This is an extract from our December 2022 Quarterly Commentary and you can read the full Quarterly Commentary here.
Simon Mawhinney, CFA, Managing Director and Chief Investment Officer
Like many things, with investing it is worthwhile spending time assessing one’s failures and successes. Apart from the almost certain and invaluable humbling experience (the best investors’ stock picks fail around 40% of the time), learnings from these ‘post-mortems’ help reduce the probability of future failures and maximise the chance of future successes.
In this Quarterly Commentary, we provide an overview of Sims Limited (Sims), a company the Allan Gray Australia Equity portfolio has held at varying weights for over five years. We explain our original thesis and what has happened since we last wrote about it in our September 2018 Quarterly Commentary.
A quick recap
Sims is predominantly a metal recycler, with operations in the United States, the United Kingdom and in Australasia. It buys scrap feedstocks from metal dealers, peddlers, auto wreckers and demolition firms. It then processes these feedstocks, usually by first shredding them, and then separating them into product streams capable of being reused and converted into everyday products. Sims uses particle size screening, magnetic separation, eddy current separators and various sensors to separate the feedstock.
Product streams include both ferrous (containing iron) and nonferrous (mainly aluminium and copper) recycled materials. Ferrous materials are primarily used in the steelmaking process: mainly by electric arc furnaces (EAF) where 100% of their feedstock is scrap (or pig iron) but also by basic oxygen furnaces (BOF) where scrap can displace up to 20% of the iron ore and coking coal consumed. Non-ferrous materials are sold to basemetal smelters and converted into aluminium and copper, which are consumed in a variety of products. Turkey is the largest buyer of Sims’ ferrous materials and China is the largest buyer of its non-ferrous materials.
Sims also provides various other recycling services (e.g. recycling the servers in data centres that power the ‘cloud’), which offer exciting growth prospects, but these are currently immaterial to its profits. During the year ended June 2022, Sims sold 7.7 million tonnes (mt) of ferrous recycled products and 0.4mt of non-ferrous products. In addition, it brokered sales for third parties of a further 1.6mt of recycled products. Graph 1 shows its revenue by country and product.
GRAPH 1 | Sims’ revenue by country and product
Source: Sims 2022 Annual Report.
Sims’ share price weakness due to developments in two of Sims’ major markets, Turkey and China, attracted us in 2018. Turkey (the world’s largest importer of ferrous scrap metal) was, and still is, experiencing significant economic difficulties. Rampant inflation with loose monetary policy was contributing to a depreciation of its currency, and the resulting weak economic outlook led to concerns around Turkey’s domestic steel demand and therefore its scrap consumption.
These concerns were exacerbated by political tensions between the US and Turkey, which saw Donald Trump double tariffs on Turkish imported steel. Developments in China also added to the melting pot of bad news. Environmental clampdowns resulted in China banning the import of several scrap and waste products and strengthening the quality requirements for other products. These affected Sims’ sales of non-ferrous products into that country.
We were also attracted to Sims’ environmental credentials. For every tonne of ferrous scrap processed and used, Sims’ activities displace the need to mine approximately 1.6 tonnes of iron ore and 0.6 tonnes of coking coal, both of which have significant environmental footprints. Furthermore, Sims’ operations enable the manufacture of steel using EAFs, which emit considerably less greenhouse gases (GHG) than a BOF.
Graph 2 reflects CO2 emissions (per tonne (t) of hot rolled coil (HRC), an intermediate steel product) for a scrap fed EAF of 0.26t of CO2 per t of HRC, significantly lower than the 2.055t of CO2 for an iron ore and coke-fed BOF. In 2020 Sims estimated its operations helped avoid between 8.5mt and 27.2mt of GHG emissions.
GRAPH 2 | Current CO2 emissions in the steel industry in t CO2/t HRC
Source: Sustainability: steel in the circular economy, Steel Australia, autumn 2021.
Our thesis in 2018
We suggested that the Turkish situation was unlikely to be permanent and that Sims had already invested heavily to improve the quality of its non-ferrous product streams. Not only would this result in it continuing to sell its products into China, but it was also likely to temporarily enhance its competitive advantage (and margins) as other recyclers had not upgraded their recycling facilities.
Sims’ market capitalisation at the time was $2.6 billion (b), it had net cash of $300 million (m) and operating profits were expected to be $240m per annum (p.a.). At approximately 10 times these
sustainable (in our opinion) operating profits, Sims was attractively priced relative to the then market’s 14 times earnings. In addition, given Sims’ strong environmental credentials, we expected the company’s earnings to grow strongly.
The bumpy ride after 2018
It has been a bumpy ride since 2018. Some things came to fruition, others not… but the journey was wildly different to how we envisaged it. Graph 3 shows three things: Sims’ share price, the portfolio’s share holdings, and Sims’ weight in the portfolio.
GRAPH 3 | Sims’ price, the portfolio’s holding, and Sims’ weight in the Allan Gray Australia Equity Fund
Source: FactSet, Allan Gray, as at 15 December 2022. The Allan Gray Australia Equity Fund is representative of the Equity portfolio, which includes institutional mandates that use the same strategy.
We started buying Sims in late 2015 but didn’t begin to significantly increase the portfolio’s holding until the share price weakness in the lead up to September 2018, when its weight in the strategy rose to around 4%. We continued buying into 2019 (the grey-shaded area on Graph 3 is increasing as the black line falls). It is from this point that it is worthwhile reflecting on our portfolio decisions. Three notable share price movements followed:
- The COVID-19 drawdown in early 2020.
- A near-fourfold share price rally from the low point in mid-2020 to the highs of early 2022.
- A near halving in its share price after its April 2022 peak.
We discuss these below.
The COVID-19 drawdown
COVID-19 saw Sims’ share price fall 40% from its pre-COVID-19 levels. Graph 3 shows only modest purchases during this drawdown, and you could argue that we missed a trick here by not aggressively adding to our investment at COVID-19’s bargain prices. However, capital is not infinite and at the time we were investing the Equity strategy’s spare capacity in our energy shares
(Woodside, Oil Search and Origin), which we felt offered better risk-adjusted returns than Sims. This turned out to be a good decision as these energy shares have contributed significantly
to performance.
The amazing rally – were we greedy?
Learnings from the second share price movement are less clear. From its share price low in March 2020, Sims rallied very strongly and well in excess of the broader share market. We began trimming our position late in 2020. By early 2022, Sims’ share price had reached $22/share and despite having sold almost a third of the Equity portfolio’s holdings by then, Sims’ weight was largely unchanged (due to our sales broadly offsetting the share price strength). In hindsight, we were not aggressive enough with our selling and we hadn’t ‘banked’ as much of the upside as we should have.
While Sims’ share price had risen significantly, so too had its earnings (2022’s operating earnings of $775m were well above our initial thesis expectations of sustainable earnings of $240m). At its share price peak, Sims’ enterprise value (its market capitalisation plus its net debt) was about $4.5b and was priced at less than six times its then operating earnings, well below the broader share market. In other words, Sims was already priced for earnings to fall significantly.
It is of course dangerous to base an assessment of value on earnings that are likely to be high. We also looked at our estimate of sustainable or ‘normal’ operating earnings. Given a series of acquisitions, the passage of time and a number of operating efficiencies, our ‘normal’ operating earnings assessment had risen to $300m p.a. At 15 times those earnings, without considering the significant benefit of higher current earnings and the very likely release of cash from working capital as prices fell to ‘normal’, Sims was no more expensive than the broader share market. It also had an earnings profile seemingly no worse, if not better, than the market.
It was not being blinded by greed that wrong-footed us. It was losing sight of the now changed payoff profile, which was initially skewed to the upside but more balanced following the share price increase. And investments with balanced payoff profiles warrant far less, if any, capital being allocated to them!
2022’s drawdown
The most recent bout of share price weakness stems from weakness in scrap markets, which has seen Sims’ recycled materials fall significantly in price. In the same way rapidly rising scrap markets contributed to Sims’ bumper $600m profit after tax in 2022, the recent falls have had a negative impact on its 2023 profits.
To make matters worse, Sims’ trading update in November laid bare the extent of the decline. Weak economic activity, and its impact on volumes (one of Sims’ profit drivers), together with persistent inflationary headwinds has seen the company guide to first half 2023 operating profits (earnings before interest and tax) to be between $65m and $75m.
The speed and extent of the earnings decline surprised the market (and us), and the price has fallen significantly. We’ve modestly increased the portfolio’s holdings in Sims, with its weight in the strategy approximating that of 2019 prior to the COVID-19 drawdown.
Coming full circle
Sims’ enterprise value today has barely changed relative to the level at which our portfolio first invested in it. Its share price is higher, but its share count is lower due to its share buybacks since 2018.
Despite earnings being depressed now, there is nothing to suggest that our previous assessment of long-term average future earnings has been impaired. If anything, it is higher than we originally forecast due to various investments the company has made over the past few years (using earnings retentions). Over the last six years, Sims has delivered average annual statutory earnings before interest and tax of $272m (with average underlying earnings of $296m p.a.).
Sims’ role in the circular economy is important and companies like Sims will need to make a return on their invested capital. Furthermore, there is reason to believe that Sims’ recycling facilities have an advantage, given their locations relative to sources of scrap and proximity to deep-seaport infrastructure. Sims trades at approximately one times its net asset base, which we think offers substantial downside protection.
On the other side of the coin, we see significant upside potential. Sims is priced at an attractive multiple (10 times) of our conservative estimate of likely future operating earnings. Not only is this much cheaper than the broader market, but we also reasonably expect its earnings to grow faster as the world increasingly seeks to decarbonise.
