Schnitzer Steel: Bullish Outlook

Schnitzer Steel Industries (NASDAQ:SCHN), a company involved in the manufacture and export of recycled metal products, reported a broadly in-line set of preliminary results across the adj EBITDA and EPS lines in Q1 2023. Commentary on the quarterly call was more upbeat, though, with management guiding to a stronger volume-driven revenue outlook (ferrous and non-ferrous), as well as EPS upside from additional cost cuts for the year. Added growth from the ScrapSource acquisition and incremental upside from post-acquisition synergies in the recycling services business should help as well.

Net, I like SCHN here – while we may be in the final stages of an upcycle, the company has utilized its cash flow well in extending the top-line growth and margin expansion runway. Over the long run, the secular recycled material demand tailwinds (e.g., decarbonization and the shift to electric arc furnaces using recycled material vs. carbon emitting blast furnaces) and a multi-year infrastructure upgrade cycle offer ample upside as well. At ~12x fwd earnings, the stock is priced inexpensively and has room to re-rate.

A Brighter Near-Term Outlook Following Broadly in Line Q1 Results

SCHN started FY23 strongly. There weren’t many surprises in Q1 – total ferrous volumes at 851k/lt and pricing of $340/lt were broadly in line given the strong domestic shipments and export volumes during the period. The forward commentary was a positive highlight, though, with management guiding to QoQ growth in EBITDA/ton on more operational improvement in Q2 2023. Volumes are primed for recovery as well – the company sees ferrous volumes up ~35% QoQ and non-ferrous volumes up ~5% QoQ post-resumption of the Everett and Oakland facilities, as well as resolved shipping delays. The only blemish was the guidance for finished steel product shipments at -5% QoQ – though much of the delta is down to seasonality, wire rod products demand weakness was also cited as a contributor.

On the margin side, SCHN is also finding some timely reprieve. Q1 already saw the company make good progress on the path to extracting an initial ~$40m/year run rate of productivity gains across labor and logistics, among others. Management has further built on this base with another ~$20m of cost cuts identified for the full year (mainly SG&A), paving the way for more upside to the EPS and perhaps even the dividend. The company’s dividend of $0.75/share currently equates to a very manageable ~13% payout on FY22 numbers and ~20% on normalized FY24 numbers. Given SCHN has used the period of high commodity prices and high cash generation during FY21/FY22 to accelerate the balance sheet deleveraging, there is ample room for a step up in the capital return going forward (dividends or buybacks).

From an industry perspective, things are looking good. Rising rates are a net negative for economic growth but given there has been little sign of a US non-residential slowdown thus far, SCHN should do fine. Infrastructure stimulus is also on the way, and while it will take some time to flow through to the P&L, the increased spending should help the mid to long-term outlook. Key peer Commercial Metals Company (CMC) echoed the optimism, citing a strong backlog and bidding activity, including from infrastructure. Like SCHN, its margins have been pressured by rising scrap in recent quarters, but this is a near-term rather than structural trend, and with some offset from counter-cyclical fabrication spreads, the P&L impact has been manageable.

Inorganic Growth Playbook Continues with ScrapSource Acquisition

In addition to debt paydown, SCHN has also been funneling its excess cash into driving volume growth via organic and inorganic means. The company closed the Encore Recycling acquisition in April last year and followed up with the construction of advanced metal recovery systems to unlock more EBITDA gains in the coming years. As part of its growth strategy, SCHN also announced the addition of ScrapSource to its portfolio, signaling its intent to further build out its recycling services capabilities. This move fits with the broader trend of companies downstream accelerating efforts to meet their sustainability goals, resulting in more recycled materials being used. Steel mills, for instance, are increasingly being displaced by electric arc furnaces using scrap materials and electricity to produce steel, playing right into SCHN’s playbook.

There are ample synergy opportunities from the ScrapSource deal. In the near term, ScrapSource’s metals recycling and industrial waste material solutions should increase the scrap supply flow, complementing SCHN’s recycling capabilities (ferrous and non-ferrous metal). While ScrapSource doesn’t offer scale at ~$4m/year of EBITDA generation, most of its business runs on ‘sticky’ multi-year contracts and can be replicated in new regions. Thus, management’s guide for potential GDP plus growth rates seems very achievable, if not slightly conservative, given the broader recycling services tailwind in manufacturing as well. Margin expansion should come with an expanded scale – replicating SCHN’s scrap yards and ports is capital intensive, and with increased environmental and land use regulations, earnings should benefit from higher entry barriers over time.

Bullish Outlook

SCHN has underperformed the broader market in recent months on cyclical concerns, but the long-term structural growth story remains intact. Helped by an ongoing shift to a low CO2 economy, SCHN’s exposure to attractive tailwinds, including the shift to recycled materials and multi-year infrastructure upgrades, looks set to drive P&L upside.

In the meantime, scrap price headwinds due to a reduction in buying activity (mainly China-related) could also reverse following the post-COVID Chinese reopening, clearing the way for an earnings recovery ahead. In line with this view, management seems bullish on the Q2 2023 outlook, projecting higher ferrous and non-ferrous volumes, as well as incremental EPS upside from cost reduction and post-acquisition synergies from ScrapSource. At the current ~11x fwd earnings, expectations are low, and more positive news flow could re-rate the stock.