Tickers in this Article: SCHN, SMS, STLD, NUE, CMC
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.

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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.

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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.

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