Is Sims Metal Management a head hitting anvil? (ASX:SGM)
Trav Mays
Follow @MaysTrav
Today we will be investigating Sims Metal Management, the
recent forecasted earnings drop, fearmongering headlines and the subsequent
price drop, puts them square in our crosshairs.
Headlines such as Sharecafe’s “Trade War Puts Sims Metal On The Scrapheap” and AFR’s “Sims Metals Management might be our biggest ASX tradewar casualty” are usually fearmongering, with the intention to increase clicks
and views on a site. On occasion, they generate sell offs, making them a great
source of potential companies worth investigating a little further. In this case however,
they seem to be pretty well on point, well, The Australian Financial Review’s
headline anyway.
Company
Sims Metal Management (ASX:SGM) is Australia’s only publicly
listed metal recycler. Starting out as a single scrap metal collection business
in Sydney, 1917, they expanded and listed on the ASX for £1
per share in 1948. They emerged from these humble begins and have risen as high
as $41.69/share. However as with most stocks, the 2008 financial crash put a
stop to these sorts of prices and now Sims Metal is trading at ~$9.98 with a
market cap of just over $2 Billion.
To grow to such a large market cap has required that Sims
Metal expand globally, with operations now in 18 countries and exporting to over
50 countries. Below shows the breakdown of the major exporting countries and
their contribution to total revenue. The mix changes year on year with only
Australia of the 6 countries staying fairly consistant. Turkey and South Korea
had the wildest swings in sales, South Korea made up only 5% in 2014 shooting
up to 23% in 2015. Turkey had similar volatility, averaging roughly 15% between
2009 – 2014, they dropped off to 3% in 2015 continued at 5% in 2016 and then
shot back up to 15% in 2017. It’s clear that results are heavily dependent on
global stability and increases in global production, unfortunately we are
currently seeing a contraction in both.
Sims Metal breaks their business down into 4 segments, North
American Metals, ANZ Metals, Europe Metals and Global E-Recycling, below is a
graph showing their contribution to total revenue. North American Metals, once
making up over 74% of total revenue, has since dropped to only 52%. A
percentage of this drop has been due to Sims focusing more heavily on a broader
range of markets and a redefining of the segments, they have however seen a $3
Billion dollar reduction in revenue from $6.37 billion in 2009 to $3.38 billion
in 2018.
Whilst revenue may be decreasing, Sims Metal’s has been
working hard on reducing expenses. Over the last 10 years, they have reduced
overall expense as a percentage of revenue by 2.6%. They did have an increase
in employee expenses of 2.7% over the 10 years and a 1.6% in other expenses.
However, they successfully reduced freight by 3.4% and raw materials by 3.1%.
Whilst the reduction in expenses is excellent, the single
biggest influence on Sims Metal’s results is the ever fluctuating and cyclical,
scrap metal price. To highlight this point, I have graphed revenue alongside US
scrap metal prices per tonne. Whilst the magnitude of the movements are not the
same, a high correlation is clearly evident.
To show the fluctuating nature of the Scrap Steel Price, below I have graphed the annual percentage change in scrap steel price along with Sims Metal’s annual percentage change
in sales volumes. Please note that I do not have the scrap steel price for 2018, it is not 0,
however even without this figure, the unpredictable nature of this commodity along with Sims Metal's sales volumes
is obviously evident. The scrap metal price had year on year percentage changes
of over 30% in 5 out of the 12 years depicted. How anyone is able to predict
with any certainty next year’s price or sales volume is something I will never
understand, unfortunately for me, I am not a super forecaster.
A decrease (increase) in the demand for scrap metal has a 2
fold effect on Sims metal, it simultaneously decreases (increases) the price
Sims’ can get for their steel, whilst decreasing (increasing) the demand for
their products. In other words, unlike a typical retailer who increases the
number of products sold when the price is reduced (unless it’s a luxury item),
a reduction in the price of Sims’ scrap will also see a reduction in the volume
purchased. A business tied so heavily to an unpredictable variable is not one I
personally would like to get involved in, unless of course it’s cheap enough.
As Howard Marks says “there are few assets so bad that they can’t be a good
investment when bought cheap enough”.
Comparison
As Sims Metal Management has no direct Australian listed
competition, I have compared them with Schnitzer Steel, an American
scrap collector and two other large Australian companies within the clean tech
sector, Bingo and Cleanaway. These are not the best comparison companies,
Schnitzer Steel is worth just over a quarter of Sims Metal and Bingo and
Cleanaway both are completely different companies to Sims Metal. However, they
do offer a direct company to company comparison within the global scrap metal industry
and show values investors are willing to pay for companies within the clean
tech sector.
Using a range of value metrics has Schnitzer Steel ranking
first, with Sims Metal closely following in second. Whilst I haven’t done any
real analysis on Cleanaway, a PE of 33.47 is quite high, especially for a non
tech growth firm. The harsh mistress, “Reversion to the Mean” is definitely
something I would be fearing if I was a current share holder. Sims 3% profit
margin compared to Schnitzer’s 7% is not something I would be worrying too much
about, clearly as a company expands, so do their expenses. The number of
employees increases, which generates the need for more non-directly-income
generating employees (middle management, supervisors etc), they then need
somewhere to house these workers and all the costs that are associated with
that and so on and so on. If we were to remove profit margin from the rankings,
this would put Sim’s only 1 point behind Schnitzer. However, the two main
points that Schnitzer bests Sims that I believe are of real importance, are the
Enterprise value per share and the Pitroski score. Schnitzer Steel is currently
trading at roughly $5 below their EV/Share and they have a Pitroski score of 7,
compare this with Sims, who are trading $1.5 above their EV/Share and have a
Pitroski score of only 4 for FY2018. Given the same working environment
Schnitzer appears to be the better of the 2 and definitely requires further
research.
Evaluation
On both a historical and sector (just the companies in the comparison
above) basis, Sims Metal is quite cheap. Using 2018’s earnings figures, if we
were to apply the historical EV multiples, we would see a gain in share price
of 79%. Even more startling, applying historical P/E multiples sees the share
price jump by 149%. These sorts of figures are quite astonishing, however when
doing analysis such as these we must ensure we keep our enthusiasm to a minimum,
huge increases such as these are usually due to the market seeing something we
haven’t yet. This is my favourite part of doing an analysis, turning over all
the rocks, looking for something others or I may have missed, similar to what I
imagine an investigative journalist does.
Unfortunately (fortunately, depending on your view point) the
search doesn’t take very long. Sims Metal’s recent 2019 Preliminary Earnings
Update was not the best, see below. They have underlying EBIT decreases across
the board, with Europe Metals being hit the hardest. One of the reasons given
for this is the current and ongoing troubles in Turkey. Sims Metals states that
Turkey has historically offered a premium, however the recent troubles have
reduced this premium, squishing margins. The effect on Sims’ is quite large, as
Turkey made up 20% of total sales in 2018, see figure 1 above.
Multiplying the Prelim HY
underlying EBIT with historical HY percentage of FY underlying EBIT and
removing outliners (Average 41%) gives us a FY2019 underlying EBIT of roughly $270
mill and a NPAT of roughly $182 mill. If we redo the multiple analysis used above (obviously only P/E can be
redone), encouragingly, we are still getting quite high values.
However, when we look at the historical
P/E multiples people have been willing to pay for Sims Metal in the past, it partially
takes the jam out of the donut. In 4 of the last 10 years, investors have paid
over 40 times earnings for Sims, these figures are obviously heavily
influencing the 10 year average P/E ratio.
Removal of these 4 years reduces
the average historical P/E to a far more reasonable 15.1. When we re-do the P/E
multiple analysis again, using the new P/E ratio, we see a reduction in the
percentage gain from 116% to 36%. This is still quite a large potential gain
and something we should keep in mind as we solder forward through our analysis.
I was going to use a range of
Scrap metal prices and sales volumes to try and determine in another way, the
potential NPAT for Sims Metals in 2019. However, the wild swings in both, see
above and my lack of understanding of all the variables that go into what
determines the scrap metal price would mean it would be a complete guess.
Better to admit a lack of understanding and knowledge, then to blindly do a
worthless and misleading analysis.
Discussion
China is the biggest producer of
steel in the world, producing 49.2% of the world’s steel in 2017.
However unlike the next two
largest steel producers the EU and USA, China had only a 17.8% Scrap Steel /
Crude Steel ratio in 2017, which whilst quite low, was still an improvement from 2016’s 11.1%. In contrast
the EU’s Scrap Steel / Crude Steel ratio in 2017 was 55.5%, whilst the US’s
ratio was 72.1%.
These figures point to a huge potential market for Sims
Metals and one that they currently are not fully utilising. China has
already begun shifting towards a higher Scrap Steel / Crude Steel ratio and as
this ratio increases, I’m sure Sims Metals will be able to increase their proportion
of sales to China. Well, that was until I read Reuters article “China to restrict imports of scrap steel, aluminium from July”, that is July 1st 2019. Interestingly
in the Prelim HY results, the only mention Sims metal made towards China’s "National Sword" initiative was in relation to its current impact on the non-ferrous
margins. I’m sure when the final half year results are published they will
mention it, but a little comment about it and how they plan to manage it would
have been appreciated.
This does however mean that two customers that made up 30% in 2018 and
35% in 2017 of sales, are markets that either have squished
margins or will be completely shut off in the near future. Due to this I
believe that unless we have stability in Turkey and/or China reverses their
plan, Sims metal is going to be in a far worse position this time next year
then they are currently. This is before we take in account the other
potentially huge macro effects, mainly Trump, North Korea, Brexit and China.
Conclusion
Sims Metal Management, as a company seems to be well run,
making the most of situations that they have little to no control over.
However, the near future does not look very good for Sims Metal, due to this I
would need a higher margin of safety before purchasing a portion of the business. The lowest
return calculated above is a very enticing 36%, however when stepping back and
viewing Sims completely, I do not believe that the likely hood of this outcome
is very high.
The stopping of all scrap metal into China and resulting
reduction in demand and increase in supply will have a large impact on the
scrap price and subsequently Sims. This may already be priced in, however I
will sit back and watch Sims over the next year, first half 2020 results will
be very interesting. As Joel Greenblatt says “I wait until an investment idea is so
good, it hits me over the head like an anvil”, Sims in my opinion is
no anvil and has the making of an anchor.
If you are interested in the Steel business, BlueScope Steel offers
much better value, read my analysis here. I am on Twitter Follow @MaysTrav and Linkedin if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point.
if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point.
Thanks for reading
Thanks for reading
Just Culture Investor
Trav Mays
Sources
5. International Monetary Fund
The author is not a current owner of a portion
of Sims Metal Management. This article is
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