You Should Avoid SunCoke

About: SunCoke Energy, Inc. (SXC)
by: Freedom in Retirement

I do not see how the company plans to fund a possible dividend on the common units.

The company should focus on paying down the debt.

The financial leverage is high even though the operating income margin is shrinking.

I am mildly bearish on SunCoke Energy (SXC). The weak demand for steel, coupled with high leverage, poor operational performance, and low liquidity, makes me want to avoid a long position in SXC.

Aspects that I do not like about SXC

I believe that SXC’s headwinds are strong, and I do not think that the company will overcome them easily. A primary concern is the lack of demand for steel. In the 2Q 2019 earnings call, Michael Rippey, President and CEO, mentioned that the domestic capacity utilization dropped below 80% for the first time since September of 2018. Also, the price of hot-rolled coil (HCR) remains weak. The futures prices have declined by $19/st to $572/st for the October contracts. December futures fell by $22/st to $572/st. Traders do not believe that prices will surge in 4Q 2019, and they do not think that the price will reach $600/st until Q4 2020.

Michael seems optimistic about the futures pricing curve.

As we look at the futures pricing curve, coupled with price hikes recently announced by primary producers, we believe domestic steel prices have bottomed and are entering a period of relative stability.

However, I believe that as long as the uncertainties regarding the Sino-American trade war and Brexit loom, we will see a continuing soft demand for steel. The outcome of these woes will result in downward prices for the commodity.

Along with the same note, United States Steel (NYSE:X) announced the temporary idling of two blast furnaces. While Michael believes that the idling will not affect SunCoke, I think that the eventual oversupply of coke will have a direct impact on SunCoke’s revenue.

On the same conference call, Michael mentioned that the company intends to establish a common dividend in the first full quarter after the "simplification transaction” was complete. However, I have no clue how SXC is going to fund the dividend since it barely generates net income. I think that instead of thinking about dividends, the board should be laser-focused on paying down the debt. I do not expect SXC to establish a common dividend anytime soon.

SXC’s recent financial performance is not exciting

There are a couple of things that I do not like about SXC’s past financial performance.

First, I want to discuss SXC’s operational performance by delving into the DuPont ROE summary. The analysis provides a holistic view of the tax and interest burden, operating income margin, asset turnover, and equity multiplier. I am showing the inputs and summary in the following tables. All figures are in 1000s unless ratios or otherwise noted.

Source: Image created by the author. Data collected from the SEC EDGAR website.

Source: Image created by the author. Data collected from the SEC EDGAR website.

First, I want to mention that SXC’s ROE is very close to 0%. In other words, the company does not produce significant income per every equity dollar invested. Now, let us dig further into the causes for the low ROE metric.

The first issue that SXC has is the low tax burden ratio. In other words, the company is paying a significant amount of taxes compared to its EBT. The trailing-six-quarter tax burden ratio average is 0.47, and the company recorded a tax burden ratio of 0.35 for 2Q 2019. Going forward, you want to see the metric improve.

Another significant issue is that the interest burden metric is low. In general, I do not want to see a ratio below 0.5. In SXC’s case, the company posted an interest burden ratio of 0.25 in 2Q 2019. Overall, the trend seems to be going south. I will speak further about the interest expense in the following section.

The operating income margin is also shrinking, which is worrisome when the leverage is high.

There is not much to write home about regarding the asset turnover as it is stable at 0.20.

Lastly, the equity multiplier ratio is substantially high. Usually, I start to get anxious when companies have equity multipliers north of 3.0. Do not be deceived by the apparent declining equity multiplier in 2Q 2019. The driver for the lower metric was the addition of $225.9 million in additional paid-in capital after the “simplification transaction.” The equity multiplier is above 4.50 if we adjust the coefficient for comparability purposes.

In brief, the operating income margin is shrinking, and the company’s leverage is high. It is a recipe for trouble.

I want to delve further into SXC’s debt. My preferred tools to assess the debt’s healthiness are the interest coverage ratio and the Debt-to-Equity ratio. The former tells me if the company generates enough income from operations to cover the interest expense while the latter tells me about the leverage related to the long-term debt.

Based on the ICR, I believe that SXC may have issues accessing the bond market if it wants to issue debt. The interest coverage ratio has been declining from 2.21 in 2Q 2018 to 1.72 in 2Q 2019. The main driver is the significant decline in operating income. Also, the D/E ratio is high. Without taking into account the additional paid-in capital in 2Q 2019, the D/E ratio is 2.0 on average for the previous six quarters. I believe that SXC should focus on reducing its financial leverage since the operating income margin is shrinking.

Source: Image created by the author. Data collected from the SEC EDGAR website.

Source: Image created by the author. Data collected from the SEC EDGAR website.

One more concern that I have going forward

Lastly, I am concerned about SXC’s liquidity. The company has $102 million in cash and $261 million in available revolver capacity, assuming that the assets backing the revolver credit do not deteriorate in value. In total, SXC has only $363 million in liquidity. Meanwhile, its gross debt is $852 million.

Source: 2Q 2019 earnings presentation deck

My takeaway

The company faces significant challenges as the steel demand remains soft. Also, the financial performance is not exciting, and the high leverage and low liquidity levels are worrisome. Let us avoid a long position in SXC for now.

Disclosure: I/we 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.

Additional disclosure: The opinions expressed herein are the author’s sole views, and they do not constitute investment advice in any form. Past performance may not be indicative of future performance. Always do your due diligence, and determine if the investments mentioned here suit your risk tolerance and objectives, your return objectives, and your personal constrains.