Schnitzer steel 2 years and 90% later – schnitzer steel industries, inc. (nasdaq schn) seeking alpha

About two years ago, I wrote an article on Schnitzer Steel ( SCHN) as I liked the company’s business plan (Schnitzer is a recycling company using scrap metal and vehicles to produce its own steel products), but I wasn’t fully agreeing with the company’s capital allocation priorities, as it seemed to protect the dividend at any cost. Now, two years later, the share price is trading 90% higher, and Schnitzer is still paying its dividend. A job well done? Or did the market get over-excited?

The company’s financial year ends at the end of August, but the financial results of the first semester are already providing a decent overview of how the company is really doing.

And I don’t think there’s any discussion possible about Schnitzer having hit the ground running in the first six months of the year. The revenue increased by 46% whilst the operating income more than four folded to $59.8M.

Schnitzer is also seeing and feeling the impact of the interest rate policy of the Federal Reserve (which is walking up its interest rates) and the higher gross debt position as the company’s total interest expenses increased by approximately 10% to $4.34M. That’s definitely not something that’s unmanageable but this will reduce the free cash flow result by a few percent. Schnitzer also reported a tax benefit of $4.62M thanks to the new corporate tax law in the United States, and this pushed the net income attributable to the Schnitzer Steel shareholders to $59.4M. The EPS came in at $2.14/share for the first half of the year, which compares very well to the $0.36 in H1 FY 2017.

In the piece from 2016, I argued Schnitzer’s cash flow results appeared to be improving. Unfortunately SCHN operates in a volatile sector, and it’s subject to a lot of parameters it doesn’t have any input on. So whereas H1 was excellent, H2 might be more disappointing and it’s really tough to make any good predictions. Just to give you an idea of the extreme volatility in Schnitzer’s sector: the FY 2015-2017 revenues were respectively $1.92B, $1.35B and $1.69B and it’s clear double digit swings are pretty normal.

Schnitzer reported a negative operating cash flow of $10.6M, but this was caused by a substantial cash absorption on the ‘accounts receivable’ and ‘inventories’ level. On an adjusted basis (adjusting the operating cash flow for changes in the working capital position), the operating cash flow was a very respectable $79M (which is almost twice as much as the $39.6M in H1 2017).

The company spent just $27M on capex, which resulted in an adjusted free cash flow of approximately $52M in the first half of the current financial year. Again, this is on an adjusted basis and due to the higher inventory and accounts receivable level, Schnitzer did need to tap into its credit facility to cover all the cash outflows. I feared the focus on the dividend would jeopardize the strength of the balance sheet

The company has been a reliable dividend payer, as the $0.75 annual dividend (which is paid in 4 quarterly installments of $0.1875 each) was protected at any cost. That’s great for dividend investors who rely on the visibility of future dividend payments, and although the current dividend yield is just 2.25%, the dividend yield was a very handsome 4.5% when I first discussed Schnitzer, two years ago. Whilst the current yield isn’t too attractive at all, longer term shareholders are probably still very happy with the yield-on-cost.

Schnitzer is expecting FY 2018 to be quite capex-heavy, as it has been guiding for a total capex spending of $60-75M. Should Schnitzer indeed spend $75M on capex this year, that would almost be as much as in the two previous financial years combined. So it’s definitely something to be aware of, as the full-year free cash flow result might be disappointing.

Fortunately the H1 operating cash flow (on an adjusted basis) would already be sufficient to cover the capex requirement. So even if Schnitzer wouldn’t generate a single extra dollar in operating cash flow, it would still be able to bankroll its capex program. As the dividend will cost Schnitzer approximately $20M (using the current $0.75 annual dividend), the company’s total capital needs this year could be estimated at $80-95M.

Even if the second semester would be weak, I don’t anticipate Schnitzer Steel to report an negative free cash flow this year, and the dividend will very likely be covered as well. With a net debt of $195M and an EBITDA of $105M in FY 2017 (and $85M in H1 2018), the balance sheet can definitely handle this year’s high capex-load, and with an EV/EBITDA ratio that will very likely come in at less than 7, Schnitzer isn’t really expensive.