Wednesday, October 25, 2017

Schnitzer Steel Returns to Profitability, Bleeds Cash in 2017.

Schnitzer Steel Industries, Inc. (NASDAQ: SCHN) is one of North America’s largest recyclers of ferrous and nonferrous scrap metal. Worldwide steel production levels drive demand for the company’s products. In the fiscal year ended August 31, 2017, the company generated almost US$1.7 billion of sales globally. Compared with the previous year, sales grew 24.8% and increased more than US$335 million. The company is benefiting from the recent massive credit creation in China, but its ability to generate cash flow is worsening.

Sales to China increased to US$216 million from US$150 million, or 43.6%. The growth of sales to China was almost double the growth rate of global sales. The increase in sales to China accounted for 19.6% of global growth for the fiscal year. There are two ways the company is benefiting from artificial credit creation in China.

First, Schnitzer Steel Industries, Inc. notes that Chinese “steel producers are generally government-owned and may therefore make production decisions based on political or other factors that do not reflect free market conditions.” State owned enterprises have the easiest access to new funds from the Chinese banking system, which they can use to buy products from Schnitzer Steel Industries, Inc.

Second, sales outside of China benefit from higher global commodity prices. The company deals with iron, aluminum, copper, lead, and zinc. According to the World Bank, in the twelve months ended August, 2017, copper increased 36.5%, zinc increased 30.8%, lead increased 27.9%, iron increased 24.9%, and aluminum increased 23.8%. Yesterday, General Motors Company reported global vehicle sales data indicating China accounted for more than half of the world’s growth in vehicle sales. That should mean China is driving demand for industrial metals. Much of this demand has been fueled by the massive increase in corporate demand deposits in China.

Schnitzer Steel Industries, Inc. used this windfall to return to profitability after two years of negative net income and reduce debt, but had poor cash flow execution. Net cash provided by operating activities increased from the prior year by only slightly more than one million dollars. Had accounts payable remained flat, the company’s operating cash flow would have been more than 30% lower than the previous year.

Similar to other companies with significant operations in China, Schnitzer Steel Industries, Inc. has generated impressive revenue growth, but worsening cash flow. Although the company did not provide information on the global market for its products, China contributed significantly to its year-over-year growth. The company’s under-performance during the economic expansion indicates the company will also under-perform during the coming economic contraction.