Short Thesis

At a price above $37, the stock has largely priced into near term strength in the int’l scrap market and subsequently good earnings prospect for SCHN during the August quarter, which SCHN is to report actual results tomorrow. Nevertheless, I recommend either shorting prior to the earnings release or shorting into a possible but not guaranteed stock rally tomorrow after the earnings call (tomorrow). SCHN’s earnings should have peaked at least in the near term, and with steel price coming down in both domestic and int’l markets, it has become increasingly difficult for SCHN to manage its processing spread in the core scrap business for the next 3-6 months – could be for a longer period of time if steel cycle actually turns down thereafter. I believe the company has a business value at anywhere btw. mid-20 to high-20, which is almost $10 below the current stock price. I also believe, just as the stock overshoots on the upside when things are good, this time the downside could be larger than the $10.

The reduction in demand for scrap as a result of the output cuts has lead to downward pressure on scrap prices. Factory bundles dropped $50/ton in late September and dealers followed suit to a large extent. This in turn reduces steelmaker input costs and allows them to cut prices further. I believe we're on the verge of a more rapid decline in prices vs. consensus view of a limited retreat.

Scrap represents more than 50% of SCHN's earnings. 60% of SCHN's recycled products are sold to overseas market, mainly Asian buyers like China, South Korea, and in recent quarters have expanded to Turkey and other SE Asian countries/regions like Malaysia or Taiwan, etc. SCHN also has a small mini-mill business (35% of earnings). In total, steel exposure is 85%+.

Current consensus SCHN's earnings estimate for FY07 is looking for $4.25 flat w/ FY06, which I believe will have to come down dramatically in a declining steel price and scrap price environment. My estimate is $1-2/shr, leading to a $20 stock – very likely in an overshooting market.

Typically what happens in a declining scrap price environment is SCHN would not get favorable sales price; at the same time, suppliers of unprocessed scrap would hold on their scrap and not sell to SCHN quickly, just waiting for price to rebound. As a result, SCHN would have to bid up to get scrap to satfisy its client need, leading to margin squeeze. This will be a reversal of what SCHN has been experiencing when steel price was on the rise - its sales price has been rising faster than raw material cost.

Last time when scrap price declined dramatically in late '04/early '05, scrap price dropped to close to $150-200 and steel price dropped to $450-500. The stock hit low-20 during that time. Today, steel price (HRC) is around or below $600 and scrap is around $270-280 in Asia. Bear in mind, steel price decline just barely started in the most recent months and appears to go down further over the next several months due to service center destocking and weak demand from auto and housing. CMC just confirmed their recycling business will be down QoQ. However, the industry is still hoping this time the decline will be much smaller than last time. I disagree.

I've concluded the business value is at maximum $29/shr, based on 4-5x mid-cycle EBITDA (using base case scenario) for its scrap and steel business. The stock is trading well above this level while fundamental is deteriorating. As the stock overshoots on the upside when things are good, I believe the potential downside in the stock could be well below $28-29

Business description

Metal Recycling

SCHN processes 3.5mm tons of ferrous metal recycling per year as well as handles 1mm tons' trading volume per year (primarily in Russia and  the Baltic countries). In addition, it also processes nonferrous metal (mainly aluminum) but to much smaller extent (300mm lbs/yr).

SCHN enters into export sales contracts by generally selling forward 60-90 days and purchase metals on a daily basis. Therefore, 4Q06 should be decent as SCHN still sells at higher price when their purchase price of raw scrap might come down. Nevertheless, eventually profitability will be impacted by lower scrap price.

SCHN operates 29 metals collection and processing facilities. Due to large capital investment required for metals recycling equipment and the scarcity of potential yard sites that are properly zoned and have access to waterways, highways and railroads, the recycled metal industry is characterized by a relatively small number of large dominant metals processors like SCHN, and many smaller regional players. SCHN collects raw scrap from many sources, including smaller metal recyclers and dealers. Direct sources include railroads, industrial manufacturers, auto salvage yards, etc. Types of raw material collected include railroad cars and tracks, home appliances, auto, and demolition metal from buildings. After collecting, SCHN then sorts, cleans and cuts into sizes and grades suitable for use by steel manufactures. It sells 60-65% of total volume to export market and below 15% to its own mill and rest goes to other domestic mills,.

Key competitors include Omnisource, MTLM, Sims Hugo Neu and regional steel mills as well as their brokers.

Key equipment used to process scrap is shredder. A typical shredder can process 1,500 tons of metal per day. SCHN recently installed a mega-schredder in its Oakland, CA facility. Such machine can handle 2,500 tons per day and provides buyers benefits like denser and more pure form of ferrous metal as well as more efficiency for mini-mills. Another mega-schredder is being added in 2H06 in the Everett, MA plant.

One thing that differentiates SCHN from other scrap companies like CMC (one division) and MM (more non-ferrous exposure and more domestic focus is its large exposure to overseas exporting market. Even its own steel mill purchase of scrap is also priced in FOB price, effectively the same as export market. Until 1Q06 (Dec), SCHN had made most of money in the scrap business from its western coast operation. SCHN has a good position there because of lack of competition. There are only four mini-mills on the western coast, including SCHN’s own steel plant (NUE has two, one in Seattle, and the other in Utah). Since it mainly exports to Asian market, which requires 4-6 weeks’ forward selling, it is easier for SCHN to manage its margin. Nevertheless, when scrap price gets too low, margin tends to get squeezed anyway even in the western coast. China and S. Korea had been big clients but recently Malaysia and Taiwan replaced them as top customers since China and S. Korea’s own scrap supplies have increased with fast growing production there. Normal margin is $50/ton on the western coast and in the trough (’02-’03), margin was down to $30/ton. In the recent quarters, margins had been well above $50/ton. SCHN expanded into Northeast and Southeast market through acquisitions and restructuring of its previous joint venture arrangements in the 1Q06. These new markets, however, are more competitive and SCHN earns more average margin in the neighborhood of $20-40/ton even in today’s market (management indicated “much lower” margin in NE and SE). Also, SE market is primarily a domestic market, so SCHN doesn’t enjoy any exporting advantage there. NE does opens up a shorter route to supply Turkey, which is increasingly an important export market for SCHN. But competition is intensive there. Overall, SCHN exports 2.3mm tpa scrap (thru west and NE) and has another 1.2mm scrap supplied to the domestic market, including its own mini-mill need of 0.5-0.6mm tons.

Int’l market’s margin is generally better than domestic, but if US steel price is higher than the rest of world, it could be just the opposite, which did occur once last year. This would be the worst operating environment for SCHN – which has not happened yet. Given the reduced demand for imports in the US, I’d expect int’l steel price to start to weaken in the latter part of 2006 and earlier 2007. As US market is dominated by disciplined players, the worst case scenario might very well occur, i.e. int’l steel price could drop below the level in the US.

Steel manufacturing 

Cascade Steel Rolling Mills is SCHN's steel manufacturing entity, located in McMinnville, Oregon. It produces rebar, merchant bar, wire rod, and other long products, mostly related to non-residential construction and has annual capacity of 0.7-0.8 mm tons. It includes one mini-mill and 2 rolling mills and currently is expanding billet reheat furncace at one rolling mill. 100% scrap is self-sufficent. It uses direct sales at the mill and has access to rail, truck, deep-draft marine terminals in Portland. It also owns two distribution centers, one in El Monte, CA and the other in Lathrop, CA (1/3 owned). Mainly focused on western coast market, particularly in CA. Key competitors include Nucor and Tamco.

Auto parts (replacement)

Auto parts business is essentailly auto dismantling and selling of used auto parts. 250,000 cars get processed each yr.

There are two types of stores. SCHN owns 32 retail stores under the brand of Pick-N-Pull (one of the largst self-service auto parts chains) and 18 full-service stores under brand of Greenleaf. In the retail stores, customers remove used auto parts from a vehicle in inventory and then pay standard prices for those parts. SCHN employees don't remove parts for them or perform repairs. By contranst, full-service stores genearlly maintain newer cars in inventory and company staff members actually dismantle, test and inventory individual parts, which are then delivered to business or wholesale customers (typically collision and mechanical repair shops). Genearlly, prices at self-service stores are significanlty lower than full-service stores prices, also lower than retail car part store and car dealership prices. 

Avg. store is located on 14 acres and contains 1,600 cars available to customers. 4mm customers walk into retail stores each year. Customers typically pay an admission charge upon arriving at a store and signs a liability waiver before entering the facility. When he finds a desired part on a vehicle, he removes it and pays an established price for the part.

Sources of vehicles include: tow companies, private parties, auto auctions and charities.1Q/3Q have genearally higer sales for retail stores - largely weather related.

Competitors in the full-service area include LKQ.

This is a stable and probably growing business, but it only represents 10-15% of current earnings.

Earnings estimates

Current consensus EPS est. for FY07 appears to be too aggressive since it doesn't assume any significant pricing weakness in overseas market nor assuming any slowdown in non-residential construction market for steel products. Therefore, FY07 EPS est. could have meaningful downside risk. 4Q06 EPS (ending August) could be still good, though, as it ends in August when scrap price just started to drop significantly. However, 1Q07 and thereafter could be difficult time for SCHN.

4Q06 good result might be a risk to our short but I don't think any rally in stock price would last too long. SCHN forward sells 60-90 days for scrap exports (60+% of total scrap sales), and scrap market did not weaken materially until August/Sept., so the negative impact will not be felt until this quarter. Ironically, its margin might have expanded in the 4Q06 due to lower unprocessed scrap cost in North America and relatively higher price they sell in the overseas market. Nevertheless, I believe any rally of stock price post earnings call will be short-lived as investors  realize what's going on during the current quarter. If mgmt makes any comment on forward outlook in the press release, there would not be even a rally at all.

Since SCHN made almost $1.00/shr in 3QFY06, I think 4Q06 SCHN could easily make $1.20-1.30 based on $52+/ton gross margin in its scrap business (vs. $48/ton realized in 3Q06) as each $1/ton spread expansion adds almost 2c/shr in one quarter. In the near term, int'l demand, particularly in Russia and Turkey, has been still strong.

For 1Q07 (Dec.), I expect SCHN to have $42-43/ton gross margin in its scrap business. That’d translate into just under $0.90/shr EPS for 1Q07. 1 yr ago, SCHN earned $0.61 in 1Q06. And for 2Q07, I estimate scrap gross margin @ $38-39/ton, and EPS would be down to $0.80-0.85/ton (assuming SCHN still gets offsetting benefit from its mini-mill business which uses scrap as raw material). That would be a YoY decline vs. $1.45 SCHN earned in 2Q05. These estimates all assume an orderly retreat of steel and scrap prices – if volatility picks up, numbers could be dramatically lower.

Business valuation