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Cautious Upgrades For Sims

 By Chris Shaw

After three straight quarterly losses, scrap metal play Sims Metal Management <SGM.AX> returned to profit in the September quarter, recording earnings of $33 million for the period. Citi notes the improvement reflected a combination of volume growth, better pricing and good cost control.

The improved earnings trend is not expected to continue in the December quarter however, given outlook commentary from management suggest ongoing difficult conditions, JP Morgan pointing out earnings for Sims are likely to be lower in the current three months as the market is entering a seasonally weak volume period in the Northern hemisphere and a decline in sales volume appears likely given demand remains choppy.

To reflect this outlook, Citi has cut its earnings forecasts in FY10 by 18% in earnings per share terms, the broker now expecting an outcome of 88c, before an improvement to 165.5c in FY11. In contrast UBS has lifted its forecasts by 17% and 11% respectively in FY10 and FY11 to 94c and 166c, which highlights the range of forecasts that had been in place prior to the quarterly result.

While December quarter earnings are likely to be weak, Credit Suisse suggests there is potential for Sims to see further recovery in the second half of FY10, as ferrous scrap prices are expected to rebound given the market is forced into paying higher prices for iron ore and coking coal.

To reflect this and changes to its foreign exchange, margin and volume assumptions, Credit Suisse has followed the UBS lead and lifted its EPS forecasts by 16% in FY10 and 18% in FY11 to 84c and 144c respectively, which compares to consensus forecasts according to the FNArena database of 81.9c and 165.4c.

Despite the soft outlook for the current three months Credit Suisse has upgraded to a Neutral rating on Sims from Underweight previously, taking the view the the combination of strong market positioning and leverage to a recovery in volumes and margins is a good one for when conditions eventually improve.

Credit Suisse estimates earnings per share could increase to around $2.20  from existing operations over the medium-term, so assuming an earnings multiple of 12-14 times this implies a share price of $26.00-$31.00. As well the broker points out there is enough balance sheet strength to consider further acquisitions, which would potentially add to earnings.

It is a similar view to that of JP Morgan, which points out its assumptions include volume growth of just 2% per annum but this is likely to prove conservative as acquisitions should deliver a faster rate of growth. As an example, if free cash flows were reinvested at the long-run return on invested capital rate its valuation would increase by around $5.00 per share from the current $23.91. Given this, JP Morgan has upgraded to an Overweight rating from Neutral previously. Overall the database shows three Buy ratings, one Accumulate and six Hold recommendations.

RBS Australia upgraded its rating to Hold from Sell post the quarterly as it, too, sees an improved medium-term outlook as scrap flows are improving and there is potential for growth in market share for Sims. RBS remains the most bearish on the stock in terms of price target at $18.15, which compares to an average target according to the database of $23.30. Current high marker is UBS with a target of $27.00.

Shares in Sims today are stronger and as at 11.20am the stock was up 48c in a sharply weaker market, trading at $20.30. Over the past year the stock has traded in a range of $10.68 to $29.15.