Soldiering on, Shaver Shop half year results (ASX:SSG)

10/03/2019

Trav Mays

Follow @MaysTrav 

Today we will be diving into Shaver Shop’s 2019 half year results, some good, some not so good, but if you’ve read my initial thesis, the results are as you’d expect, fairly average.

Before we begin, here is a refresher on Shaver Shop, click here.

HY Report

Shaver Shop has a mixed start to the fiscal year, they achieved a 7.7% increase in sales (ex. Daigou), with online sales increasing a further 10.6% (1H 2018 66.6%) to now form 12% of total sales. This sounds great, but then you continue on and see that they actually increased their store count to 113 (7 stores in 6 months) and their like for like store sales decreased by 5% (flat if you exclude Daigou re-sellers).

Another half year achievement was the increase in the gross margin of 1.3% to 42.7%, which is a total 5 year percentage change of 3%, very impressive considering how much Shaver Shop has expanded over those years and the reduced Aussie dollar. Unfortunately, whilst they may be having success in reducing cost of goods sold, their other expenses are increasing disproportionately to revenue. As you look down the margin table below, you can see that all of the other margins are decreasing year on year, with Net Profit After Tax (NPAT) decreasing 1% pcp, taking the total 5 year percentage change to -32.7%.

When we breakdown the expenses and calculate them as a percentage of total revenue, the increasing culprits are, employee wages, 2.1%, occupancy, .5%, and other expenses, 1.2%. Marketing continues to be the area Shaver Shop is targeting their cost cutting, reducing by another 1.2% pcp (just over a $1mill) and halving over the last 5 years.

Shaver Shop stated in their conference call, that they are moving away from the more traditional and expensive advertising mediums (television, print, etc.), towards the cheaper online marketing campaigns, which can explain some of the reduction in their marketing spend. I understand their desire to reduce this expense, it’s an easy one to reduce with little revenue impact over the short term (it does help their margins as well), but as competition increases, they need to be differentiating themselves from other companies, especially online, such as Amazon. Why would a customer choose to go to their website, what advantage do they offer in this space? In store is a different story, they have a consistently high Net Promoter Score (NPS), but as customers are becoming more sophisticated, many doing their own research before even setting foot in the store, this competitive advantage will be eroded away. Consumers are obviously moving towards online, Shaver Shop can see this move and are therefore promoting online more, but again, what can they offer a potential customer that Amazon or another big retailer can’t, a bigger discount? Fast delivery (Good luck beating Amazon on this one)? A simple to use website, with a streamlined purchase process and a limited number of purchase pain points? None of these or others I can think off gives Shaver Shop any advantage over other online websites, in my opinion they have no online competitive advantage.

Evaluation

The reject shop on a number of metrics, see below, is trading at historical lows, making it appear to be a good buy. Interestingly, the trend over the years has been downward, this means when looking at the numbers alone, there has never been a better time to buy Shaver Shop.

On a historical 7 year Enterprise multiple, shaver shop appears to have ~19.8% upside potential, which when added to the ~10% dividend yield, is a pretty healthy return.

As I believe Shaver Shop has become a dividend stock, with little chance of future growth, I have also included the Gordon Growth Model in this evaluation. For those unfamiliar with the Gordon Growth Model, it is a simple formula for evaluating the price of a stock using its dividend and the potential shareholders required return. It does however have a number of large limitations, it assumes the growth rate goes on forever, that a potential shareholders rate of return doesn’t change over time and doesn’t take into account the time value of money. There are more complex versions which overcome some of these limitations, but if you keep them in mind, it works as a quick and easy evaluation technique.

As you can see below, assuming that Shaver Shop continues to payout a $.024 dividend in the second half and using growth rates of 5 (roughly the dividend growth rate over the last 2 years) and 3 percent, we calculate a share prices offering a 65 and 29 percent increase on today’s values. Quite encouraging, but are these growth rates achievable over the long run? When doing the final overview of the evaluation results, I wouldn’t put too much weight on this one. 

Using Shaver Shop’s FY2019 EBITDA guidance and the historical NPAT/EBITDA ratio, we can calculate possible EPS for FY2019 and using this, see what P/E the share is currently trading at. Below you can see that assuming we have no large hiccups, Shaver Shop is currently trading at between a 5.5 and 7.5 P/E ratio, quite low, but in my opinion not too far off where I would expect them to be.

Discussion

Using historical references, Shaver Shop is currently looking cheap, but with the limited growth opportunity available, it appears about right. They did look at an acquisition over the half, rumoured to be Hairhouse Warehouse, which after costing them $1mill in due diligence, they decided against it. I’m sure that they made the right choice, but instead of looking for further growth opportunities, they have decided to increase the dividend payout ratio and suspend share buybacks (Somewhat contrarian to other companies willing to buy back their stock at any price, but further cements my opinion that they are currently priced roughly right). During the conference call, an investor asked if they would be looking at other potential acquisitions, with Shaver Shop stating (not exact quote) that if a very obvious buy hit them in the face, they would obviously purchase, but they are not currently looking. Which is a shame, a growth plan (along with the increase in stores) would be great, even if it isn’t an acquisition, maybe something like focusing on expanding into NZ market more could be a good option. Anything would be good, they are nearing the top of the number of stores Australia can handle, having already started to talk about store cannibalisation (the close proximity of stores, moves sales from one store to another). Obviously this is something all retail companies need to worry about, but I didn’t think this would be something they needed to worry too much about this far away from their goal of 145 stores.

The real question is what is Shaver Shops competitive advantage (moat)? In store they have excellent customer service. But as many customers are doing their own research before entering the store, for a large number of customers, the store is just the place they purchase the product they had already mentally purchased before setting foot in store. The future is online and here I really struggle to see what they can offer over other online stores, especially ones without brick and mortar stores, with low fixed costs and therefore larger margins. For a long time to come, there will always be people who enjoy the brick and mortar experience, but as this number is dwindling, so too will Shaver Shop’s advantage.

Conclusion

Shaver Shop on the face of it looks like a screaming buy, but when you step back from the numbers and look at the whole landscape I believe that they are priced about right. They are an excellent dividend stock, having increased their payout ratio of cash NPAT from 50% to between 60 – 80%, but with little growth opportunities and the decrease in available funds, I believe they will continue to shoulder on, paying out a great dividend over the short to medium term, until they can’t anymore.

If you would like to read another retail HY report, check out my recent Cellnet article 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.

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

The author is a current owner of a portion of Shaver Shop, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action  

You can’t predict. You can Prepare; Cellnet HY update (ASX:CLT)

04/03/2019

Trav Mays

Follow @MaysTrav 

Today we will be examining Cellnet’s HY2019 results; a recent drop in share price of roughly 27% just after the results were released got my attention, so I put the kettle on, sat down at my desk and dived into the numbers.

Before we get stuck in, I recommend if you haven’t read or want a refresher, my original Cellnet article can be found here.

Description

A ~27% drop in the share price roughly a week after a report is released is quite worrying, with the typical things going through my head, What did I miss? How could I have got it so wrong? etc, compounded by the fact that I hadn’t had a chance to read it yet, let alone analyse it.

Yahoo Finance, retrieved 24/02/2019

Fortunately for me, I have been reading a lot of Howard Marks lately, statements such as “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological” were still in the front of my mind. Armed with this and other powerful logical insights from Howard Marks, I calmed myself down and inverted the situation, maybe instead of looking at it as a potential mistake, I should look at it as a possible chance to average down.

HY Report

Looking at the first page, it’s clear that H1 2019 is not going as well as H1 2018, with a reduction in underlying operating profit before tax of ~32.3%.

Positively they have seen an increase in revenue of 20.8%, when excluding the Turn Left acquisition, revenue still increased by 6.5%. A very positive sign, however they have clearly allowed expenses to blow out. Cellnet acknowledges this and attributes the decline in operating profit to the reduced dollar’s impact on materials, packaging and consumables used (AUD/USD has reduced from .78 to .71 in the past year, with it hovering around .71 over the past 6 months). They also wrote off $0.405mill of Turn left’s inventory, included in materials, packaging and consumables. Never one to take a person on their word (especially company directors, no matter how reputable or respected they may be), below I have tabulated Cellnet’s HY expenses as a percentage of revenue. It’s clear that there has been a large increase in materials, packaging and consumables, ~3.7% above the trailing 4 year average (~2.8% when adjusted for the inventory write-off). Within the report, Cellnet stated that “Measures have been taken in December 2018 to mitigate this impact”, which is encouraging, a reduction of 1% in expenses, sees an additional $0.522mill added to the profit before tax. Looking at the other expenses Cellnet has reduced their employee benefits, finance costs, freight expenses and occupancy expenses, a total reduction of 0.77% of revenue, which is excellent. The increases, D&A includes a $0.212mill in customer and supplier relationships acquired with Turn Left, materials explained above and warehousing expenses due to the increase in inventory. Which brings us on to the next section, the statement of financial position or better known as the balance sheet.

Below I have tabulated interesting sections of the 2018 and 2019 HY balance sheets, along with the percentage change (%Δ) and also their % of total assets. Straight away you can see huge increases in assets, with inventory and trade and other receivables more than doubling, some of which can be attributed to the Turn Left acquisition, but not all. The reduced dollar, I would have thought, would be a time to reduce inventory stock levels, not more than double them. Is there stock no longer selling, a sign of the cyclical nature of the business or did they recently get a bargain on an item?  

Whilst the assets have increased a considerable amount, they are still roughly making up the same percentage of total assets, unfortunately the same can not be said of the increases in liabilities. Trade and other payables increased by 270% and current borrowings 530%, saying that another way, trade and other payables more than tripled whilst current borrowings increased by over 6 times. These are some really worrying increases, again some of these increase can be attributed to the Turn Left acquisition, but the magnitude of the increases is quite concerning. The result of all of this is a reduction in tangible assets of 20% and due to the Turn Left acquisition being partially paid for with shares, a reduction in Tangible assets per share of 28%. Interestingly they are currently trading at roughly their tangible asset per share price, $0.26.

Along with the decrease in tangible assets the increase in borrowings increases the debt to equity to 1.581, which is a lot higher than their trailing 10 year average, excluding 2018, of ~1. I have included in the table below the debt/equity if Cellnet hadn’t purchased Turn Left, it however isn’t much better at 1.41, not unprecedented, by uncommon.

Evaluation

Below I have calculated my forecasted 2019 results both as is and if they had owned Turn Left for the entire year. Assumptions are as follows 

• Over the past 8 years, Cellnet has generated, on average, 55% of their revenue in the first half of the year; Cellnet’s revenue for FY2019 is therefore predicted to  $94.95mill.
• As Cellnet has stated that “Measures have been taken in December 2018 to mitigate” the low dollar, I have reduced the 2^nd half’s expense ratio by .6% to 98% of revenue.
• Cellnet stated that had they owned Turn Left for the entire year, they would have generated $64.54mill in revenue and $1.11m in profit before tax, which equates to a profit margin for TRL of 1.72 (expense ratio of 98.28). Using this and assuming that TRL generates 65% of their revenue in the 1^st half, gives TRL's 2HY revenue of $8.21mill and profit of $0.176mill.
• 1HY TRL expenses adjusted for the $0.405mill inventory write-off.
• No. Of shares outstanding 62,595,096
• Share price $0.245

The result of all of this is a Profit before tax per share of 0.0286, which is slightly worse than 2017 and 2015, but falls quite below 2018 and 2016, see below. It also shows us that they are currently trading at a price to profit before tax of 8.4, which is slightly below the trailing 8 year P/PBT ratio average of 8.96 (excluding 2014 as it is an outlier).

The 2019 TRL full year forecast, keeping all things equal, gives a good indication of the 2020 full year results. Which if correct and assuming the P/PBT increases to the current level of 8.1, will see the share price increase by ~13.25%.

Discussion

The increase in the expense ratio by 3.7% has really hurt Cellnet, added to this the untimely acquisition of Turn Left and you have the receipt for some disappointing results. The low profit margin of both Turn Left and Cellnet gives a lot of opportunity for improvement, especially when compared to their historical expense ratios. 

Cellnet has operated with the dollar at these low level (July 2015 to March 2016), however, today the global economy is in a much different position than it was then. Therefore unless the dollar rises back up in the near future the FY2016 expense ratio is not a comparative figure. I do believe that Cellnet will be able to reduce their expense ratio, just not as far as we have seen in recent years. To see the impact different expense ratio’s will have, I have tabulated, using FY2019 figures, the varying PBT for a range of expense ratios.

A reduction of the expense ratio to 97.5% or 98% (which is still 1.61% and 2.11% above the trailing 4 year average) in 2020 and assuming all other things being equal, has Cellnet currently trading at a 5 – 7 multiple. These expense ratios are in my opinion achievable, Cellnet, since Alan Sparks took over, have been continuously driving expenses down. The multiples are however not amazing and certainly do not offer enough of a safety margin to rush out and buy. However I believe that keeping everything equal, the company is currently trading at roughly where it should be.

Keeping everything equal (or Ceteris Paribus for the economists or Latin speakers out there) is an assumption that I don’t believe is justified in today’s economy. The Australian dollar has been predicted to fall further in the short term, a likely result of a range of possibilities, more specifically, China’s economy slowing, a reduction in the demand for Australian resources (other than coal at the moment due to the tragedy in Brazil, but this too will balance out), a slowing of the world economy (due to a number of different reasons). All of these will further squeeze Cellnet's profit margin over the short term. They have in recent times started to expand into other markets, helping to untether their profits to the Aussie economy, but I think this may be a little too little too late.

Conclusion

Cellnet since Alan took over have reduced expenses, increased revenue, obtained strategic partners and increased their product mix, allowing them to enter a market that is predicted to grow quite substantially. On the negative side, over the first half of 2019, they have increased their debt to equity ratio to unprecedented levels and allowed expenses to blow out. Cellnet is a good company, 2019 is in my opinion an unfortunate culmination of two unrelated events that have impacted Cellnet quite substantially, I see it as a hiccup more than a ongoing problem.

After doing my analysis I believe that Cellnet is trading at roughly where they should be and therefore the loss has already been made. As consumer spending is predicted to decrease and the dollar as well, I believe that Cellnet will have a rough couple of years ahead but I see Cellnet as a long - term member of my portfolio. It, in my opinion, is therefore not a time to buy nor is it a time to sell (if you have a long term perspective and have no other better prospects), but a time to trust management and remember that we purchased a portion of the company for the long term. I am writing this constantly wondering if I am being affected by conformation bias, if you feel I am, feel free to get in contact or leave a message below, I am always happy to hear from people who visit and read my blog.

During my initial analysis of Cellnet, I did not consider the impact the lowering of the dollar would have on Cellnet. Howard Marks says “You can’t predict. You can Prepare”. Whilst the lowering of the dollar may be unpredictable, it should be included in a pre-mortem, allowing an investor to require an adquate safety margin. I believe that the underlying thesis for Cellnet is still good, there most likely wasnt a large enough safety margin when publishing my initial thesis.

One last Howard Marks' quote that I believe sums up my mistake in my original analysis of Cellnet perfectly, "There’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future".

If you are interested in the retail industry, you can also read my opinion on Shaver Shop and The Reject Shop. 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.

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

The author is a current owner of a portion of Cellnet, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action  

Is Sims Metal Management a head hitting anvil? (ASX:SGM)

17/02/2019

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 1^st 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.

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

Sources

1. https://www.afr.com/brand/chanticleer/sims-metals-management-might-be-our-biggest-asx-trade-war-casualty-20190121-h1aa9h

2. https://www.sharecafe.com.au/2019/01/22/trade-war-puts-sims-metal-on-the-scrapheap/

3. https://www.reuters.com/article/us-china-environment-waste/china-to-restrict-imports-of-scrap-steel-aluminum-from-july-idUSKCN1OS02X

4. https://www.bdsv.org/fileadmin/user_upload/180222-Ferrous-report-2017-V07.pdf

5. International Monetary Fund

The author is not a current owner of a portion of Sims Metal Management. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action