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Morningstar | No-Moat Sims Lowers 1Q2019 Guidance on Soft Non-Ferrous Scrap Volumes; FVE Unchanged

No-moat Sims Metal’s revised guidance disappointed the market, but tracks our long-term thesis for the firm. We retain our fair value estimate of AUD 10.10 per share, in spite of the near-term downgrade. Management lowered first-quarter fiscal 2019 EBIT guidance to a range of AUD 58 million to AUD 63 million, down from a previous AUD 73 million. The downgrade relates to soft performance from Sims' joint venture associate, SA Recycling, or SAR, which is now expected to deliver AUD 10 million to AUD 15 million lower income than in fourth-quarter fiscal 2018. Nonetheless, this updated outlook implies a full-year EBIT of about AUD 230 million to AUD 250 million, tracking our forecast for AUD 243 million. While Sims shares reacted strongly to the revised guidance, trading 10% lower as a result, we continue to view Sims’ shares as expensive, trading approximately 1.2 times our fair value.

Outside of weakness in SAR, the business is otherwise performing to expectations, in line with fourth-quarter fiscal 2018. However, SAR's intake volumes have been lower than the prior quarter and thus below management’s prior expectations. Further, SAR’s zorba sales continue to exhibit weakness, the result of China’s national sword policy which now limits the import of low-quality zorba. This softness in zorba, a mixture of shredded, non-ferrous scrap metals, corresponds with our long-term view China will become a net exporter of non-ferrous scrap metals in the future, as domestic Chinese scrapping rates increase from current low levels.

As a counter to soft zorba volumes, SAR is in the process of upgrading its plant and equipment to produce higher quality zorba with fewer impurities, which management sees as beneficial to regaining zorba sales momentum. Sims expects to have necessary equipment operational by Dec. 31, 2018. But we do not forecast a rebound in zorba sales in the second half of fiscal 2019, given the supply overhang that has been created by China’s policy change.

Nonetheless, we view Sims’ efforts to alter its non-ferrous scrap sales mix by moving up the value chain to produce twitch (isolated aluminium scrap) and heavies (isolated copper, brass, stainless steel and other scrap metals) and less zorba, which constitutes a mix of these scrap metals, as positive. While the production of twitch and heavies overcomes the current issues in the zorba market, they also command a significant price premium over zorba, with this premium currently around USD 120 per tonne. Management aims to reduce zorba volumes to 7% from a current 15% of total non-ferrous sales volumes by the start of fiscal 2020, while increasing twitch and heavies sales volumes to 19% from a current 9%.