Schnitzer Steel Industries: Moderate Sell Initiated At $22.96 Amid Headwinds In Steel Industry

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About: Schnitzer Steel Industries, Inc. (SCHN)
by: Elmore Wallace
Summary

Headwinds in the steel industry will squeeze SCHN's key financials.

Sell recommendation initiated at $23.68 one-year target price.

The price of steel is expected to fall 2.60 percent.

Authors: Elmore Wallace, Iliya Krutko and Stephen Crisp

Investment Summary

We issue a moderate SELL recommendation with a one-year target price of $22.96 representing 3.07 percent downside potential as of SCHN’s May 3rd, 2019 closing price of $23.69. This recommendation rests on the influence current industry trends and forecasts will have upon SCHN financial performance going forward and primarily include: A) The decline in the price of steel, and B) A decline in industrial production which will pigeon hold SCHN’s ability to grow.

  1. Price of Steel: SCHN’s sales growth since FY16 has reflected growth in ferrous steel prices. Due to overproduction in world markets and a weakening demand in mainland China the price of steel is forecasted to decrease in FY19. The spot price of steel is forecasted by Bloomberg, LP to fall by 2.60 percent by the end of FY19 and by 8.30 percent in FY20.
  2. Industrial Production: We modeled percent changes in sales growth for SCHN using regression and sensitivity analysis based on highly influential factors. Using an industrial production forecast of negative 2.00 percent among SCHN’s consumer base and the FY19 spot price percent change we project a 15.00 percent decline in sales growth for the company in FY19.

Business Description

SCHN was founded as a scrap metal business in Oregon by a Russian immigrant named Sam Schnitzer in 1906. Since then, it has become one of the largest recyclers of ferrous and nonferrous scrap metals in North America through a long series of acquisitions of self-service auto part stores, recycling facilities and continued expansion into new markets. It began fulfilling its demand for greater volumes of scrap metal through a joint venture with Pick-n-Pull in 1989. The joint venture provides a self-service format for retail consumers seeking to obtain used auto parts and uses the bodies of the salvaged vehicles as an input into its scrap metal recycling business. Ownership of 52 Pick-n-Pull stores across the U.S. and Western Canada provides SCHN with its largest source of automobiles to recycle. In addition, it operates 91 scrap metal recycling facilities in 23 states as well as Puerto Rico and Western Canada which provides jobs to 2,796 employees.

Industry Overview

As part of the manufacturing sector there are approximately 788 different companies within the global scrap metal recycling industry. SCHN is included in this market as 79.30 percent of its revenues are industry relevant. It is one of the top global companies in the scrap metal recycling industry with a market share of 1.10 percent reported in FY18 with its closest competitor being Commercial Metals Company (CMC), a publicly traded company with 2.70 percent global market share in the scrap metals recycling industry.

SCHN combined two of its three previous business segments of auto parts and recycling into one entity called Auto and Metal Recycling (NASDAQ:AMR) in FY15 to reduce cost and increase efficiency in reporting. AMR controls six deep water ports for the exportation of products to consumers in 25 countries. in 1968 SCHN acquired an electric arc furnace (NYSE:EAF) steel maker located in McMinnvile, Oregon which uses recycled ferrous metals from AMR in the production of finished steel products such as rebar, wire rod, coiled rebar, merchant bar and other specialty products. At the end of FY17, SCHN began reporting the production from Oregon recycling facilities along with the finished steel production from the EAF - and the corresponding feeder yards - as an entity called Cascade Steel and Scrap (NYSE:CSS).

AMR and CSS form a vertically integrated business model where salvaged end-of-life (EOL) vehicles from self-service auto part stores are recycled into non-ferrous and ferrous scrap metal components and sold globally to steel mills, foundries, smelters and recycled metal processors. Portions of the ferrous components are sold to the EAF in Oregon to produce finished steel products sold to manufacturers as an input to produce common products such as chain link fencing, nails, wires, and stucco netting. Construction industry subcontractors and steel fabricators located in the western U.S. and Canada are the primary customers of CSS.

Earnings in FY18 were reported separately between AMR and CSS. The sale of non-ferrous and ferrous scrap metals within AMR accounted for 74.40 percent of SCHN’s total sales with 54.30 percent of its sales resulting from the sale of ferrous scrap metal and 20.10 percent from that of nonferrous scrap metal. Auto parts sales accounted for 5.60 percent of total sales. This classifies SCHN as part of the scrap metal recycling industry rather than part of the U.S. steel industry. The remaining 20.00 percent of sales is derived from CSS and are split between finished steel product sales accounting for 15.10 percent of SCHN’s total sales and 4.90 percent from Oregon recycling facilities and corresponding feeder yards. AMR’s export sales account for 62.00 percent of its revenue: Sourcing 44.00 percent from Asia and 16.00 percent from Europe. North American customers account for 38.00 percent of AMR revenue.

Key Competitors

1) CMC

Headquartered in Irving Texas, CMC was the first metals company to use a vertically integrated business model which sells recycled ferrous and nonferrous scrap metals from its 30 scrap metal processing facilities. CMC sells ferrous scrap metal to its own steel mills, other specialty steel producers, alloy manufacturers, foundries, aluminum refineries, and copper and brass mills. CMC also has a fabrication segment to serve customers in commercial and public construction and the infrastructure, energy and agriculture sectors. CMC is the only producer in the U.S. of spooled rebar and has net sales of $4.60 billion with 24.00 percent of it acquired through its recycling segment and the remaining 76.00 percent through its American and international steel mills and fabricators. Geographically, 75.00 percent of CMC’s sales come from the U.S., 19.00 percent from Europe and the remaining 6.00 percent from other regions. CMC owns four EAF mini-mills, two EAF micro-mills and a re-rolling mill. Each mill has its own supporting recycling yard for supply of input materials to produce steel primarily for U.S. and European markets.With its large and most recent acquisition of U.S. rebar steel mill and fabrication assets from Gerdau S.A., CMC is looking to almost double its mill and fabrication capacity with four new EAF mini mills and 34 new fabrication facilities. The EAF mini mill, which is in California and once owned by Gerdau Long Steel but now owned by CMC, is in direct competition regionally with the CSS segment of SCHN in Oregon. Across 13 countries Gerdau S.A. also has vertically integrated operations with 21 scrap yards and 6 shredders in its metals recycling division which allows it to sell all grades of ferrous and non-ferrous scrap metals throughout North America.

2) Metalic Inc

Metalico Inc is privately held company owned by Ye Chiu Metal Recycling China, LTD. It employs over 450 people in 27 operating facilities across New York, New Jersey, Ohio, West Virginia, Pennsylvania, and Mississippi. Its global market share is approximately 1.20 percent and is a significant player in the scrap metal recycling industry. Within the past six years, Metalico has acquired Bergan Auto Recycling LLC, a similar company to Pick-n-Pull, to provide the scrap metal required to produce recycled ferrous and nonferrous scrap metals. Metalico was expected to generate over $474.00 million in industry-relevant revenue in FY18.

3) SIMS

The largest global competitor of SCHN is SIMS Metal Management (SIMS), an Australian domiciled corporation. Traded on the Australian Stock Exchange with $5.35 billion AUD ($4.59 billion USD as of Jan 5, 2019) in net sales from industry-specific metals recycling, SIMS controls over five percent of global market share in the scrap metal recycling business. With 131 wholly-owned and joint venture facilities in the U.S. and Canada 52.00 percent of net sales are derived from North America. SIMS’ 50 facilities across Australia and New Zealand accounted for 17.00 percent of net sales for the company while 19.00 percent of net sales were sourced from 44 facilities across the U.K. SIMS has also expanded into municipal (curbside) recycling, energy recycling and electronics recycling with electronic recycling sourcing $758.00 million AUD ($540.00 million in USD as of Jan 5, 2019) in revenue for the company in FY18.

Competitive Positioning

Porter’s Five Forces (1 Low Threat to 5 High Threat):

SCHN finds itself in a mature industry where products are clearly segmented, industry saturation is high and global commodity prices have clear effects on its performance. This industry is also highly cyclical, primarily dominated by large companies, and likely declining in economic importance. The growth of revenues in the global scrap metal recycling market is expected to decrease by 3.80 percent in FY19.

Increasing globalization has introduced larger industry rivalries to SCHN because most of its revenues come from exports. As companies seek to acquire assets to help them secure demand the industry for SCHN has become highly competitive. This level of competition affects SCHN’s selling prices of recycled ferrous scrap and therefore its profit margins.

Although SCHN is one of the top companies in the industry, it does not control enough market share to have strong purchasing power which limits its bargaining power with suppliers. A lack of bargaining power with suppliers leaves SCHN susceptible to fluctuations in scrap metal prices which affects its COGS and squeezes margins as salvaged auto prices increase.

SCHN experiences benefits from high barriers of entry to the scrap metal recycling industry due to capital intense characteristic of the industry. This allowed SCHN to grow through multiple acquisitions throughout its history. Without product differentiation throughout the scrap metal industry, SCHN is highly subjected to the bargaining power of buyers, and therefore world prices of metals.

As a substitute in the production of steel, iron ore further empowers the price of steel to affect margins for SCHN. As Iron ore prices decrease, demand for ferrous scrap is lost to iron ore demand. With the price of iron ore forecasted by Bloomberg to decrease by 4.60 percent in FY19, the threat of it as a substitute is only moderate.

Financial Analysis

The following financial analysis of SCHN is based on the reported financial statements under GAAP accounting metrics for FY18. With a Beneish M-Score of negative 3.77 there is no indication that SCHN manipulates its accounting information. However, it has displayed receivable and inventory growth much higher than revenue growth in almost every year since FY07. In addition, inventory turnover and days of sales outstanding are significantly higher for SCHN than its peers. This could indicate aggressive accounting policies within SCHN or simply operational inefficiency.

Growth: SCHN has reported high YoY revenue growth since FY16, a 24.80 percent increase in FY17, and 36.80 percent in FY18. A major contributing factor to this growth is the increasing price of steel which posted an increase of over 20.00 percent since the end of FY15. With recycled ferrous and nonferrous scrap accounting for a significant portion of SCHN’s source of revenue, its revenues have closely reflected the increase in steel price.

Over the past six-years, SCHN’s revenue has had a correlation of 0.80 with the U.S. Iron and Steel Production Index. Steel production in the U.S. rallied during FY18, rising over ten percent YoY, which can be attributed to the tariffs on imported steel favoring domestic producers. However, we estimate industrial production growth to slow moving forward which we assume will lead to an estimated decline in revenue of 15.00 percent.

Profitability: Historically, SCHN has had profit and operating margins below the industry average which in recent years has yielded net losses and poor performance - even amid the current expansionary period. However, over the past four-years, it has been able to rapidly increase its profit margin to 6.54 percent up from only 0.17 percent in FY15 when steel prices were extremely low. In addition to rising steel prices, SCHN’s five-year average effective tax rate of only 6.31 percent has improved its profitability. Revenue growth tied to the increase in steel price and improved profit margin led to an average YoY net income growth rate of 83.60 percent in the last three-years. As a result, SCHN has a trailing twelve-month growth rate exceeding its competitors by 19.00 percent. While these figures reveal recent strength in the company’s profits, increased margins have mainly been attributed to higher steel prices, which we expect to decline, causing forecasted margins to drop as well. At steel’s low point in FY15, SCHN’s P/E multiple was at 149.00x. The average P/E multiple for the industry is 14.00x. Even during unfavorable conditions, it increased to only 19.00x. Although SCHN has since reduced its P/E ratio to 17.40x in FY17 and further to 4.90x in FY18, shareholder value is far too dependent on the price of steel - presenting a tremendous risk for potential investors.

Debt Structure: SCHN appears to be lightening its leverage using its recent increased profits. Currently, its Debt-to-Assets ratio is nine percent, decreasing from 21.00 percent two-years ago. Long-term debt has been brought down 72.00 percent since FY13. Compared to its competitors, SCHN relies much less on debt and has a Debt-to-equity of 16.00 compared to the industry average of 66.00. This may indicate that management may be foregoing opportunities or simply fails to see them. The Altman Z-Score for SCHN is 4.47, revealing the company is financially stable and unlikely to go bankrupt.

Dupont Analysis: The DuPont analysis affirms that SCHN is aligned with the industry average ROE. No apparent advantages are held by SCHN compared to its competitors in terms of ROE. Based on the DuPont formula (Profit Margin x Asset Turnover x Financial Leverage), it currently has a ROE of 23.00 percent, driven almost purely by increased profit margins over the last three years. Trending upwards simultaneously is Asset turnover with sales increasing disproportionately to assets. The same analysis of its competitors reveals similar trends with a volatile profit margin being factored into the ROE and trending upward over the previous five-years. Compared to its peers, SCHN currently has a higher ROE, though its five-year average has been lower. With profit margins expected to decrease, ROE will subsequently follow.

ROA for SCHN is also volatile. At its late business stage consistent returns are expected. However, over the last ten-years ROA has ranged from negative 17.80 percent to its current 15.40 percent with highly variable year-to-year changes in returns ((standard deviation of returns of 23.20 percent, its competitors’ standard deviation being only 3.30 percent)). The 10-year average ROA for SCHN is negative 5.90 percent while its competitors yielded 1.30 percent over the same time period. The underperformance and inconsistency of ROA for SCHN can be attributed to its susceptibility to poor market conditions. For example, SCHN made a large amount of acquisitions of plants from FY09 to FY11 to expand its AMR operations. However, a downturn in market conditions in FY13 forced them to report massive impairments of goodwill of $321 million and $141 million in FY13 and FY15 respectively. Despite the large capital expenditure, the downturn in the industry’s conditions lowered total assets from $1.763 Billion at the end of FY12, to $960 million in FY15 - a decline of 45.00 percent.

Costs: Over the last five-years, SCHN’s management has placed focus on “cost reduction, productivity improvement, and restructuring initiatives.” In that time COGS as a percent of total revenue decreased from 92.00 percent to its current 85.00 percent. Management attributes this increase in gross margin to its cost reduction efforts.

Valuation

We initiate a moderate SELL recommendation on SCHN with a one-year target price of $22.96 based on a 10/65/25 percent weighting applied to three valuation models: A perpetuity DCF model (65%), an unlevered DCF model (25%) which also incorporates a terminal EV/EBITDA multiple, and P/E multiple valuation (10%).We believe this target price is in line with general market trends and commodity price uncertainty.

Methodology: The valuation and weighting methodologies used appropriately account for and correctly blend together the value SCHN could deliver to shareholders’ over the next year as well as the general volatility that surrounds the drivers of revenue and FCF. The key assumption incorporated into the models involve a 15.00 percent decrease in revenue growth for SCHN due to the decrease of steel and recycled scrap prices, global growth stagnation, decrease in industrial production (particularly in the U.S. and China), further appreciation of the U.S. dollar and an increase in prices of SCHN’s input materials such as salvaged auto bodies.

Revenue Growth Sensitivity Analysis: Our sensitivity analysis indicates a decrease in the price of steel of 2.60 percent as well as an overall slow in industrial production growth for the geographic regions in which SCHN’s customers are based in. The forecasted weighted average industrial production growth percentage input into the model is 2.00 percent. The average of industrial growth among SCHN’s customers were weighted taking into account the information provided about the revenue by continent and weighting that among the forecasted industrial production growth rates of known customers residing in those continents.

Discount Rate: Our WACC of 10.32 percent can be decomposed into a cost of equity, derived using the CAPM, of 11.30 percent and weighted at 86.76 percent and an after-tax cost of debt of 3.95 percent weighted at 13.24 percent. There is no incorporation of preferred equity. The CAPM uses a six-month beta of 1.139, a five-year treasury rate of 2.54 percent as the risk-free rate and a five-year adjusted market return of 9.80 percent as inputs.

Beta Assumptions: Through the use of a daily regression model with data inputs from November 3rd, 2018 to May 3rd, 2019, we calculated a raw beta of 1.139. Rather than use a five-year beta which would represent our forecasting period, we chose to use a six-month raw beta to capture the markets increases in volatility which we believe will continue for the foreseeable future rather than return to below historical levels.

Free Cash Flow Growth Assumptions: SCHN is heavily dependent upon the price of commodities as inputs and as a source of revenue. These factors are heavily influenced by overall economic conditions both domestically and abroad. We believe the U.S. economy is currently in the final stage of economic expansion. A similar story is told in countries where SCHN draws the larger part of its revenue. Given this, a growth rate for FCF was implied to be negative for FY19 throughout FY21. However, due to the volatility in commodity prices, positive values were implied in the model between FY22 to FY23.

Capital Expenditures: SCHN has precipitously increased spending through capital expenditures in FY16, FY17 and FY18 in order to upgrade equipment and infrastructure as well as investment in nonferrous processing technology and environmental and safety-related assets and amounted to $35 million, $45 million, and $78 million respectively. According to company guidance, capital expenditures in FY19 are expected to be at least $80 million excluding investments for environmental and safety-related assets. Including these additional investments, expenditures will likely be in the range of $100 million. The increase in capital expenditures is reflected primarily in the unlevered discounted cashflow model in the form of a seven percent increase. We do not, however, foresee this growth in capital expenditures to continue to grow much higher. Thus, a lower capital expenditure growth rate is reflected in the subsequent years after FY19.

Discounted Cash Flow: Our first DCF model incorporates a WACC of 10.82 percent and a varied FCF growth rate in the first three-years of the forecast before settling into a perpetuity growth rate of 1.00 percent thereafter. Doing so derives an implied EV of $694.55 million. After subtracting total debt of $107.38 million and dividing by a shares outstanding of 26.70 million results in a one-year target price of $21.99 which we weighted at 65.00 percent of our valuation.

Price-to-Earnings Multiple: Using a P/E multiple valuation methodology we arrived at a one-year target price of $26.93 weighted at 10.00 percent of our valuation. This methodology used a forward P/E multiple of 10.74x, basic EPS of $2.00 and an adjusted cash-per-share of $5.45. Historically SCHN has experienced frequent negative earnings, rendering the price to earnings multiple useless or extremely high. The 10.74x forward P/E multiple is based on our lower earnings outlook for FY19 which will decrease the denominator in the formula and thus make P/E rise from its current level of 4.59x to 10.74x in one-year.

Unlevered Free Cash Flow - EV/EBITDA Multiple: Due to SCHN’s historical revenue and earnings volatility, an unlevered free cash flow methodology that incorporates a terminal EV/EBITDA multiple was used in order to remove the effects of noncash expenses, debt, and other cost that contribute to the volatility. An EV/EBITDA multiple of 4.5x and 5.0x was used to create a sensitivity model given different WACC assumptions. Taking the average of the price-per-share at 4.5x and 5.0x with a 10.32 percent WACC derives a one-year target price of $23.91.

Investment Risks

Market Risks

MR 1: Increasing probability of a U.S. Recession - [Impact: High, Probability: medium]: A recession would decrease the demand for steel products and recycled scrap metals, adversely affecting revenues, as experienced during and following the Great Recession. Factors which may contribute to a recession may include failure to come to a resolution over trade tensions between China and the U.S. by the end of the 90-day trade truce, which may intensify the dispute and decrease business and consumption expenditure. Furthermore, increasing inflationary pressure leading to interest rate hikes contrary to Federal Reserve indication may further tighten financial conditions in the markets. Lastly, potential negative effects on the U.S. Q1 GDP caused by the U.S. government shutdown is another factor that may increase the probability for an upcoming recession in the U.S.

MR 2: Regional and Global Growth Stagnation [Impact: High, Probability: Medium]: Weakening global growth in FY19 as predicted by International Monetary Fund’s World Outlook, particularly in China and the U.S., may lead to reduction in demand for steel and subsequently for SCHN’s recycled scrap and steel products.

MR 3: Fluctuations in prices of raw materials - [Impact: HIGH / Probability: High]: SCHN relies on third-party suppliers for supply of input materials such as raw materials and end-of-life vehicles. Inability to secure steady supply of these input materials due to suppliers holding their products from being sold to increase price would reduce revenues of SCHN and adversely affect its obligations with customers.

Financial Risks

FI 1: Foreign Exchange Fluctuations – [Impact: Medium / Probability: High]: The WSJ Dollar Index showed a 4.30 percent appreciation of the U.S. dollar in FY18 against a basket of 16 other currencies. Further appreciation of the U.S. dollar has potential to lower global and U.S. demand for SCHN steel and scrap products. This is important because foreign ferrous and nonferrous scrap metal sales revenue for SCHN accounted for 74.00 percent and 55.00 percent of total revenue respectively in FY18. Uncertainty over the U.S.-China trade relationship also causes investors to flee to U.S. Treasurys, further strengthening the U.S. dollar and affecting SCHN’s bottom line. Failure to achieve a trade agreement at the end of the 90-day truce between the U.S. and China will reduce demand for Chinese yuan and stop the ease in the depreciation pressure on it. Additionally, uncertainties over the Turkish central bank’s next monetary policies, and pressure by the Turkish President Tayyip Erdogan to lower interest rates ahead of local elections on March 21, are predicted to put pressure on and depreciate the Turkish lira, which will reduce Turkish demand for SCHN’s products (Turkey accounts for 11.00 percent of SCHN’s total revenues).

FI 2: Failure to Hedge - [Impact: Low / Probability: Medium]: As of November 30, 2018, no derivative instruments were purchased to hedge against Canadian dollar fluctuation. Further depreciation of the Canadian Dollar will result in transactional loss for SCHN.

FI 3: Goodwill Impairment - [Impact: Low / Probability: Low]: Goodwill accounts for roughly 15.00 percent of SCHN’s assets, thus, impairment of the goodwill due to changes in market conditions may affect assumptions made by the company to establish fair value of the company (future cash flows, growth rate, WACC). This may affect the investors’ confidence and lead to a sell-off of SCHN stock.

FI 4: Tax Changes - [Impact: Low / Probability: Medium]: Changes in tax laws in nations that conduct business with SCHN - as a response to the introduction and signing of the Tax Act law by the U.S. President on December 22,2017 - may adversely affect SCHN operation and future cash flows.

Business and Operational Risks

OP 1: Employees strike - [Impact: High / Probability: Low]: Failure to renew or achieve agreement with SCHN’s 21.00 percent of full-time employees represented by unions under collective bargaining agreements may result in strikes and disruption in SCHN operation.

OP 2: Consolidation in the steel industry – [Impact: Low / Probability: Medium]: Firms acquiring steel mills and steel mills acquiring steel fabricators to safeguard demand for their products may lower demand for Schnitzer’s steel products and scrap (e.g. CMC’s acquisition of Gerdau S.A).

OP 3: Disruption in the Shipping Industry – [Impact: Medium / Probability: Medium]: SCHN relies on third-party shipping companies to handle its exports and imports of raw materials and final products. Any disruption in the shipping industry, especially increased volatility in the oil future price, would reduce profit margin for SCHN. Additionally, natural disasters can hurt operations and abilities to fulfill business obligations.

OP 4: Failure to sustain cost reductions – [Impact: Medium / Probability: Medium]: For the past three years SCHN invested heavily in productivity and restructuring initiatives to reduce costs and increase profitability. Failure to sustain this level of profitability will adversely affect profits.

Regulatory and Legal Risks

RL 1: Environmental Costs and Liabilities – [Impact: High / Probability: Low]: Potential environmental costs for cleanup of Portland Harbor may reduce SCHN’s bottom line. Although no settlements or remediation payments are predicted to be incurred in the next year, there is still risk of expenditure on legal fees.

RL 2: Failure to renew permits/licenses – [Impact: High / Probability: Low]: Inability to renew or obtain licenses and permits to operate in different locations, due to changes in regulations or local laws, failure to comply with current and future climate change and greenhouse emission laws and regulations, may require SCHN to close certain facilities or fail to expand operations into new regions. These may adversely affect SCHN’s operations and subsequently its profit margin and future cash flows.

RL 3: Product Liability claims – [Impact: High / Probability: Low]: Failure to prevent contamination of SCHN’s metal scrap mixture by radioactive metal scrap poses a liability risk that SCHN’s insurance may not adequately cover, thus, reducing SCHN’s bottom line.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.