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. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  5. Professionals

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  6. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  7. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  8. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  9. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  10. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  6. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>

You May Also Like

Trading Center