Treasure Chest: Is There Substantial Leverage In Sims Metal?

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

Citi begs to differ with consensus forecasts which imply no improvement for Sims Metal in the first half of FY17.
 

By Eva Brocklehurst

Citi makes the observation that IBES consensus estimates for Sims Metal Management ((SGM)) in FY17 suggest no improvement is expected in the company's operating performance versus second half run rate experienced in FY16.

The broker considers it folly to annualise fourth quarter EBIT (earnings before interest and tax) of $63m and believes consensus assumptions are implying no improvement and/or falling sales volumes at a time when scrap prices are relatively stable.

Hence, Citi's FY17 EBIT estimates are 22% ahead of consensus and the broker expects, near-term, stability in global steel markets will prevail, supporting its Buy rating. Other brokers are not so sure.

Macquarie believes China's excess capacity has not diminished and importing regions will struggle to absorb more steel. In this context the broker envisages downside risks for scrap prices as well as volume pressures. Morgan Stanley is also cautious about the company's target for a return on capital by FY18 of over 10%, suspecting Chinese steel exports will remain high and negatively affect key markets.

As background, Sims Metal sold or idled 29 underperforming assets in FY16 and has sold eight facilities already in the first half. Hence, the drag on earnings from these facilities will not be repeated in FY16. Only five small facilities are now pending sale or closure.

As a result, Citi interprets consensus estimates to be excluding the annual run of benefits delivered in FY16. The estimates are also assuming lower volumes and lower scrap prices, or factoring in a combination of all three. Moreover, a reduction in personnel should provide an incremental benefit in the full year of $28m, the broker calculates.

Most brokers acknowledge the benefits of supply initiatives which have supported realised margins, but note the decline in absolute volumes across all the company's market segments. Either way, Ord Minnett suggests the company needs to demonstrate several consecutive periods of operational improvement in order to increase market confidence.

Deutsche Bank believes the industry's structure is not supporting rational behaviour. The broker is also unsure as to whether the company's capital base will remain unadulterated by the cost cutting, given the potential for a decline in scrap prices.

The broker cites downside risk to scrap prices based on the fact the scrap/iron ratio is above the historical average and current iron ore spot prices are well above the FY17 forecasts.

Given management suggested a US$50/t increase to the scrap price is needed for a 500,000t increase in volumes, the broker believes there is downside risk to scrap prices and EBIT, notwithstanding cost reductions. In its analysis, on the back of the FY16 results, the broker downgrades to Sell from Hold.

In analysing just how costs have been managed across the business, Citi highlights that management appears, in terms of gross margin analysis, to have done more than the market has over the past several years. The broker believes substantial leverage is possible, if and when volume returns to the business.

Admittedly, external sales have come under pressure over the last four years and the continued decline in iron ore also placed downward pressure on ferrous scrap metal prices, which on average declined 22% during FY16.

Yet while the rally in physical steel markets has been spectacular, it reflects several factors at play creating a perfect storm, in Citi's opinion. The factors include record low steel prices in December, low end-user inventories and, most importantly, Chinese fiscal stimulus spearheading a recovery in Chinese residential construction.

The broker envisages historical relationships between steel and raw materials and fundamentals will resume the upper hand, which means steel prices must fall and/or raw materials prices rebound.

Citi considers the former is more likely, as a structural decline in Chinese crude steel production continues while the country transitions to a consumer-driven economy. Citi is also neutral to bearish on iron ore pricing in the near term because of weak seasonal downstream demand and continued volumes being shipped from Brazil and Australia.

FNArena's database shows two Buy, three Hold and two Sell ratings for Sims Metal. The consensus target is $9.55, suggesting 2.8% upside to the last share price.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms