SunCoke Energy (SXC) failed to deliver on fourth quarter results, missing expectations by 30%. The company posted 4Q EPS of $0.16, where most analysts were looking for $0.23. Revenues missed by $4.7 million, coming in 18% lower year over year. The weak steel industry has limited SunCoke's upside. However, with rising demand for steel being driven by a rebounding global economy, 2014 should be a great year for the coke maker.
Despite the miss, 4Q wasn't all that bad
The biggest drag on 4Q earnings was SunCoke's Indiana Harbor operations. Indiana Harbor witnessed lower volume demand due to the severe weather and delays in its refurbishment. As a result, SunCoke's adjusted EBITDA for 4Q came in at $59.7 million, compared to $69.7 million in 4Q 2012. Full year EBITDA was also down, coming in at $215 million versus $265 million in 2012.
Beyond that, its other coke plants performed inline. And despite missing analysts earnings estimates in three of the four quarters during 2013, SunCoke blew through its operating cash flow target by $30 million for the year, raking in $150 million total for 2013.
The weakness in coke demand has come due to a slowdown in steel making. SunCoke calls North America's three largest steelmakers its top three customers, ArcelorMittal, AK Steel and U.S. Steel.
It will be interesting to hear ArcelorMittal's results later this week, which is SunCoke's largest customer, accounting for over 50% of revenues. AK Steel is its second largest customer, accounting for 28% of revenues, and reported 4Q earnings last week that beat expectations on higher than expected shipments. The stock soared 20%, giving investors some confidence in the steel space.
Ultimately, refurb and new plants help drive growth
We expect the Indiana Harbor refurbishment to continue to lag expectations. At least through the first quarter. After all, the Indiana Harbor refurbishment is the first time SunCoke has attempted to refurbish a plant while maintaining ongoing operations. 1Q results should also come in weak given the severe weather we continue to see across the U.S.
However, once the refurbishment of Indiana Harbor is complete, SunCoke will be able to ramp up production, just in time for a rebounding economy that will boost steel demand. The company is already fairly close to refurbishment completion. There are four coke batteries at Indian Harbor, three of which are done and the fourth being partly done. Again, the adverse weather has extended the completion date to further out in 2014, but EBITDA at Indiana Harbor are still on pace to accelerate in the second half of the year.
In addition to refurbishing Indiana Harbor, SunCoke already has a draft permit for a new coke plant in Kentucky. The draft permit came through in December, and SunCoke should see the final permit sometime this quarter. However, what investors should be more focused on is the number of customers that would be interested in the coke. The plant will be a multi-customer one, meaning SunCoke doesn't have to find a single customer to carry the full 600,000 ton capacity, allowing for a more flexibility in bringing the plant online.
With the final permit in hand later this quarter, SunCoke will be able to generate firm quotes to start formal conversations with customers during the summer. Assuming all goes as planned, SunCoke would be able to break ground later this year and ultimately start producing coke from the new plant during 1Q 2017. SunCoke only needs about 65% to 70% of the plant capacity to be spoken for before breaking ground.
Restructuring could be a bright spot
As part of its spinoff from Sunoco in 2011, SunCoke has been limited with what it can do as far as restructuring. Those limitations disappeared in January, leaving SunCoke free to pursue some strategic alternatives. Hence the idea that SunCoke could look to make a change in its domestic coke business or sell off under-performing operations. SunCoke has already hired a few financial advisors to explore strategic alternatives.
We believe that restructuring its operations would strengthen profitability. The continued drag on the company remains its coal mining segment. Coal mining was down year over year during the fourth quarter, and sequentially from 3Q. Specifically, coal mining operations saw a $15 million fall in EBITDA year over year during 4Q due to weak coal prices.
As a result, the company could well be looking to sell off its coal mining business. SunCoke already buys coal for its other plants and could do so for all of its operations, meaning a sale of its coal mining business would be easier than many would expect.
As an alternative, SunCoke could shut down the met coal mine in the interim. There would still be costs related to keeping the mine "hot," but it could be a way to keep total costs down until prices return to normalized levels.
M&A could be a growth angle
On the flipside of selling off its coal business, SunCoke could also make a number of tuck-in acquisitions. The coal logistics space is clamoring for consolidation and with an debt-to-EBITDA ratio of 3.3, SunCoke has room to spearhead consolidation. SunCoke also has a lot of flexibility in how it can structure a deal, including alternative structures that would afford SunCoke the upside for the project, while allowing another party to operate it.
As far as where SunCoke might look to get active, the most obvious choice is coke plants. In reality, the area of coke logistics looks to be the near term focus for the company. That would allow SunCoke to leverage its MLP, SunCoke Energy Partners, which has domain experience and operational capabilities. SunCoke Energy Partners did two deals in 2013 in that very area.
Free cash flow margins of around 4.5% should hold up in the interim, eventually expanding back to its historical average of between 6% and 6.5% as Indiana Harbor comes back to full capacity. Assuming a 3.5% annual growth in free cash flow over the long-term, coupled with a 10% discount rate, suggests fair value is around $25.50. Meanwhile, using a steel and iron industry average price-to-book multiple of of 2.9 yields a price target of $23. We have Brean Capital and Credit Suisse on our side as well, with both raising their price targets on the stock within the past month. Credit Suisse has a price target of $24 and Brean Capital is at $26.
SunCoke has an opportunity to gain more market share if it's new facility comes online as planned. All in all, SunCoke should continue performing well on the back of a rebounding economy. Mr. Market appears to be over discounting the impact of the Indiana Harbor slowdown, setting the company up for a potential earnings beat later this year.