Can Sims Metal Prevail Against Falling Prices?

This story features SIMS LIMITED. For more info SHARE ANALYSIS: SGM

-Reducing uneconomic volumes
-But can volumes hold up?
-What if scrap prices fall further?
-Concern over risks to margins
 

By Eva Brocklehurst

Sims Metal Management ((SGM)) has made sound efforts to turn around its business and brokers believe some benefits are materialising, particularly via improved margins in North America.

The first half was, overall, positive. Sims Metal has reduced uneconomic volumes and controlled costs but, while there is a skew to the second half in terms of cash flow, Morgans wants to confirm the improvement before becoming more comfortable. The broker warns the recent slump in the iron ore price is not reflected in the first half results and will become more apparent in the second half. Morgans believes the fall in iron ore will affect end markets and investors will moderate the multiple they apply to Sims Metal's earnings as a result. Much of the company's ferrous scrap is used as a substitute for iron ore in certain types of steel making. The broker advises investors to use current strength to reduce exposure to the stock.

Deutsche Bank hailed the achievement of some ambitious targets from the strategic review, in the US in particular. The broker believes there is significant upside to be had from the US economic recovery. The scrap price may have fallen over the course of 2014 and there may be further downside, which could make the second half tough going, but Deutsche Bank contends these are short term concerns. The broker suggests looking further afield to FY16 and beyond, given the valuation upside if the strategic review is fully implemented.

Near-term headwinds persist but JP Morgan considers the company is better placed now to withstand the challenges. The broker notes earnings margins were an issue over recent years in North America, being only slightly above break-even on average between FY12 and FY14. Margins are now closer to levels achieved in the past and are coupled with margin expansion in both Europe and in e-cycling. The company has indicated it is operating on a strategy whereby sales are contracted with customers before volumes are procured to fill those orders, instead of purchasing intake without the certainty these volumes would be sold.

In summary, this means management is reducing the risk of being caught long on scrap. Nevertheless, JP Morgan considers the effectiveness of such a strategy may be impacted if the availability of scrap declines to a point where Sims cannot access material. The broker also points out that the company actually expects, in the near term, a decline in ferrous scrap prices to have a negative effect on supply and lead to elevated levels of competition for intake. What should mitigate this risk, the broker hopes, is the extensive nature of the company's trading arm.

Macquarie echoes this view, in that market dislocation from lower scrap prices should not carry over the long term. The broker notes Sims Metal is actively moving its model to avoid uncovered inventory positions. In this way, pricing risks are reduced and volume becomes the main driver. The broker observes management is also confident it can maintain margins despite declines in the scrap market.

Citi does not buy this idea and downgrades the stock to Sell from Neutral. With confirmation that foreign exchange rates and volumes are the key levers for growth, the broker cannot look beyond softer volumes in the first half half and the risks to volumes in the second half. The broker forecasts volumes to fall as scrap markets continue to deteriorate. Moreover, when tonnage is only bought if it has been effectively sold forward, there should never be a surprise with inventories, in Citi's opinion. Operating cash flow should have been a beneficiary of falling inventories, generated by smarter supply chain strategies but the broker observes working capital actually grew in the first half, by $24m.

UBS attributes the working capital build-up to seasonal factors. The broker is upbeat, noting Sims Metal is ungeared and should generate annualised free cash flow that implies a normalised free cash flow yield of 7-8% over the next two years. This should provide scope for capital management and/or acquisitions. The broker finds the multiples undemanding and retains a Buy rating.

Credit Suisse is sceptical and found the message for investors to focus on the 2018 target and not worry about short-term scrap market dislocations as vague and disconcerting. The broker remains concerned about the recent record of shrinking tonnage, in evidence despite acquisitions and yard additions. The broker also cannot understand how there will be no tonnage impact in the second half, given both ferrous and non-ferrous prices are now materially lower than the average of the first half. Moreover, Sims Metal envisages no risk to margins in the second half, when there is far less scrap income to be shared around the supply chain. Therefore, the broker believes the company's expectations for flat inventory in US dollar terms are not consistent.

Sims has three Buy ratings, one Hold and three Sell on FNArena's database. The consensus target is $12.14, signalling just 0.1% upside to the last share price. Targets range from $10.40 to $14.18.
 

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