Therefore, SunCoke Energy’s trailing 12-month EV/EBITDA, which is well below the industry average, could now represent something of a honey trap because, as shown earlier in this analysis, there is a gap between market valuation and SunCoke’s ability to generate income which seems to have expanded too much to be accepted any further.
The S&P 500’s nine-week winning streak, which may also have led to the recent meteoric rise in SunCoke Energy’s stock price, was also because the stock market liked that corporate interest expenses remained low despite aggressive Fed on rates. The latter trend is evidenced by the fact that the debt service burden of S&P500 companies is significantly lower compared to 10-year US Treasury yields. Companies engaged in debt refinancing activities ahead of central banks’ restrictive monetary policies and thus capitalized on expansionary interest rates. As a result, 50% of the companies represented in the S&P 500 index have debt maturing beyond 2030.
The aforementioned trigger may have had an indirect impact on the rally in SunCoke Energy’s shares as its narrative also fueled bullish sentiment for nine consecutive weeks, but unlike 50% of companies in the US stock market index, the financial situation of the North American coking coal producer is not as solid as. This is another cause for concern and an element that supports the contention that a “Hold” rating is now the most appropriate stance to limit the risk associated with an investment decision in SunCoke Energy stock.
As can be seen from the following situation of SunCoke Energy, interest rates are well above 50% of the S&P 500 index and the 10-year US Treasury yield. In addition, a significant part of the debt leads to the obligation to repay the funds borrowed within the next two years. Although the company believes that the source of cash is currently sufficient to ensure continued operations and replace decaying assets, this does not exclude that a major debt renegotiation may be necessary while the Fed’s restrictive policy continues to be felt in the capital market.
As of September 30, 2023, SunCoke Energy’s balance sheet had $125.9 million in cash and short-term investments against the following liabilities: $350 million of available borrowings under a revolving facility due 2026, plus $500 million of 4.875% interest-bearing notes due 2029 and $6.3 million of 5.346 % interest rate carrying financial obligation due in 2024.
Plus, as of Q3-2023, the average 12-month Cap Expenditures was around $95 million in the past 3 years, and the 12-month cash outflows for financing purposes (debt renegotiation and dividend payments) averaged $118 million in the past 3 years, while the average 12-month Operating Cash Flow was around $223 million in past 3 years. The company pays quarterly dividends of $0.10/share leading to a forward dividend yield of 3.69% as of this writing.
However, as a measure of solvency, a twelve-month operating income of $121.4 million divided by a twelve-month interest expense of $28.2 million results in an interest coverage ratio of 4.30x, which is well above the threshold of 1.5x, meaning the company is seen by investors not having problems in covering the financial costs of the outstanding debt.
On the other hand, the Altman Z-Score of 2.06 suggests that the balance sheet is in a gray area, implying the risk of bankruptcy within a few years, although the probability of this unfortunate event is not high.
SunCoke shares have staged a strong rally over the past 9 weeks and are in the very top half of the share price cycle today. There is not enough room for shares to rise significantly further from current levels, although several factors are expected to support the share price at least until the end of the calendar winter.
Recession headwinds are expected to weigh on US-listed shares but only well into 2024.
Then it may be possible to increase the stake in SunCoke Energy because the long-term outlook for demand for coking coal is good.
As for the possibility of selling some shares now and take a profit, it still seems premature despite the nine-week rally.
Essentially, adding SunCoke Energy stock to the position now poses a noticeable risk.
Although the long-term outlook is positive, there is a mismatch between value and share price, making it more difficult to balance risk with the return of future share price increases. The mismatch is because the company’s profitability deteriorated while the share price went up anyway. The portfolio includes blast coke sales contracts that could significantly better handle the volatility of the coking coal market, but not currently due to macroeconomic and geopolitical concerns. This inability is reflected in declining income. In addition to this discrepancy, the company may still need to refinance the asset portfolio while interest rates remain high, increasing financial stress on the balance sheet, which is not 100% sound.
A “Hold” rating appears to be the most appropriate at the moment.