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Morningstar | Scrap Metal Pricing & Volumes Drive Strong but Unsustainable 2018 Result for No-Moat Sims Metal

Robust metals prices and volumes drove a strong fiscal 2018 result for no-moat Sims Metal Management. Sales grew 27%, with revenue of AUD 6.45 billion in fiscal 2018, in line with our expectations. Underlying EBIT was also strong at AUD 279.2 million, 5% ahead of our expectations, with operating margins improving again in fiscal 2018 to 4.3%. While Sims sold off approximately 7% following the result, we still view the stock as expensive, trading at approximately 1.3 times our AUD 10.10 per share fair value estimate, which is unchanged following the result. We still believe the market is extrapolating currently elevated scrap metal prices into perpetuity. We expect EBIT to decline from a fiscal 2018 high at an average of 7% per year over the forecast period as metals prices fall.

In Sims’ North America metals segment, representing roughly 50% of group revenue, volumes eclipsed our expectations, growing 19% versus our 11% forecast. In tandem with stronger pricing, segment sales rose 40% to AUD 3.38 billion. Underlying segment EBIT disappointed, however, with EBIT of AUD 80.3 million well below our forecast of AUD 137 million. China’s recently announced waste policies precluded the importation of mixed scrap paper and resulted in an AUD 0.2 million EBIT loss in the segment’s municipal recycling unit. In spite of this, segment EBIT margins firmed to 4.1%, up from 3.0% a year prior. We anticipate moderating margins, reverting to an average of 2.6% as metals prices decline.

European segment sales also grew considerably, up 30% year on year due mainly to higher volumes, which increased 6.3% and were largely in line with our expectations. Underlying EBIT fell 43% to AUD 20.1 million, however, resulting in EBIT margins sliding to 1.7% as strong competition for input volumes more than offset the effect of higher sales volumes and selling prices. We expect this competition in Europe to continue and forecast average EBIT margins of 1.6% over the coming five years.

Ferrous scrap metal prices rose in the fiscal year off the back of higher global steel consumption and greater demand for high-grade steelmaking raw materials, particularly in China, in fiscal 2018. U.S. East and West Coast heavy melting steel prices advanced 32% and 37%, respectively. Nonferrous prices also rose, with copper and aluminium up 25% and 20%, respectively, in fiscal 2018. Strong pricing saw Sims’ return on invested capital surge to 9.8%, up from an already elevated 7.5% in fiscal 2017 and above Sims’ cost of capital of 8.9%. However, as scrap prices retreat from their current levels, so will ROIC. We expect ROIC to average 7.1% over fiscal 2019-23.

U.S. tariffs on Chinese steel imports positively affected U.S. ferrous scrap pricing and led to increased collection of secondary metals in North America. Total U.S. ferrous scrap collection volumes amounted to 53 million tonnes, up 4% through to March 2018 on a rolling 12-month basis, according to the U.S. Census Bureau. While this was a positive for North American ferrous sales, China’s retaliatory aluminium import tariffs are having an opposing effect, with nonferrous exports to China falling. While nonferrous scrap represent around 17% of total sales, the decline in volumes and prices that are associated with the Chinese tariffs aligns with our longer-term view that China will become a net exporter of scrap in the future. Our fair value estimate is therefore minimally affected.

The Australia and New Zealand segment, roughly 16% of group sales, benefited from higher average ferrous selling prices, driving improved segment sales of AUD 1.1 billion, up 9.1% from the prior year. Sales volume growth also contributed, up 2.4% but slightly behind our expectations for 4%. Thus, underlying segment EBIT of AUD 83.4 million trailed our expectations, but EBIT margins were strong, improving to 8.6% from 6.4% a year earlier. We expect a moderation in operating margins to average 5.8% over the five-year forecast period.

The global e-recycling business performed well, with sales of AUD 758 million and underlying EBIT of AUD 24.8 million coming in well ahead of our expectations for AUD 14 million. Copper and precious metals, including gold, comprise the two primary commodities recovered from the electronics recycling process. During fiscal 2018, the price of copper rose 25% while average gold prices increased 3%, with this benefiting the fiscal 2018 result accordingly. The majority of the improvement flowed from the U.S. e-recycling business, which contributed AUD 6.8 million greater EBIT than in fiscal 2017. With business improvement plans in the U.S. bearing fruit, EBIT margins firmed to 3.3%. We expect margins of 3.0% from the business over the coming five years.

A heavy year on capital expenditure, with AUD 75 million spent on acquisitions and growth capital expenditure, led to negative free cash flow of AUD 10 million, slightly below our expectations for positive AUD 33 million. Next year will be another heavy year for capital expenditure, with Sims guiding to AUD 200 million, roughly split between maintenance and growth capital expenditure, We expect moderation in capital expenditures from fiscal 2020 onwards, with outlay expected to retrace lower towards depreciation levels. Meanwhile, the firm’s balance sheet remains solid, with net cash of AUD 298 million at year-end fiscal 2018.