Sims’ Warning Shocks Brokers

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

-Medium term under scrutiny
-Lack of short-term catalysts
-Well placed for eventual turnaround
 

By Eva Brocklehurst

The going appears to be getting even tougher for Sims Metal Management ((SGM)). The company has issued a warning for first half earnings to only break even, also announcing a $230m write down at the AGM. The company expects earnings to return to FY15 levels by the end of FY16.

The AGM address was used to significantly re-base guidance to account for a materially weaker earnings outlook, Credit Suisse observes. This not only represents a material downgrade from just three months ago but also triggers alarm bells for brokers.

The severity of the downgrade is one such alarm, in Credit Suisse's view, as management appears to have been caught on the hop. While there is no denying declines in scrap prices exceeded expectations, the broker points out that evidence of the weak market was readily available at the results in August, when the company reiterated its guidance and earnings targets.

Moreover, Credit Suisse is frustrated by the lack of detail in this update, with the blame for the downgrade seemingly being attributed to the decline in ferrous prices, despite non-ferrous prices also being weak. What has occurred so far in FY16 is a large drop in ferrous prices and volumes to what the company calls "the new norm".

No comment was made about divisional or geographic performance. The broker's cautious outlook is based on the difficulty of identifying where a scrap recovery will come from in the near term.

JP Morgan now believes the medium term will come under scrutiny, especially as management did not reiterate its earnings target of $321m by FY18.  Management this time has opted to refer to making an acceptable return on capital. JP Morgan calculates this to mean earnings in FY18 will be more like $200m. The broker reduces its earnings estimates by an average of 51% for the next three years.

In the absence of scrap price appreciation or any other near-term catalysts, JP Morgan downgrades to Neutral from Overweight. Target is lowered to $8.65 from $11.90. Citi has followed suit with a downgrade to Neutral from Buy, and a target cut to $8.30 from $12.20.

Other brokers have also severely trimmed targets on the news. Macquarie observes the significant reduction in intake volumes on the back of sharp falls in scrap prices was expected to some extent, but the impact on Sims Metal has been worse than expected. In the current environment Macquarie believes the company's strong balance sheet and network are key differentiators and as 2016 gets underway its outlook should improve, aided by better conditions in the US market.

Feedback from the ground suggests to Macquarie that many US traders are choosing to retain full yards as they await better markets.The main challenges in that regard the broker foresees is that export markets from the US will depend on the displacement of Chinese exports of steel. There would be a benefit to scrap dynamics if this supply was curtailed in any way but the broker is not confident enough to factor this into its base case.

A more positive aspect of low prices for Sims is that small players have no incentive to collect scrap and larger players are better placed to offer services to large industrial scrap suppliers. Macquarie is content to retain an Outperform rating while lowering its target to $8.90 from $12.60. Deutsche Bank believes the negatives are factored into the current share price and, despite the disappointing downgrade, sticks with a Buy rating.

Deutsche finds some evidence of delivery on improvements in operations but does not believe this is the last of the asset write downs and more might come from the central region of the US. The closure of some of the facilities in this region makes sense to the broker as the company should be focused on the more profitable export markets.

The forecast bottoming of the iron ore price at US$45/t implies a scrap price of US$153/t, the broker calculates. Historically, Deutsche Bank highlights the correlation between iron ore and scrap prices is 92%.

UBS understands that two facilities in Chicago have already been shut in with restructuring to be completed by June next year. The company expects after its latest restructuring initiatives it will finish FY16 at an annualised earnings run rate equivalent to FY15. This implies earnings of $240m, in UBS' calculation. The broker's FY18 estimates are more around $145m, which assumes no improvement in scrap volumes or ferrous prices over the next two years.

UBS finds little visibility in the future earnings capacity of the company, given the tough conditions, but retains a Buy rating on the basis that Sims Metal is net cash and well placed for an eventual cyclical turnaround in earnings.

Morgan Stanley notes that the central American region remains the most challenged and likely driver of the downgrade. The broker expects this is the area where the majority of closures and write-downs are occurring. As management is now talking about an acceptable return on capital rather than a FY18 earnings target, on the revised asset base, Morgan Stanley calculates this equates to a 15% downgrade to consensus expectations.

The broker expects any improvement in demand or supply side metrics should drive out-performance and, should scrap prices stabilise in the next few months, supply side weakness may ease.

Ahead of the announcement the consensus target on FNArena's database was $11.97. It is now $8.91, suggesting 25% upside to the last share price. Targets range from $8.36 (Deutsche Bank) to $10.45 (Morgan Stanley). There are five Buy ratings and two Hold.
 

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