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Will Sims Metals outperform the market in 2014?

At its core, the scrap metal industry could almost be the perfect business – you take the scrap that people don’t want or can’t use, pay them for it, sort and process it a little, and then sell it to somebody else for more money. Everybody wins. However, ASX-listed metal recycler Sims Metal Management (ASX: SGM) has had a very poor run over the past few years. Is the time right for investors to make another entry into this sector?

Contrary to what is commonly thought, the scrap industry makes its best money in boom times. Construction (particularly refits of large buildings) and capital works projects are literally a gold mine for scrapyard owners because of the volumes of copper wire, aluminium, steel and other metals that are generated as a result.

During slower times, renovations, regular construction and seasonal works (such as air conditioners in summer) provide enough scrap to keep the businesses turning over, allowing consolidation and expansion. Unfortunately, theft of valuable materials from worksites and businesses is also believed to contribute to recyclers’ income.

Scrapyards have an enviable cash flow because of the continuous inflow of scrap and outflow of processed metals being sold.  There are also extremely high barriers to entry as a result of the amount of capital required to invest in machinery, and the amount of time it can take to earn a return on that investment. Large competitors won’t crop up overnight.

If this sounds like an excellent investment opportunity, that’s because it is – in theory.

Australia actually has two scrap metal companies on the ASX, Sims Metal and CMA Group (ASX: CMV), both of which are going through tough times. CMA appears to have over-extended, was caught short by debts and is now in voluntary administration. (You don’t want to buy this one!) Sims Metals suffered a FY2013 net profit after tax decline of 76%, taking the group to a $466.1 million loss.

If anything, Sims’ problem is that it is too large to have weathered the perfect storm of poor global recycling conditions intact. The Australian scrap metal industry has been going great guns for a number of years (albeit with slow times this year that may be starting to subside), but it is a different story in Europe and America. Sims’ business in these nations has been harmed by stiff competition for scrap, which has driven down prices and decreased scrap volumes. A stubbornly high Australian dollar has also harmed Sims’ bottom line.

However now that the Australian dollar has begun to recede and prices for base metals are rising, Sims Metals star could be in the ascendant. JP Morgan’s head of research has listed Sims as one of his five top picks for 2014. In the very same article though, Motley Fool writer Mike King states his opinion that Sims Metals is not investment grade and points out that has a very poor history of creating value for shareholders. Past returns are of course no indication of future returns, but a 10-year history of poor returns may make some investors think twice.

Foolish takeaway

If you believe a global economic recovery and a shrinking Australian dollar is on the cards next year, Sims Metals could be a great way to make money and gain exposure to the Aussie dollar, foreign economies and commodity markets.

 

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Motley Fool contributor Sean O’Neill doesn’t own shares in any company listed in this article.

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