Steel sector part 2: Sims Metal Management

If he were alive today, we’d guess that Andrew Carnegie would be running Google or some other modern version of a winner-takes-all business. But if he were forced to invest in an Australian-listed metals company, though, he might well have his eye on Sims Metal Management. The business displays better economics than OneSteel or BlueScope, which we covered in the first instalment of this sector review.

Sims is the world’s largest metals and electronics recycler. The company is Australian in heritage and listing only, with more than 85% of revenues coming from outside of Australasia (mainly North America) and a head office in the US.

Like BlueScope and OneSteel, Sims sells a commodity product. Thanks largely to acquisitions, its sales are now larger than OneSteel’s, although it still has lower revenues than BlueScope. But Sims has less pricing power than its two peers because it sells generic recycled metals to steel mills and foundries. It also operates in bigger, more competitive markets.

Downturn dishes out a clobbering

The lack of pricing power was painfully apparent in the quarterly results to 30 September 2009, with revenue down 50% and earnings before interest and tax down 80%. The 2008-09 economic slowdown had an acute effect on the metal recycling industry. A collapse in steel prices, and the relative ease with which many consumers and corporations can delay new purchases of metal-intensive items, meant diminished flows of scrap metal into the company’s recycling facilities.

This doesn’t seem to line up with what you’ll notice in the 2009 annual report, where scrap intake actually rose 8% to 12.6m tonnes. But the 2009 result includes the first full year’s ownership of Metal Management, a large acquisition completed in March 2008 that added more than 5m tonnes to capacity.

In fact, production per individual recycling facility fell almost 20% between 2007 and 2009. This lower utilisation, in combination with lower steel prices, resulted in the big drop in revenues and the even bigger drop in profits. By the September quarter, though, utilisation had improved considerably and Sims looks on track to process more than 14m tonnes over the next twelve months.

The storm abates

Last year was terrible, but should be thought of as a 1-in-20 or 1-in-50 year storm. Looking at prior year results shows why we believe Carnegie might opt for Sims over the two alternatives.

Prior to the acquisitions of Hugo Neu in 2005 and Metal Management in 2008, the company was a bit player. These company-transforming acquisitions somewhat restrict our ability to use the past as a guide, but over the three years to 2008, ROA averaged 16% and ROE 17%. These are reasonably impressive numbers for a producer of commodity products.

Still, the three-year average is higher than Sims should count on earning given the boom conditions over that period. But Sims should earn higher than average returns on capital than either BlueScope or OneSteel, perhaps high enough to classify the business as ‘average’ rather than ‘poor’.

Any competitive advantage stems not from the recycled metal it sells but from the network it uses to collect and process scrap. No other company can boast 230 recycling facilities in more than 20 countries and market-leading positions in North America, Australia, New Zealand and the United Kingdom.

Sims’ business is competitive, but being the biggest in the industry gives it scale advantages, and is the key to its higher returns on capital. Sims uses its scale to produce recycled metals cheaper than most competitors. It’s a competitive advantage also helped along by the tailwind of recycling’s green credentials.

Another factor differentiating Sims from BlueScope and OneSteel is that it didn’t stretch its balance sheet during the boom. It raised $441m in an institutional placement and share purchase plan late last year, increasing its equity base by about 10%. But Sims’ raising was at a reasonable price compared with the punishingly dilutive raisings made by OneSteel and BlueScope. The conservative positioning heading into the downturn sets shareholders up to reap the rewards of any recovery.

Not on the scrap heap yet

So, despite recent poor results, we suspect that the business’s economics and financial footing mean that Carnegie would be more attracted to Sims than its peers. But Carnegie was a noted miser and the price would have been crucial.

After the company’s equity raising in November (at prices similar to today’s), we estimate that net tangible assets is about $1.9bn, give or take a few hundred million depending on profitability for the half year to 31 December 2009.

The market capitalisation of Sims is today $4.5bn. So the stock is trading at more than twice NTA, greater than BlueScope’s 17% premium and OneSteel’s 95% premium, meaning the higher quality of this business is at least partly reflected in the price. While Carnegie might have admired its market-leading position, he would surely have baulked at the fancy price.

What might a rational value investor pay for Sims? We’d argue it becomes attractive at NTA, or perhaps a small premium. In late 2008 the share price fell to less than $12. If it traded there again – a 25-30% premium to current NTA – we’d become more interested.

Andrew Carnegie built a great fortune buying reasonable assets at dirt-cheap prices. Sims Metal Management has reasonable assets but is far from a bargain. We’ll keep one eye on the stock in case an opportunity emerges. For now, with the stock down 30% since our last review on 3 Oct 07 (Sell – $31.47), we’re switching our recommendation to AVOID.