Tuesday, July 20, 2010

Schnizer Steel (NASDAQ:SCHN): Upgraded to Buy at UBS, checks indicate pricing upside

UBS is making a fairly strong call on Schnizer Steel (NASDAQ:SCHN) upgrading the name to a Buy from Neutral with a $56 price target (unchanged).

They are upgrading shares of scrap processor Schnitzer Steel on the basis of scrap prices seen rising into August and after a sharp retreat in the share’s value. More than 85% of FY2010 profits are likely driven by its scrap (metals recycling) segment, of which at least 2/3 is generally exported. UBS likes the business model of procuring scrap in the U.S. and selling in stronger growth markets overseas but often struggle to find an attractive entry point in terms of valuation and the volatile scrap cycle. They find shares currently attractive at 5.1x FY2011E EV/EBITDA and 4.3x FY2012E EV/EBITDA, compared with a 5-year average 6.7x and a 10-year average 5.9x multiple.

UBS conducted channel checks on Monday, speaking with five scrap dealers and other sources who confirmed market conditions had begun to improve. Most cited higher offers of $10 to $20/t of late, while some said price levels could rise as much as $50/t in the next 30 days. Firm thinks August scrap prices rise $10- $20/t m/m. Shredded grades were cited back at $315/t and No 1 heavy melt was quoted at $280/t from levels as low as $230/t in the past month but still down from a peak $400/t in April. Scrap contacts said their supplies, or flows to their yards, were slim and overseas demand had improved, with several citing exports to India and Turkey in recent days.

UBS thinks the biggest concern weighing on SCHN shares aside from scrap prices has been demand in China. They spoke with the company recently, and they reiterated demand has been solid from Asia, despite falling scrap and iron ore prices of late. Their colleagues in Asia and in global Metals and Mining strategy have begun to talk of iron ore price stabilizing imminently as imported iron ore prices, down to $124/t as of July 16, now are very close to break-even mined costs in China of $110-$120/t. UBS industry contacts have been adamant that many of China’s iron ore miners will shut production rather than produce below cost. They think iron ore price stability can also support a floor to scrap prices.

Schnitzer shares often anticipate moves in scrap prices, and in recent months seems to have baked in a sharper drop in scrap prices than the reality of the scrap market. The latest No. 1 heavy melt price quoted in the chart was $347/t as of June but they have heard levels as low as $230 in the export market, although recently recovered to $280-$300/t. The chart above roughly indicates a scrap price value of $250/t reflected in SCHN shares compared with levels recently recovered to about $280-$300/t.

SCHN management is targeting eventual scrap EBIT profit per ton of $40, highlighting lower-cost procurement when the economy recovery and greater metal extraction capability from recent technology investments. It achieved $43/t of EBIT in a robust May qtr but UBS expects this falls to $18/t for its Aug qtr. For 2011 and 2012 they model scrap EBIT/t of $34/t.

UBS thinks valuation looks compelling on consensus estimates relative to historical multiples. They prefer to use EV/EBITDA as it gives more credit to the company’s strong balance sheet. Some use of cash for acquisitions or share buybacks can yield upside to their earnings estimates. Firm anticipates just 3% net debt to capital at the end of fiscal year 2011, and sees it being debt free in its fiscal 2012 absent other uses of cash.

Notablecalls: I think the pricing tid-bits UBS has uncovered in their checks will come as a moderate surprise to many. I'm sure very few were expecting any near-term upside to scrap pricing, especially in light of rather weak scrap performance exhibited by Steel Dynamics (STLD) last night.

It also appears UBS is being rather conservative with their EBIT estimates for this year and the next. Despite this they see 30%+ upside to the stock price.

SCHN is rather thin, so getting fills in the pre market will be tough. I'm more interested how it will perform after open.

Absent a market crash I would not be surprised to see SCHN trade $44+ today.

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