2023-10-21 01:54:13 ET
Summary
- SunCoke Energy is a major producer of coke, a coal derivative crucial to the steelmaking process.
- The company has stable margins, low debt, and a solid dividend, and is trading at a low valuation.
- Catalysts such as strong demand for steel, rising steel prices, and potential M&A activity could unlock more value for shareholders, in addition to the robust dividend.
- We rate SXC a Buy.
At PropNotes, our focus is on spotting unique alpha you won't find anywhere else.
In the investing sphere, there are two key ways to generate alpha; either being involved in companies and positions that aren't widely followed, or structuring trades in well-known companies in ways that are more accurate , and therefore produce more return with less risk.
Often times for us, here on Seeking Alpha, generating alpha means structuring trades in well-known names in the most efficient way possible.
You can see examples of this in many of the recent articles we've put out where we've advocated for short put option strategies, among other things, in order to best earn returns off of our insights or expectations about what's to come.
However, sometimes producing alpha really does require you to head off of the beaten path in search of hidden gems that nobody is looking at.
In today's article, we're doing just that.
In today's article, we're looking at SunCoke Energy ( SXC ), a major producer of coke, a coal derivative that is crucial to the steelmaking process.
The company has stable margins, low debt, and a solid, well-covered dividend. And, best of all, its trading for an absolute song, at only ~5x free cash flow.
We don't typically cover stocks that are less than 1B in Market Cap, but today we're making an exception for what we believe is one of the best values on the market.
Sound good?
Let's dive in!
SunCoke's Business
In case you're unfamiliar, SXC is a major producer of coke, a grey, hard, and porous coal-based fuel with a high carbon content and few impurities. Coke is produced by heating metallurgical coal in a refractory oven, which releases certain volatile components from the coal, thus transforming the coal into coke.
Coke is key in the steelmaking process for two main reasons.
First, it's used as a fuel . Coke is a fuel that provides the heat necessary to melt iron ore and produce steel. The blast furnace, which is the heart of the steelmaking process, operates at temperatures of over 3,000 degrees Fahrenheit - 3/10ths the temperature of the surface of the sun. Coke is the primary fuel used to generate this heat.
Additionally, Coke is a reducing agent . This means that it removes oxygen from iron ore, converting it to iron. This is an essential step in the production of steel.
For our purposes, the key is that Coke is very different to thermal coal, which is what most people think of when they think of carbon fuel sources. Thermal coal is used to generate power in power plants, causing pollution and significant CO2 emissions - something many consider to be a dying industry.
But steelmaking isn't dying, and thus the coke market is poised to continue well on into the future, growing in lockstep with demand for steel, and construction in general.
This is important to note as one keeps in mind the following financial statements and subsequent valuation.
Financial Results
SXC's results have been strong.
Despite occupying a somewhat cyclical industry, SXC has produced positive EPS in 16 of the last 20 quarters over the last 5 years:
This consistency is also matched by mostly consistent revenue growth over the same period. Some of this is down to increases in the price that SXC delivers its contracted coke at, but some is also due to improvements in the company's foundry business which just recently completed an expansion.
Looking at SXC from a segment perspective, domestic coke is still responsible for the lion's share of revenue:
While FCF margins aren't amazing, often coming in between 4-8%, they have been highly consistent over time - something that is likely due to SXC's massive market share at more than ~25% of the North American coke market:
While margin stability is good, its management's use of cash that has us excited:
In their most recent quarter (Q2), the company brought in $69 million in cash from operations. They did 3 things with it - pay down debt, continue investing in Capex, and pay an 8c dividend per share.
For a profitable business in a saturated market, this is a perfect allocation of capital, in our eyes.
Taken together, the consistent business, stable end market, solid margins and great capital allocation have us excited about underlying base of the business.
Solvency
But what about solvency? Has management leveraged the future to earn in the present?
Thankfully, it doesn't appear that they have.
Right now, the company only has $470 million in long term debt outstanding, and a current ratio of 1.72. This is highly manageable.
Doubly exciting are the terms of that long term debt; 500 million in long term debt at a 4.8% rate, due in 2029:
Effectively, SXC is currently paying less to borrow money than the U.S. Federal government.
If rates stay high throughout this decade then refinancing may add some costs to the business, but given how fast the company is paying it off - in $30 million chunks per quarter - we think there's no material risk here.
Valuation
So - ask yourself. How much would you be willing to pay for a stable company in a stable industry that produces solid FCF with a strong competitive moat and a great balance sheet?
Would you say 10x FCF? 20x?
Right now, the company is trading at a mere 5.5x FCF and 0.39x sales:
While the valuation isn't scraping the bottom of the barrel from a historical perspective, nominally, vs. the average S&P 500 market stock, it is quite cheap.
While we like the deep value here, without any 'reason' for the multiple to expand, it's easy to see the company trading at this price for a ways into the future.
Here's why it's still a buy.
First, the dividend. Value is good in theory, but better when it turns into cold hard cash regularly. Paying 40c a year per share on a forward basis, SXC's dividend yield looks to be quite attractive at more than 4%.
But why hold SXC instead of Bonds?
In short, there are some upcoming catalysts that we think could unlock more value for shareholders over the interim:
- Continued strong demand for steel. Coke is a key ingredient in steelmaking, and demand for steel is expected to remain strong in the coming years, driven by growth in the global construction and manufacturing sectors. This increased demand for steel should translate into higher demand for coke, which could boost SXC stock.
- Rising steel prices. Steel prices have been rising in recent months, and this trend is expected to continue in the near term. Higher steel prices would benefit SunCoke Energy, as it would allow the company to charge more for its coke. Some of the company's contracts are flexible in this way.
- M&A activity. SunCoke Energy is a relatively small player in the broader steel industry and there is potential for the company to be acquired by an end customer. An acquisition would likely send SunCoke Energy's stock price higher, as investors would expect the acquirer to pay a premium for the company.
All in all, the solid underlying company performance, the dividend, and the valuation make SXC a highly attractive deep value play in our mind.
Risks
While we like the setup, there are some overall risks.
SXC suffers from customer concentration. Of the company's facilities, the majority of them feed into Cliffs Steel ( CLF ) mills:
While that may make CLF an obvious suitor in an M&A scenario if the company tries to verticalize, it also means that SXC is at risk of massive revenue issues if CLF has any issues.
If CLF has issues, SXC has issues.
Additionally, SXC faces considerably macroeconomic risks.
A slowdown in the global economy would likely cause a slowdown in demand for steel, which would, in turn, hurt profits. This is the 'cyclicality' we mentioned earlier.
SXC did well during 2020 and only suffered from some brief setbacks, but as the global macro environment seems tenuous, it's possible that the stock could get hurt in a wider selloff.
Summary
All in all, we like SXC as a well-run deep value play with a solid dividend, an attractive valuation, and a clean capital stack.
There are several catalysts which could send the stock higher, and we're looking forward to more value being unlocked in the future, either via heightened capital returns to shareholders, M&A, or other business tailwinds.
We rate SXC a "Buy".
Editor's Note: This article was submitted as part of Seeking Alpha's Best Value Idea investment competition , which runs through October 25. With cash prizes, this competition -- open to all contributors -- is one you don't want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!
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SunCoke Energy: An Extremely Compelling Value