Summary: Sims Metal Management buys scrap for the cheapest possible price and sells it for the highest possible price. The company is a recovery story and has been one of the few stars on the Australian market in recent weeks after full-year results showed an increase in profit and fine margins. One investment bank has doubts about the company’s earnings forecast, while another says it is improving strongly.
Key take-out: China is the world’s biggest consumer of iron ore to make steel but over the next 10 years it is likely to become a major user of scrap metal in its steel-making furnaces.
Key beneficiaries: General investors. Category: Commodities.
Not every business exposed to steel is being hurt by low commodity prices. As my colleagues show elsewhere today investors are reassessing commodity markets at these prices: Notable investors are picking up bargains (see Have oil and industrial commodities bottomed?), BHP is remaking itself as a dividend paying utility (see Battered and bruised: A new BHP emerges) and many in the market believe oil is untenable at recent low levels (see Oil: Time to take another look). Meanwhile, scrap collectors are enjoying reasonable trading conditions, while they also get ready for the boom years to come as China becomes a major generator of scrap.
Currently the world’s biggest consumer of iron ore to make steel, China over the next 10 years is likely to follow the US and European trend and become a major user of scrap in its steel-making furnaces.
The trend can already be seen as the country’s 20-year building boom starts to generate rising levels of scrap steel.
Much of the old metal is suitable for recycling and represents yet another potential future threat for Australia’s iron ore miners, especially if China’s use of scrap rises from its current 10 per cent of furnace feedstock to the 60 per cent level in most advanced economies.
Still, a future problem for iron ore miners could prove to be a winner for the handful of specialist scrap collectors, including one of the few Australian companies which can claim to be a world leader, Sims Metal Management.
Not an easy business to analyse, Sims has disappointed investors in the past through ill-timed expansion moves and poor profits. Even today, as it appears to be overcoming its problems, there are analysts who find it a difficult business.
Credit Suisse in its latest look at Sims criticised the company’s guidance as being unreliable, noting that while it was not suggesting that management had been misleading “the business is almost impossible to forecast”.
This story about Sims and the scrap business does not contain an investment recommendation, rather I am using Sims as a window into one of the most intriguing commodity stories just now – scrap metal and China. I will leave recommendations to professional analysts such as those at Credit Suisse who have a neutral ranking.
Interestingly however, that middle-of-the-road view from one investment bank is out of step with the broader consensus opinion which can be seen in the latest crop of buy notes from other banks, including J.P. Morgan, UBS, Deutsche Bank and Macquarie.
The attraction of Sims is that it is both a recovery story as well as being a rare Australian-listed company which does most of its business in the US, a result of the 2008 acquisition of Metal Management which left Sims with a New York head office and a North American focus.
That deal, just before the onset of the global financial crisis, hit Sims hard with its share price crashing from $41 in mid-2008 to around $16 by the end of that year, and then a long slide down into the sub-$10 range until a recovery started last year, and which seems to be accelerating thanks in part to a major management overhaul.
Over the past four weeks Sims has been one of the few stars on the Australian stock market, rising by 25 per cent to $11.74, seemingly on its way back to a 12-month high of $13.05 reached in late March.
The strong rise by Sims is in contrast to the share-price falls of conventional mining stocks over the same time, underlining the point that Sims is in the metal business, but it’s very different to the miners despite sometimes being referred to as an “above-ground miner” with an ore body comprising mountains of junk metal.
Sims – in common with several stocks in a similar business across the US and Europe – is really a trader, buying scrap for the cheapest possible price and selling it for the highest possible price, like all junk-yard operators.
The new management team at Sims, led by former Alcoa executive, Galdino Claro, has made major changes to way the business operates, returning it to the scrap-metal basics which made the company a success as far back as its Sydney foundations in 1917.
The benefits of a return to a business model based on collecting scrap, shredding it, and then selling it to metal producers, with tight control of costs, was reflected in a profit increase in the year which ended on June 30.
Earnings before interest and tax (EBIT) rose from $77 million to $145m despite a 10.1 per cent fall in revenue from $7 billion to $6.3bn. The annual dividend was increased from 10c to 29c.
The latest result shows the fine margins in the scrap business, and also illustrates the ability of a dealer to adjust its business to difficult market conditions.
Galdino told analysts last month that the economic slowdown in China had pushed surplus Chinese steel into the world market with low prices for scrap diminishing the appeal for the collection of more marginal material which had cut the intake of scrap, particularly in North America.
Those comments about lower prices for scrap are a clue to the complex forces which drive Sims and partly explain why Credit Suisse has doubts about a Sims management forecast of earnings before tax and interest rising to $321m in 2018.
“The unreliability of management (past and current) projections means that we might be better off taking an educated guess about future margins based on history,” Credit Suisse said while also forecasting a rise in EBIT this financial year to $178m.
Macquarie, in its comments after Sims released its latest results, was less critical, describing the company as a “diamond among the rough”, tipping this year’s EBIT to come in at $207m.
“Sims’ self-help driven profit trajectory is improving strongly,” Macquarie said. “This makes the group unique among its peers. While market conditions are challenging, we think the strategy for improvement is credible.”
UBS (also an EBIT of $207m) and Citi ($204m) echo Macquarie’s view with four positive factors likely to work in the company’s favour: Exposure to the US economic recovery, ongoing cost cutting, high levels of cash in the business and an attractive asset backing.
The importance of North America to Sims can be seen in the latest results with more than half of the company’s revenue generated in the US and Canada with Australia, New Zealand and Europe the next biggest markets.
Citi, which has upgraded its view of Sims from sell to buy, noted the ongoing “structural concerns” about the global steel industry but likes the company’s debt-free status and cash generating capacity even in a problematic global environment.