Australia | Sep 25 2018
Confidence in Sims Metal has taken a hit, brokers suggest, after the company downgraded guidance for first quarter earnings less than a month after reiterating it at investor briefings.
-Downgrade attributed to challenges for low-grade Zorba sales
-Adds to volatility and uncertainty inherent in the scrap business
-Turkey remains a key risk, being the company's largest scrap export market
By Eva Brocklehurst
Sims Metal Management ((SGM)) has sustained a deterioration in output and sales at its US-domiciled Sims Adams Recycling joint venture, causing a downgrade to first quarter earnings estimates. Based on current market conditions, management now expects underlying operating earnings (EBIT) of $58-63m in the first quarter versus guidance of around $76m previously, the drop wholly attributed to the JV earnings.
UBS believes the market set its expectations for FY19 earnings by simply annualising the September quarter guidance, and believes this simple modelling will continue for now because of the challenges facing scrap markets.The broker has low confidence in forecasts and reduces FY19 estimates for earnings by -17%.
Ord Minnett finds the announcement impinges on management's credibility, as guidance was only provided in the past month. In terms of overall quantity, the company has reported growth of 35% over the same period last year, despite a deterioration in the Turkish economy and US tariffs on Turkish steel.
The broker assumes the issues at the Sims Adams operations persist into the second quarter before being addressed through the installation of cleaning facilities. Heavy investment by Sims Metal in upgrading its own plants over recent years appears not to have extended to the JV.
Macquarie believes visibility may have been more opaque than management previously acknowledged but, all up, considers this downgrade more than discounted in the current valuation. Credit Suisse, nevertheless, finds the magnitude of the first quarter earnings slump hard to accept although acknowledges, as the 100%-owned and managed operations are unchanged, the issue is specific to the joint venture.
This could relate to the different geographic locations of the Sims Metal operations versus the JV, and a steep deterioration in Zorba [mixed non-ferrous scrap] material pricing. Based on the fall in the share price Credit Suisse upgrades to Outperform from Neutral.
The broker is most surprised that management was able to foresee a looming crisis in accepting low-quality Zorba material two years ago and implement technology upgrades across its US operations but not at (albeit not managed by Sims Metal) Sims Adams Recycling. Sims Metal is responsible for handling and selling the export volumes from the JV so knowledge of these challenges should have been well communicated and an abatement strategy implemented, the broker contends.
The issue demonstrates, again, brokers believe, that there is very limited visibility over volumes and earnings in the scrap business. Credit Suisse also points out, if guidance has a short shelf life, then modelling and forecasts are largely guesswork, heavily affected by global scrap prices, steel prices and non-ferrous prices as well as economic activity.
Zorba And Twitch
UBS notes Zorba and Twitch prices into the US midwest have been falling, affected by reduced Zorba demand from China and a re-allocation of supply from China to Southeast Asia. There is also low demand from US consumers of Twitch, affected by the large inventory positions held by these consumers.
Zorba non-ferrous processing specifications provide a grade that is not uniform and generally not ready for smelters. The destination for Zorba is usually further processing facilities, while Twitch involves a separation and upgrade on Zorba.
Sims Metal has advised that improvements to the Zorba processing have commenced at the Sims Adams JV and will be completed by December. If improving the Zorba quality entails expenditure of just $5-10m, then UBS asserts this is not a large sum of money for processors if it secures customers that have increasingly high product standards.
Credit Suisse agrees as, given this technological challenge can be overcome within three months, it undermines a strategic advantage the company has articulated regarding its capacity to undertake upgrades that others cannot afford.
Meanwhile, the equity market has been concerned about the risk to the company's largest scrap export market, Turkey, and whether Sims Metal may need to find alternative markets for its US east coast production.
Ord Minnett notes tariff issues in Turkey do not appear to be having a negative impact on Sims Metal as yet and this is a key positive. The broker finds the stock cheap, although acknowledges sentiment around the company is overwhelmingly bearish.
FNArena's database shows three Buy ratings and three Hold. The consensus target is $14.48, signalling 22.5% upside to the last share price. Targets range from $12.50 (UBS) to $16.60 (Macquarie).
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