Sims Metal Management Ltd (ASX: SGM) can't catch a break. Despite cost-cutting initiatives and competitors exiting the market, deteriorating conditions in the recycling industry have sent its revenues plunging and driven the company to another full-year loss.
Here's what you need to know:
- Revenues fell 26% to $6,310 million
- Net Profit After Tax (NPAT) fell from $110 million to $216 million loss due to impairments
- Underlying NPAT fell 63% to $38 million
- Underlying Earnings Per Share fell 62% to 18.6 cents
- Dividends per share of 22 cents, down from 24 cents previously (2.3% yield)
- $242 million in cash, just $6 million in debt
- Outlook for ongoing tough market conditions with continued cost-cutting initiatives
- Expect 2017 to be a step on the way to achieving returns on invested capital above 10% in 2018
Overpriced, yet poor value
On the face of it, Sims doesn't have a lot to offer investors. It trades on 47 times its underlying profits for this year and pays a dividend of 2%. Worse, it's a capital-intensive business with close to zero control over commodity markets, meaning it has to spend big on facilities that can't earn an attractive return at the bottom of the cycle – like now. That's also why there's been so many impairments in recent years.
Management has done the right thing in closing under-performing facilities and reducing headcount, yet their ambitious plan to grow Earnings Before Interest and Tax (EBIT) by 350% by 2019 may yet prove fruitless.
Conditions in recycling markets have continued to decline, and I saw a disturbing chart on page 6 of the accompanying results presentation yesterday:
If you look closely, you'll notice that quarterly volumes (yellow line) drop 25% from ~2.6 million tonnes in the first quarter, to a low point of ~2 million tonnes in the third quarter – yet earnings (blue bar) completely evaporated.
This is because of the high fixed-cost nature of Sims' businesses – when production levels are lower and facilities are operating below capacity, it still has to pay the full level of operational costs.
Here's a simple example. Imagine you make $1 of revenue, and pay 70 cents in costs, earning 30 cents as profit. If revenues (and thus profits) fall 15 cents due to lower sales, you're now making 15% less revenue. Yet your profits will decline by a whopping 50% to 15 cents since profit was only 30 cents to begin with.
This is what appears to be happening with the above chart, and the main way to reverse it is by lifting productivity, sales prices, or cutting costs. Sims sells in an open market, so it can't really raise prices, and thus it has been forced to sell under-performing businesses and reduce its headcount. I think when we look at the slight improvement in Underlying EBIT (blue bars) in the second and third quarters – despite a further decline in volumes – we're seeing the positive impact of these measures.
Yet Sims appears to be still trading uncomfortably close to its break-even point. We can see additional evidence of this in the cash flow statement, below:
Here you will note that receipts from customers fell substantially from 2015 to 2016, but so did payments to suppliers and employees.
Yet if you divide the 'payments' line by the 'receipts' line, you will see that costs as a percentage of sales actually rose from 94.9% to 96.8% between 2015 and 2016.
To give additional context – albeit using a totally dissimilar business – shares in G8 Education Ltd (ASX: GEM) copped a hiding last week after its costs as a percentage of revenue rose from 79% to 82%. Sims shares — under-followed, with higher costs, and far more expensive in Price to Earnings (P/E) terms — rose 5% but things could easily have been quite different.
The bull case
That was the bear case – now hear the positives. Sims has no significant debt and despite its headline losses has continued to deliver positive cash flows over the past few years. As Peter Lynch once quipped, it's extraordinarily difficult to go broke if you haven't got any debt, and Sims now also has a cash buffer to endure further deterioration in the resources market.
Once demand and prices pick up, management stated that they have the vacant capacity to produce another ~5 million tonnes per annum,which would lead to a rapid multiplication of profit. To revisit my oversimplified example from above, if you have revenues of 85 cents and costs of 70 cents, when revenue increases by 15 cents to $1, your profit rises 100% from 15 cents to 30 cents (all else remaining equal).
Market conditions in Turkey and the US are improving and in particular, recycling competition in the US is now at low levels not seen since 2010. Sims' electronics recycling business has the potential to become significantly bigger in coming decades with the proliferation of electronics, and the company already has the geographic footprint and scale to benefit.
Yet, global commodities remain oversupplied and prices are at very low levels, while a significant amount of the upside appears already priced into Sims – probably as a result of investors waiting for the above-mentioned turnaround.
I'm convinced there will be a turnaround somewhere, but until there are signs that is starting to materialise (and not worsen, as has been the case in recent years) it's tough to see value in Sims today. It remains an investment only for the patient, and those comfortable with volatility.
