A Possible Play On China's Domestic Economic Growth: SinoCoking Coal And Coke Chemical

| About: SinoCoking Coal (SCOK)

In keeping with my quest to find Chinese companies whose future is tied to China's domestic growth and not tied to the country's export economy, I've been following SinoCoking Coal and Coke Chemical Industries, Inc. (NASDAQ:SCOK) for some time. Once you get beyond the name, which one has to wonder why they haven't shortened, I've come to the conclusion that right now the company is not a long or short opportunity, but instead a company worth watching over the coming months.

SinoCoking and Coke Chemical is a vertically-integrated coal and coke processor. It uses coal to produce basic and value-added coal products which are sold to manufacturers of steel, producers of power, and for other industrial customers. In the past, a key source of the supply of coal was from the company's own mines, but now the company has been forced to source all of its coal from third parties.

For the year ended June 30th of this year, the company announced that its total revenues increased by 6.2% to $78.9 million, compared to revenues of $74.3 million for the year ended June 30, 2011.

The company's gross margin also decreased from 36.4% for its 2011 fiscal year to 19.2% for this year. The company's net income decreased, from $39.9 million in 2011 to $12.5 million for this year.

The company's stated reason for the reduction of its gross margin and net income was the impact of having to purchase coal from other provinces and third-parties instead of using coal produced by its own mines.

The real issue for SinoCoking and Coke Chemical is the critical need to obtain a steady and long-term supply of coal, since the company and apparently all other non-governmental controlled coal miners have been ordered closed. While the company has indicated that it is hopeful that it will be able to restart its own mining operations, that, I believe is not necessarily a likely outcome.

In the company's fiscal year-end earnings announcement, the company's chairman and CEO, Jianhua Lv stated:

Due to the ongoing mining moratorium, coal supplies in Henan Province remained limited as were production activities for all producers other than state-owned enterprises. Operations at our four coal mines remain halted as we continue to wait for clearance to resume operations. Thus far, no private coal mine operators have received clearance, and the timing as to when such clearance will be issued remains unknown.

SinoCoking and Coke Chemical is a company that should grow as China's economy grows. But, obtaining a steady and dependable source of coal at a good price is a critical necessity.

On September 14th the company announced that a subsidiary had entered into a supply agreement with Datong Coal Mine Group, Inc. (Shanghai Stock Exchange: 601001) for the purchase of up to 120,000 metric tons of thermal coal. While at first glance this announcement could be seen as very good news, the company's announcement raises significant issues. One key item is that the supply agreement only related to coal purchases through September 30th of this year.

Yes, while indicating that it was hopeful of a long-term business relationship with Datong Coal Mine Group, the company announced a purchase agreement that would last only slightly over two weeks.

Since September has now come and gone, it's also an open question as to how many tons of coal the company was actually able to purchase during the term of the agreement. The company has made no follow-up announcement, so investors should be concerned. I called the company's U.S. investor relations representative Tuesday for clarification, but received no insight.

Conclusion

I can't suggest that buying SinoCoking and Coke Chemical's shares should now be considered. Nor can I suggest that the company's shares be sold short.

It's likely that the company's management is committed to finding a long-term and steady supply of coal at a good price. Perhaps September's short-term purchase agreement with Datong Coal Mine Group will evolve into that kind of relationship. But there have been no subsequent announcements as to a long-term relationship with Datong Coal Mine Group, or for that matter with any other coal supplier. This lack of a steady supply of coal should be a concern to investors.

Also, the company's substantial decrease in gross margin and net income should concern investors.

My conclusion is not to suggest that this company be written off as a way to participate in China's economic growth. Instead, I believe that the next two quarters will be critical for investors to be able to determine whether the company is able to obtain a viable solution to its coal supply needs and whether the company is able to substantially return its gross margin and net income to prior levels.

Then it will become apparent whether SinoCoking and Coke Chemical is a buying opportunity or a company to be shorted.

Caution

There is no question that investing in smaller-capitalization companies, as well as investing in companies in emerging markets, specifically those in China, are not suitable for all investors, and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risk.

Since SinoCoking and Coking Chemical is a U.S. reporting issuer, and subject to the reporting requirements of the U.S. Securities and Exchange Commission, U.S. transparency and disclosure is available to investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.