Sims Well And Truly Off The Scrap Heap

It has been an investment conundrum for years now. There seems no doubt that the “cleantech” sector’s time has come. The term covers companies involved in recycling, renewable energy, alternative energy, biofuels, energy efficiency, water purification technology, anti-pollution technology, environmental remediation and rehabilitation and new materials. It’s everything that a clean, green world should need, and it is touted as the next big wave in technology.

But it has proven very hard to invest in – particularly what should be the cleantech poster child, the daddy of them all in terms of Australian stocks, Sims Metal Management (SGM), the world’s largest listed metal and electronics recycler.

Sims has been a major Australian success story, since Albert Sims, a Sydney-based scrap metal dealer, originally established Sims Metal Management in 1917, when he started to collect scrap on a bicycle, before graduating to a horse and cart. Eventually the horse and cart were replaced by trucks and mechanised equipment, and the business was incorporated as Albert G. Sims Limited in 1928 (it was renamed Simsmetal Limited in 1968.) The company first went on to the Australian stock market in 1970, but was acquired by Peko-Wallsend Limited and delisted. Simsmetal went through various owners before relisting on the ASX in 1991.

Along the way, the company – now known as Sims Metal Management – became the world’s leading listed metal recycler, with 200 operations in five continents, including the United States, Australia and the United Kingdom, comprising a network of processing facilities, many with deep-water port access, supported by an extensive network of feeder yards from which it sources recyclable ferrous and non-ferrous metals. The electronics recycling business, Sims Recycling Solutions, is the largest in the industry, with 33 facilities in more than 20 countries. The smallest arm of the group, Sims Municipal Recycling receives and recycles household waste in municipalities such as New York City and Chicago.

Sims is an Australian global leader, but it has been a poor investment lately. Over the last five years, it has lost 10% a year for shareholders. Over three years, it is barely in the black – it has delivered the princely total return (capital growth plus dividends) of 0.18% a year. In the last 12 months SGM has gone backwards by 10.5%. From a peak share price of $39.06 in June 2008, Sims sank to $8.74 in July 2013. From there it has slowly moved higher, and had reached $12.71 earlier in the year: the stock is now at $10.05, which capitalises the company at $2.05 billion.

The problem has been a combination of the Chinese economic slowdown, weak steel prices, excess capacity and the gut-wrenching plunge in iron ore prices, from US$187.18 a tonne in February 2011 to US$47.08 a tonne in April 2015 (prices have recovered slightly, to US$57.30 a tonne at present.) This has hurt Sims because its major business is selling scrap metal to electric arc furnace (EAF) operators to make steel, as opposed to blast furnaces, which use iron ore. Sims takes scrap metal from recycled items such as cars and household appliances through its buyers and network of scrap yards and sells it to EAFs to make steel: the company also captures and resells non-ferrous metals, such as copper.

Sims is very sensitive to the economic cycle, and has suffered from sluggish global growth. The US and European markets have been particularly weak. The company’s profitability has been hammered, with writedowns plunging it into the red in 2011-12 (a $622 million net loss) and 2012-13 (a $466 million net loss) and 2013-14 (an $88.9 million net loss). A major fraud in its UK operation, where the value of inventory was found to be hugely overstated, did not help, either.

However, in 2013, Sims bit the bullet. After chief executive Daniel Dienst retired, and after an eight-month search, global metals industry veteran Galdino Claro was appointed CEO with a mandate to “make difficult decisions necessary to steer Sims Metal Management through the global environment it confronts at this time, as well as positioning the company for any recovery in international markets.”

Claro has certainly been prepared to wield his mandate. In 2014, Sims unveiled plans to more than quadruple its earnings by 2018, announcing a five-year plan to lift earnings through improvements to its operational performance. It was an impressive aim: Sims was endeavouring in effect to change its cyclicality. The plan called for underlying earnings before interest and tax (EBIT) to rise by more than 350% by FY18, over FY13, without relying on cyclical market recovery or major acquisitions. The strategy promised to deliver returns above the company’s cost of capital, even at bottom of the economic cycle.

In February this year, investors started to see the fruit, when Sims reported a 5.7 per cent drop in half-year revenue to $3.4 billion, but a 53% jump in underlying profit, to $64.4 million.

Then, in August, Sims reported its full-year FY15 result, which saw the bottom line rebound to a $110 million net profit, a big turnaround from the $88.9 million loss in FY14. Underlying EBIT rose to $142 million, up from $119 million in FY14, and the fully franked dividend was lifted by 3 cents to 29 cents a share. On the other hand, group revenue fell 10%, to $6.3 billion, and sales volumes dropped 11%, to 10.5 million tonnes, as lower iron ore prices and tough weather in North America – Sims’ biggest market – bit into ferrous scrap prices and volumes, particularly during the third quarter.

Arguably more importantly, two years into the five-year plan, Sims has lifted its return on capital from 2.3% in FY13 to 4.6% in FY14 and 5.5% in FY15: the target is 11% in FY18.

Underlying EBIT (earnings before interest and tax) has risen from $67 million in FY13 to $119 million in FY14 and $142 million in FY15: the target is $321 million in FY18.

The plan is based on “streamlining” and “optimising.” The former attacks operating costs by working the operating assets better, shifting both fixed and variable costs down the cost curve, rationalising the equipment fleet, outsourcing any non-essential functions, employing flexible workforce solutions and being much more disciplined about capital investment. “Optimising” focuses on supplier relationships, logistics, operational excellence, and product and service quality.

In essence, the transformation that Claro and his team has put in place works like this: the “streamlining” initiatives drive fixed cost per tonne lower, which decreases the volume required for break-even, while the “optimisation” initiatives drive margin per tonne higher. Critically, the company believes that optimisation will improve its return on capital even at lower volumes: Sims said earlier this month that the Optimise initiatives had driven a gross margin improvement of $47 a tonne since the start of the strategic plan.

With the entire company committed to the plan, improvements are emerging everywhere. For example, better supplier analysis tools analyse every tonne of scrap purchased by profitability, and deliver critical feedback to buyers; the resulting feedback loop reduces unprofitable tonnes, and expands Sims’ relationships with profitable suppliers. Another example is taking the transport of some of the New England scrap headed for the New York shredder off trucks and putting it on barges, making significant savings on freight cost. (Barges are also used to transport NYC municipal waste to Sims’ recycling facilities in the city, including the state-of-the-art new facility at Sunset Park in Brooklyn.)

Another example is the installation of metal loss monitors in all downstream scrap plants: this technology helps plant management lift recovery rates, while reducing waste disposal. The company says it is seeing numerous small improvements compounding into large gains. All of this is working to stabilise the core business, and get it ready to take advantage of new growth markets.

What Sims’ business review has also told it is that the sales and profitability of the metals business is constrained by very competitive markets, but as it learns to run its metals recycling business better, that may create a stronger platform for acquisition of under-performing metals assets in new markets.

The company believes that its future material supply is likely to be significantly different that present: it says the increasing composition of electronics and alloys in consumer goods and vehicles will present new challenges and opportunities for the metals recycling industry. However, Sims says it is uniquely positioned to leverage technology from its electronics recycling business to capitalise on these opportunities, lead on industry innovation, and grow in new markets.

The electronics recycling business is equipped to handle large-volume recycling of material from municipalities, compliance schemes, and equipment producers; but it is leveraging away from a reliance on recycling to capture the growth in its “asset management” area, which manages for corporate clients the recycling and data destruction of their retired IT assets.

Sims also thinks it has definite growth opportunities in municipal recycling – in particular, it believes it can replicate its successful New York City model in other major markets – and electronics recycling, where ‘streamlining’ the business under the five-year plan precepts has “positioned it better for growth.” Also, the company is exploring other opportunities in high-margin recycling markets that are attractive.

The company says there is “much more to be accomplished,” and analysts are convinced of that, too. On Thomson Reuters numbers, the analysts’ consensus earnings per share (EPS) figure for Sims in FY16 is 66.4 cents a share – almost double the 34.7 cents a share earned in FY15. In FY17, analysts are looking for 84 cents a share.

Dividend growth is also expected, with 35 cents a share expected in the current year – up from 29 cents a share in FY15 – and rising to 45 cents a share in FY17. On FY16 consensus expectations, Sims is trading on a price/earnings (P/E) ratio of 15.3 times earnings, and a fully franked prospective yield of 3.4%. Even more alluring is the analysts’ consensus target price, which at $12.15 implies upside of almost 21%.

The turnaround at Sims Metal management has been fairly impressive – and it looks like it has further to run.