Sims Ltd (ASX:SGM) is a recycler of ferrous and non-ferrous metals. They operate as a purchaser, processor, and seller. The Company’s primary operations are in the US, although it also has significant exposure to Europe and Australasia. Since our research report on the Company in The Dynamic Investor on 1 March 2022, the shares have jumped by over 10%, as favourable market conditions have results in scrap prices continuing to rise.
But beyond this favourable external factor, there are numerous Company-specific factors that are supporting earnings growth over the medium term. With the share price now having re-rated, are these factors (both external and internal) now starting to be reflected in the share price? Or does the re-rating in the shares have further momentum?
Key Fundamental Drivers of Sims Ltd
Further Upside in Volumes
A key factor underpinning the strong volume increase over the last 12-18 months is that China has announced new regulations allowing high-quality recycled ferrous to be freely imported from 1 January 2021. Accordingly, as China’s domestic price premium started to collapse, scrap prices in other parts of the world lifted, which in turn boosted volumes.
Sims Ltd noted that momentum has continued into the current half-year period (for both ferrous and non-ferrous volumes), as producers seeking scrap alternatives in light of higher coal and iron prices. Volumes are still only just approaching pre-COVID-19 levels. This suggests further upside. High prices likely to help drive volumes given increasing obsolete scrap supply.
Further, the supply of obsolete material in the US is expected to result in tailwinds. This is given elevated construction/demolition (20-30% of obsolete materials), as infrastructure programs come to fruition following a period of under-investment.
Margin Likely to Remain Elevated
Scrap prices for East Asia ferrous, US HMS (Heavy Melting Steel) and Turkey have continued to rise into the current half-year. In addition, non-ferrous scrap prices remain elevated, notably Zorba and Twitch.
The combination of elevated scrap prices, volume growth and strong cost control should see EBIT increase further in the current half-year period (2H22).
Looking beyond FY22, ferrous scrap markets are expected to peak and begin to decline from FY23 onwards. However, we contend that medium-term scrap volume growth and margin expansion is likely to offset the expected decline in ferrous prices. In terms of the expected volume growth, SGM is targeting a ~40% increase in its ferrous scrap volumes (to 9.6Mt) by FY25. It also expects a doubling of its US non-ferrous business to 300ktpa by FY25.
The 9.6Mt ferrous scrap volume target partly relies on acquisitions, which are a key strategic focus for the Company. In particular, SGM has acquired ~1Mt of ferrous capacity through the SA Recycling JV in the US since 2017. This includes the recent acquisition of PSC Metals.
Overall, higher volumes, elevated ferrous and non-ferrous scrap prices and a restructured cost base underpin expectations for the EBITDA margin to remain at ~9% over the medium term (i.e. only slightly below the elevated EBITDA margin levels in FY20/21 but well above pre-COVID-19 levels), especially as SGM has significant operating leverage across both ferrous & non-ferrous scrap. Notably, non-ferrous scrap typically accounts for ~5% of volumes and ~20% of revenue and generates higher margins than ferrous scrap. SGM have noted that they have significant additional capacity in non-ferrous scrap.
Balance Sheet Remains in Net Cash Position
Net cash as at 31 December 2021 was $45m. While this was an improvement from the net cash balance as at 30 June 2021 ($8.3m), it appeared to be below expectations. This was because of a build-up of working capital. The Company also completed a number of acquisitions.
SGM prefers to maintain a high net cash balance given that it operates in a highly cyclical industry and capital management is typically undertaken in the form of share buybacks. The Company targets average net cash of $100m over the working capital cycle.
In terms of the potential use of the net cash position (SGM also has unused debt facilities of ~$300m), firstly, further acquisitions are likely, especially as the Company’s strategy is to expand its global footprint.
Secondly, under the capital return framework, SGM intends to return 50% of EBIT to shareholders. This would be through a combination of dividends and share buybacks. The Company has already committed to additional share buybacks in 2H22. Dividends will remain limited by available franking credits, which in turn depend on the contribution from the Australian operations to group profits. In context, the ANZ Metal Segment accounted for ~36% of group EBIT in 1H22.
Scrap markets are expected to remain supported in the near- to mid-term driven by a potential increase in Chinese demand. China is expected to import more ferrous scrap in coming years as part of the transition towards higher scrap usage in blast furnaces in order to help reduce emissions. Further, the global decarbonisation of steel making, and electricity generation industries is driving demand for recycled metal.
The significance here is that these structural tailwinds are expected to keep earnings elevated for the next 18-24 months and support cashflow. This should in turn allow the Company to take a proactive approach to capital management.
While the expected decline in ferrous scrap markets from FY23 presents an earnings risk, the potential for further accretive acquisitions (supported by a net cash balance sheet) and effective cost management and favourable product mix (both supportive of EBITDA margin) are likely to be offsetting factors.
Since our report earlier this month, the 1-year forward P/E multiple has re-rated from ~9.5x to ~11x at present, which, in our view, does not appear demanding in the context of medium-term EPS growth of ~9% over FY21-FY24 on a CAGR basis.
For much of the past year, there had been some strong resistance near $17.50 which had been tested on a number of occasions. In the past several weeks we have seen Sims Ltd finally break free of that, do a successful retest, and then continue to kick on. Volumes have also been healthy. The overall chart looks bullish and we expect this uptrend to continue for now.
Michael Gable is managing director of Fairmont Equities.
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