Rocky Road Ahead For Sims Metal

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

-No improvement signalled in supply chain
-Reliant on cost reductions to drive growth
-Fairly valued trader of scrap?
 

By Eva Brocklehurst

Sims Metal Management ((SGM)) has surprised brokers with its updated guidance for FY16 but sentiment remains cautious, given the rocky road ahead for scrap metal prices. The company expects second half earnings to be $55-65m, with the majority earned in the fourth quarter because of higher ferrous metal prices, sales volumes and cost cutting. This guidance implies the company has exceeded its previously guided annualised earnings run rate of around $140m.

Yet Macquarie expects the good news to be short lived. US scrap prices have now subsided and this undermines incentives to collect supply. This is the issue for the broker, as the volatility in scrap pricing is not allowing any improvement in the material supply chain and this is an obstacle to a lasting recovery in Sims Metal throughput.

The broker notes there is only one bright spot for steel globally, and that is in the US. Yet scrap metal does not benefit from trade protection, such as flat and coated steel products, and feedback from a recent New York steel briefing signals to Macquarie there is no positive catalyst for scrap markets. The broker revises forecasts to reflect the adjusted guidance, with a slight upward change to FY17 estimates.

On UBS analysis, the volume leverage is critical. Sims Metal has re-set its break-even level to 7mtpa, from 13mtpa, over the last three years, lowering its fixed cost base to $920m after full realisation of cost reduction benefits. The broker calculates the company can achieve its targeted 10% return on invested capital in FY18 without the need for margin improvement, provided volumes can increase by 10% to 9.2mtpa.

But channel checks suggest 25-50% of the scrap price increase since the November lows has not resulted in a sustained recovery in volume, thus highlighting a need to deliver on cost reductions to drive earnings growth. Still, the recent under performance of the stock suggests a opportunity and UBS retains a Buy rating.

Credit Suisse concurs that break-even tonnage has been aggressively reduced but believes this lags the volume decline. The broker maintains current iron ore prices and falling Asian long product prices are not supporting a recovery in scrap, although resumed buying by Turkey, the world's largest ferrous scrap importer, should mean prices stabilise at current levels

Sims Metal is a large exporter of ferrous scrap to Turkey and this traditional market has contracted significantly. The broker also notes, while not explicitly updating on environmental recycling, the company implies this segment remains weak.

To Ord Minnett, the main catalyst is progress on cost savings and further evidence is required to bolster confidence in guidance and help re-rate the stock. The broker suspects consensus estimates may not incorporate the full potential of the re-setting of the company's base. Management's commentary indicated only a modest portion of its guidance upgrade came from cost savings. Higher scrap prices and volumes have delivered a margin benefit, which highlights for the broker the substantial leverage in the stock to macro conditions.

Sill, Ord Minnett remains cautious, given the reversal in scrap prices from the peak in April/May. The broker expects sales volumes in FY17 and FY18 to modestly improve, with volume benefits primarily offset by reduced cost cutting assumptions.

Citi, too, while welcoming the upgrade is aware of the volatility surrounding global steel and scrap prices. The broker had expected, given the April/May rally in scrap prices, that the company would have provided an even more positive update, but the cautious tone suggests Sims Metal did not fully participate in the price rally and momentum is not necessarily going to continue into FY17.

Talk of large scrap traders filling orders at low price points does nothing to inspire Citi regarding the state of the market. Over the longer term, the broker reiterates a view the risk to scrap volumes and prices is to the downside. Moreover, Citi views Sims Metal as a fairly valued trader of scrap and not a creator of value in industrial products.

While acknowledging the company is doing what it can to reduce costs, Deutsche Bank maintains that weakness relating to industry structure and competition is too difficult to offset and there is downside risk to FY17 earnings. The broker suspects the recent fall in scrap prices in the US will lead to a corresponding drop in volumes and a squeeze on Sims Metal margins.

FNArena's database has two Buy ratings and five Hold for Sims Metal. The consensus target is $8.23, suggesting 6.0% upside to the last share price. Targets range from $7.40 (Citi) to $8.75 (UBS).

See also Outlook Not Too Flash For Sims Metal on June 20 2016.
 

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