All parts of the steel cycle have been volatile lately, as investors fret over demand for steel from ArcelorMittal (NYSE:MT) and Nucor (NYSE:NUE) and the demand for inputs like met coal, iron ore, and scrap steel. While improving economic conditions and a possible revival in North American commercial construction may seem to augur well for Schnitzer Steel (Nasdaq:SCHN), investors shouldn't ignore the significant long-term challenges of this leading scrap processor.

A Volume Recovery And Better Margins Drive Fiscal Q2 Results
Schnitzer did reasonably well for the fiscal second quarter. While the reported results were inflated by tax benefits, it was still a decent quarter on balance.

Revenue fell 25% from the year-ago period, but did improve 12% sequentially. These results were driven primarily by volumes, as ferrous scrap volume fell 18% from last year but improved 16% from the fiscal first quarter. Price erosion has also eased, as ferrous prices fell 12% from last year but improved 4% sequentially. In the smaller non-ferrous business, volumes fell 26% and rose 6%, respectively, while pricing improved 7% and 2%.

The company's steel manufacturing business saw revenue declines of 16% and 23%, respectively, while the auto parts business was flat and up 12%.

Schnitzer's cost reduction efforts do appear to be paying off, though improved volumes certainly helped as well. Gross margin rose 150bp from the year-ago period and 70bp from the prior quarter. Adjusted operating income fell 28% from last year, but more than quadrupled on a sequential basis. Interestingly, Schnitzer had a very different margin experience this quarter than Commercial Metals (NYSE:CMC) recently reported. 

SEE: 5 Must-Have Metrics For Value Investors

The Future Looks Cloudy
Admittedly, there are major unknowns about every company's future, and that's even more true in commodity businesses. Even so, I believe Schnitzer's future is even more complicated than the “normal” commodity company.

On the positive side, the scrap processing business is still highly fragmented, with the top eight processors holding about 50% share. That means more opportunities for Sims (NYSE:SMS), Schnitzer, and TMS (NYSE:TMS) to add volume and revenue and drive better operating leverage.

Schnitzer is also well-positioned from a cost and margin standpoint. The company's access to seven deepwater port facilities (and ownership of four of them) helps control shipping costs, and the company's heavy exposure to exports (80% of scrap revenue) protects it from the likely increased use of direct reduced iron at domestic mini-mills like Nucor and Steel Dynamics (Nasdaq:STLD). It's also worth noting that Schnitzer has also been active in using technology and know-how to improve recovery of non-ferrous materials in its processing operations.

On the negative side, there has been significant growth in North American scrap capacity over the past six or seven years (on the order of 60%). At the same time, scrap supply in Asia has been growing, and that represents a real threat to Schnitzer's model, which is based in part on arbitraging the difference between scrap prices in the U.S. and Asia.

The Bottom Line
Although a few analysts have talked about Schnitzer as a potential acquisition target, I think their notion that a mini-mill operator like Nucor would buy the company is likely misguided, given the cost advantages of direct reduced iron relative to scrap steel. On the other hand, I would dismiss the possibility that a company like Itochu (OTC:ITOCY) or a Chinese trading company could see value in Schnitzer, as the company does hold about 20% share of the U.S. scrap export market.

SEE: Analyzing An Acquisition Announcement

For now, though, I don't see a lot of value in Schnitzer shares. Using the historical median average of 7x EBITDA suggests a fair value of about $28. While I'm willing to acknowledge the possibility that the arrival of the long-awaited steel recovery would drive EBITDA estimates higher as the year rolls on, I think investors would do better for themselves in names like Vale (NYS:VALE), Nucor, Steel Dynamics, or ArcelorMittal if they believe in a steel recovery.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Active Trading

    Value Investing

    Learn everything there is to know about value investing.
  2. Active Trading

    Value Investing + Relative Strength = Higher Returns

    Buying value stocks that are moving higher helps investors steer clear of value traps.
  3. Fundamental Analysis

    Value Investing Using The Enterprise Multiple

    This simple measure can help investors determine whether a stock is a good deal.
  4. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  5. Markets

    Why Gluten Free Is Now Big Business

    Is it essential to preserving your health, or just another diet fad? Either way, gluten-free foods have become big business.
  6. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  7. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  8. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  9. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  10. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Middle Market

    Definition of middle market
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How can a company execute a tax-free spin-off?

    The two commonly used methods for doing a tax-free spinoff are either to distribute shares of the spinoff company to existing ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!