Sims's thin skin

Sims Group is a capital-intensive recycling company whose stock has soared during the past few years thanks to the commodity boom. For folks like us who simply hate losing money, that’s enough reason to stay out of the game. It’s a situation that reeks of trouble to come. But don’t just take our word for it, management itself provides us with an indicator that this stock is no bargain. We’ll get to that in a moment, but first let’s take a look at the business.

Sims is often mistaken for being purely a metal recycling company, and while this area contributes about 85% of earnings, in recent years the group has moved into other areas, adding a small manufacturing division and some renewable energy businesses. Last year, the company completed the acquisition of Tyrecycle, Australia’s largest processor of used vehicle tyres, to add to its existing UK tyre operations. Sims also has a diverse geographic spread, with only about a third of earnings sourced locally. The US and UK are the other major contributors and there is also a small New Zealand operation. Sims, like most other resources and materials companies in Australia, not to mention manufacturing companies, is looking to China for growth in the future.

Riding high

The company is currently riding high, with a scorcher of an interim result being announced recently. Net profit more than tripled to $105m and earnings per share increased by a like amount to $1.16. With the share price now up 44% since our last review in issue 159/Sep 04 (SELL—$12.43), it appears investors are firmly focused on the positives in the result. And there are plenty of them. On top of the earnings growth, the company has a strong balance sheet with the net debt-to-equity ratio standing at just 22%. And Sims is on track to record a full-year profit of around $200m, placing it on a prospective PER of 8.

Extrapolating these figures is fraught with danger, though. Since 1996, profits have only exceeded $50m, or a quarter of this year’s forecast, on two occasions: in 2003 and 2004, when metal prices took off. In last year’s annual meeting presentation, the company produced a slide showing average Korean ferrous (relating to, or derived from, iron) prices for the previous five years. For the period 2000 to 2003, average prices ranged from US$18 a tonne to US$28. Suddenly, in 2003, the price doubled to US$57, and it then skyrocketed in 2004 to almost US$165. It doesn’t take a genius to figure out what would happen to profits if the ferrous price were to revert to pre-2003 levels. That single-digit PER would only be maintained if there was a very dramatic drop in share price.

Derisory holdings

And it seems that the company’s senior executives are all too aware of this, since they barely have any skin in the game themselves. Page 66 of the 2004 annual report sets out the details in alarming simplicity. Jeremy Sutcliffe, the chief executive, owns just 2,000 shares in the group. And it’s not as though he can rely on the excuse that he just joined the company. Sutcliffe has been with Sims since 1990, so it has taken him about 15 years to build up a holding worth a whopping $36,000. That might be a sizeable stake for a retail shareholder, but it’s chump change for the chief executive of a major company. To put it in perspective, that’s less than a week’s pay for Sutcliffe. And as if that wasn’t bad enough, we checked the shareholdings of the next five specified executives of Sims. Combined, guess how much stock they hold in the company? Zip, zero, nada, nix. Not a single share amongst them. That tells us a lot more than all the colour photos in the annual report.

Imagine this mob going to a meeting with institutional investors to promote the stock. How could these five seriously expect institutions to spend tens of millions of dollars buying the stock when they haven’t bothered to invest a single cent in the company’s shares themselves? We should say that some members of the board, including the finance director, have reasonable holdings, but this doesn’t make up for the lack of faith shown in the company by the rest of the management team.

Sims is a classic Warning Bell stock. The share price has soared on an unsustainable surge in metal prices. When the boom ends, investors will be faced with the reality of owning an overpriced, capital-intensive company. But most of Sims’s top brass won’t feel the pain and neither should you. SELL.