Schnitzer Steel: The Dividend Is At Risk

Summary

• Schniter's Q1 was very tough due to a shift in customer preferences and low prices.
• The adjusted OpCF was just $11M (compared to almost $40M in Q1 FY 2019), and Schnitzer plans to invest $125M during this year.
• This means the dividend, which costs the company north of $20M per year, is at risk if the situation doesn't change soon.
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Introduction

Schnitzer Steel Industries (SCHN) has been around for a while as the company was created in 1906 and has since grown to be one of the largest recyclers of scrap metal (both ferrous and non-ferrous) in North America. It also operates the Pick-n-Pull brand, a self-service auto parts chain where customers can just take the desired parts out of a salvaged vehicle. Once that's been done, Schnitzer then usually just recycles the wreck itself.

Data by YCharts

The first quarter of 2020 (which ended in November) was tough for Schnitzer as it had to deal with disappointing volumes and prices. This weighed on the operating result and on the free cash flow performance, which turned negative.

Q1 2020 wasn't great, but Schnitzer claims to have a plan

According to Schnitzer, its first quarter was suffering from weaker scrap markets (both export and domestic) and a structural shift for certain non-ferrous projects. This structural shift has been ongoing for a while, and Schnitzer is still working on mitigating the impact of this shift by investing in metal recovery technologies while pursuing shipping higher volumes of ferrous products and improving the efficiency of its operations. Rome wasn't built in a day, and just like the construction of Rome, Schnitzer will need time to effectively and efficiently implement its plans. Schnitzer is dangling a carrot in front of its shareholders mentioning 'this will provide additional opportunities to grow and return more capital to our shareholders'.

Source: press release

Maybe that will indeed be the case, but near term, I'm mainly looking forward to seeing Schnitzer mitigating the impact of lost business.

In the first quarter of the (financial) year, Schnitzer's revenue fell from $564M in Q1 FY 2019 to just $406M in the current financial year. Yes, the COGS obviously decreased as well and so did the SG&A expense, but Schnitzer couldn't avoid reporting an operating loss of $7.9M in the first quarter. And that's a painful loss as the company was clearly profitable in the previous year with an operating income of almost $23M and a net income of $16.2M.

Source: SEC filings

In Q1 FY 2020, Schnitzer's bottom line showed a net loss of $7M or 26 cents per share despite being able to record a $2.5M tax benefit. In the ferrous division, Schnitzer pointed at a tightening of supply flows which resulted in a 10% lower volume, while in the nonferrous division, the new restrictions of China on its domestic scrap importers tightened, which reduced the demand for nonferrous scrap from the country. To protect itself against future shocks, Schnitzer has reduced its exposure to China, and the Asian country now represents just 12% of is nonferrous volumes.

There's no way to sugarcoat this: Schnitzer's Q1 wasn't good. Fortunately, the company did remain cash flow positive, but the free cash flow result was clearly negative.

Schnitzer reported an operating cash flow of $11.1M, but this included quite a few changes in the working capital position. On an adjusted basis, the operating cash flow was just $8.46M, and just $7.9M after taking the payment to non-controlling shareholders into account. And with a total capex of $24M, Schnitzer was clearly free cash flow negative, to the tune of $16M.

Source: SEC filings

And that could be an issue as Schnitzer continues to invest in growth. Its full-year capex guidance points to $125M to be spent in a mix of $60M on growth and $65M on sustaining capex. So, even if we would only look at the sustaining capex, the normalized quarterly rate of just over $16M still wouldn't be covered by Schnitzer's operating cash flow.

Which also means the annualized dividend of 75 cents per share or just over $20M clearly isn't covered either.

Data by YCharts

The balance sheet: Schnitzer can weather the storm for a little while

Schnitzer has one thing going for itself: the balance sheet is actually quite robust. The company has $9.6M in cash on the bank and $1.4M in short-term debt and $127M in long-term debt, for a net debt position of around $119M.

Source: company presentation

Additionally, Schnitzer has access to its existing credit facility which currently has a total size of $700M. As Schnitzer has drawn down just $119M, an additional $581M could be drawn down to fund its investment plans. And as debt is cheap with LIBOR +1.25-2.75%. At the current 3-month LIBOR yield of 0.9%, this means Schnitzer's interest expenses will range between 2.15% and 3.65% on an annual basis, using $120M as the amount that has been drawn down. At the end of November, the average cost of debt was 3.25%, but the higher leverage ratio (due to the slightly higher net debt and lower EBITDA) may result in Schnitzer's mark-up moving higher.

As the credit facility only expires in 2023, Schnitzer does have three years to figure things out, but if it doesn't start generating a positive free cash flow soon, its debt ratio will start to increase relatively rapidly due to the combination of a disappointing EBITDA and increasing net debt (to fund the $125M capex program this year).

Investment thesis

Schnitzer Steel is figuring out how to deal with the 'new normal' and focuses on efficiency and the products that are in higher demand. At least, there is a plan on the table, but we can't be satisfied with Schnitzer's financial performance as the Q1 operating cash flow wasn't even sufficient to cover the maintenance capex.

I have no position in Schnitzer Steel. I'm interested in the business concept, but the volatility in the scrap prices and customer preferences is tough to deal with, so I am standing on the sidelines for now.

Analyst’s 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.

Comments

[Little, Einstein]

"Schnitzer has one thing going for itself: the balance sheet is actually quite robust. The company has $9.6M in cash on the bank and $1.4M in short-term debt and $127M in long-term debt, for a net debt position of around $119M"

That was to laugh $9.6M in cash,robust?

[The Investment Doctor]

I didn't call the cash robust. I called the balance sheet robust. With access to $581M of the credit line and a relatively low net debt, yes, that balance sheet is relatively robust in normal circumstances.

[Dollarman1971]

Thanks for the article. I have been watching SCHN for about a year and like you have been on the sidelines. I like the yield though your article may be right that a cut could be in the future. Strong balance sheet, in an industry(ies) that will not go away (recycling and vehicle parts) and available cheap debt if needed are pluses to me. That said, I think the market needs more good news globally and SCHN can at least cover capex.

[The Investment Doctor]

Maybe I misread your comment and you intended it to sound as 'if there's more good news, Schnitzer will be able to cover capex', as right now, the capex is clearly uncovered.

[Dollarman1971]

I see that my message wasn't clear. For SCHN to increase in value we need; 1. better economic news globally and 2. SCHN must at least cover CAPEX. That is what I meant.

[The Investment Doctor]

Gotcha. Yes, I fully agree! Sorry if I interpreted it wrong - it totally could have been me who created the confusion, I just got off two back-to-back intercontinental flights.