SCHN - Schnitzer Steel Industries: Justifying The High Current Valuation

2023-07-10 03:26:59 ET

Summary

• Schnitzer Steel Industries is a promising investment, despite its high forward P/E, due to its growth projections and strong balance sheet.
• The company's focus on recycled metals offers exposure to a niche industry and aligns with global efforts to reduce emissions.
• Despite fluctuations in commodity prices, SCHN maintains a positive bottom line and is expected to benefit from increasing demand for recycled metals.

Investment Summary

A company that can grow at a significant pace is often appointed a higher multiple, which is the case with Schnitzer Steel Industries Inc. (SCHN). In most cases I might be a little skeptical if a company is trading at forward p/e of about 30 or 40, so I was surprised myself when I found SCHN to be quite an intriguing buy, despite trading at 41x earnings . The company specializes in recycled metal products in both the United States and internationally, however, more nearly half of the volumes in Q3 FY2023 were domestic, i.e. the United States.

What SCHN has above other companies is a very sound opportunity to get exposure to what I find an exciting niched industry. The growth projections for SCHN remain very positive and by 2025 the EPS is estimated to reach $3.52 which would put SCHN at a p/e of under 9. This shows why sometimes you need to look beyond the valuation of today and instead see what the potential might hold, and with SCHN it seems very great. The company has a healthy balance sheet with a leverage ratio of 27% which has helped the company remain stable and still distribute a solid dividend yield of 2.5%. If SCHN gets a valuation in line with the rest of the sector by 2025, then the potential return would be about 19% annually from today's prices. The projection is that SCHN would have an EPS of $3.52 and a 13x multiple would be applied.

Steel Remains A Vital Part

It is no secret that steel prices have decreased compared to a year ago when the war in Ukraine began. Steel prices typically follow cycles of peaks and valleys. During prosperous market conditions, companies like SCHN can accumulate capital for strategic investments and shareholder distributions. Although there has been a recent surge in steel shipments from China, I believe it does not heavily impact SCHN. While it does create pricing pressure for US-based companies, the trend of manufacturing returning to the US mitigates the potential impact on SCHNs future performance. The global demand for steel, not just in the US, continues to rise.

SCHN is a way to benefit from the incentives placed to reduce emissions. The recycled metals that SCHN offers produce far fewer CO2e emissions when used compared to mining for new metals and using those. Some of the more significant tailwinds that are driving SCHN forward is the potential shortage of several critical metals that are used throughout our different manufacturing industries. The shortage will most likely create further demand for the metals and result in price hikes as well. Demand will come in many ways, but some of the domestic industries in the US that will plant a major role is the automobile industry, primarily EV productions but also new renewable energy technology like solar panels.

The operations of SCHN focus on first acquiring from cars to industrial machinery and then processing this and finally salvaging the valuable part and recycling that into usable materials for various industries to use.

In terms of prices of steel prices, it has dropped somewhat from the in Q3 - Q4 FY2022. This of course harmed the last report's revenues, and a decrease of around 24% was visible. But that was somewhat offset by the higher volumes shipped the company had. Going forward I think this will be the way that SCHN somewhat hedges against more unfavorable pricing environments, by increasing production and maintaining a lower inventory level and ultimately running a more efficient operation.

Quarterly Result

The previous earnings report for SCHN Q3 FY2023 was a highlight as to why SCHN has been able to grow so steadily over the last few years. The company showed a strong operating performance as finished steel sales volumes shipper were up 3.5% YoY and the rolling mill utilization was up to 97% compared to 96% the year prior.

As far as the future market opportunities that SCHN has it remains very positive. The global recycled market for example is expected to experience a 4.2% CAGR until 2030 as more and more manufacturers are seeing the benefits of using materials that cause less emissions and ultimately could be more cost-effective too.

Going into the coming quarters the main point I will be watching is how SCHN can maintain margins. So far they have been quite lackluster but if prices rebound then I can see a scenario where they get net margins back to around 6% like a year prior when prices were very positive.

Risks

The risk with any commodity-driven company is fluctuations in the prices which causes inconsistent reports. The CEO Tamara Lundgren had a comment on the performance, "While the near-term economic environment is showing some signs of a slowdown, the long-term structural demand for recycled metals remains positive, supported by the increased focus on decarbonization". I think however SCHN has done very well to still maintain a positive bottom line in the face of a challenging market environment. Investing in SCHN is perhaps more about making it a long-term position rather than a swing trade that benefits from the ups and downs of a market cycle like steel prices. As far as the balance sheet it offers little risks and SCHN even sees itself in a strong enough position to be buying back shares. This reassures me that SCHN is a well-run company that can weather the storm efficiently.

Valuation & Wrap Up

What SCHN has that other metals companies might not is an interesting angle that makes them out to be an almost "green play". They focus on recycling metals and lowering CO2 emissions around the world through their international operations. But they also benefit from acts like the Inflation Reduction Act which somewhat aims to bring manufacturing back to the US. With SCHN already having nearly half of its sales here, the influx of more manufacturing companies will create stronger demand for its products.

What might make investors quickly turn away is the high p/e it currently has at 41x on a forward basis. Much the result of less favorable prices for steel among others. It seems likely a surge like what happened in 2022 won't happen in the short term, but it still leaves the long-term outlook strong as demand from many industries persists. SCHN has capitalized on the growth in 2022 and funneled more capital to shareholders through both dividends and buybacks. I like the performance so far of SCHN and will be rating it a buy.

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