Sector Watch: Scrap metal recyclers

Everything from vinyl records to spandex leggings has seen a resurgence in one form or another, and heavy metal is no different. No, not the music genre; we’re talking the recycling of steel, aluminum and tungsten by scrap metal recyclers such as Metalico (AMEX:MEA) and China-based Sutor Technology, Ltd. (Nasdaq:SUTR).

An estimated 90 million tons of scrap metal are recycled in the United States each year, at a value of more than $60 billion. While the United States has become increasingly reliant on other countries for manufactured goods, scrap metal has become a vibrant export market. Domestically, according to the Institute of Scrap Recycling Industries, two of every three pounds of steel produced in the United States is made from scrap. 

Demand for ferrous (iron-based) scrap will likely continue to climb because the world’s steel producers are replacing virgin iron ore blast furnaces with electric arc furnace mini-mills that use scrap as their primary feedstock. Electric arc furnaces are more energy-efficient and environmentally friendly, and produce much less air and water pollution. Demand for non-ferrous (aluminum, copper, stainless steel, brass, nickel and other alloys) is also rising. Secondary smelters using non-ferrous scrap can produce metals at much lower costs than primary smelters using ore because of lower labor costs, energy consumption and environmental compliance expense.

Which brings us back to Metalico and Sutor Technology.

Metalico is a leading full-service scrap metal recycler, operating 11 scrap metal recycling facilities along the East Coast, an aluminum plant in Syracuse, N.Y. and five lead product manufacturing plants. Its primary business involves collecting ferrous and non-ferrous scrap metal, processing the metal into reusable forms, and supplying recycled metals to electric arc furnace mills, integrated steel mills, foundries, secondary smelters, aluminum recyclers and metal brokers.

In addition to buying, processing and selling metal scrap, the company also manufactures de-oxidized aluminum, a form of refined aluminum, for the steel industry. Metalico mitigates its exposure to volatile commodity metal prices by diversifying its metal mix. To that end, in 2007 the company acquired Transzact Corporation, a recycler of molybdenum, tantalum and tungsten scrap, and Totalcat Group, a recycler and manufacturer of catalytic devices from which platinum, palladium and rhodium are obtained.

Metalico’s revenues climbed 61% to $334.2 million in 2007, from $207.7 million in 2006. Net income improved 44% year over year, to $14.8 million from $10.3 million. Per-share earnings rose 25% to $0.50. This growth reflects 44% year-over-year gains in unit volume, a 20% year-over-year improvement in ferrous metal prices, 58% higher average non-ferrous metal prices and a 53% increase in prices for fabricated lead products. First-quarter 2008 results show a continuation of these strong trends with sales up 230% year over year to $170.5 million, from $51.8 million, and net income up 97% year over year to $6.1 million, or $0.20 per share, from $3.1 million, or $0.12 per share. The company is also commissioning a new high-speed lead rolling mill in the second quarter of 2008 that will significantly boost its rolled product capacity and enable Metalico to expand its product mix and reduce operating costs. Analysts look for this company to generate 43% growth this year and 43% annual growth over the next five years. My $18 price target for Metalico is above Tuesday’s closing price of $12.91.

Across the pond from Metalico, Sutor Technology Group Limited is benefiting from China’s growing appetite for high-end steel. The small cap is among China’s leading manufacturers of steel-finishing fabrication products, and utilizes a variety of technologies to convert steel manufactured by third parties into finished-fabrication products. The company produces hot-dip galvanized (HDG) steel and pre-painted galvanized (PPGI) steel, which are used in construction, appliance, infrastructure and manufacturing applications, as well as acid-picked (AP) steel and cold-rolled steel. Most of its AP steel and cold-rolled steel production is further processed into HDG steel and PPGI steel products.

At present, Sutor operates one HDG steel production line with annual manufacturing capacity of 200,000 metric tons, one PPGI steel line with 120,000 metric tons of annual capacity, an AP steel line producing 500,000 metric tons annually and a cold-rolled steel line with 250,000 metric tons of annual capacity. This fall, Sutor will start up an additional HDG steel production line that will increase its annual HDG steel capacity to 600,000 metric tons.

Sutor Technology benefits from its high degree of vertical integration, focus on higher-margin, high-end steel products and established presence in China’s fast-growing steel market. Demand for high-end steel exceeds supply in China; despite importing more than 20 million metric tons of high-end steel in 2006, industry experts believe only 30% to 40% of demand was satisfied by imports. Vertical integration has enabled Sutor to improve efficiency and control costs, but also presents a potential risk since about 40% of the company’s revenues are derived from related-party sales. 

During the first six months of fiscal 2008, Sutor’s revenues soared 53% year over year to $214.4 million, from $140 million in the same period one year ago. Operating income for the six months rose 98% year over year to $17 million, from $8.6 million. Net income jumped 78% year over year to $13.3 million, or $0.35 per share, in the first six months of FY 2008, from $7.5 million, or $0.23 per share, in the first six months of FY 2007. Favorable foreign currency translations pushed comprehensive income up 96% year over year to $17.5 million, from $8.9 million in the same period last year. Analysts expect this company to produce 20% average annual growth over the next five years. I think these shares are attractively valued at an 8.5 times P/E multiple and a 0.4 PEG ratio. Share liquidity should improve because of the company’s move from the OTC Bulletin Board to Nasdaq on Feb. 11. My $8 price target for Sutor Technology is higher than Tuesday’s closing price of $6.14.  

For more on Sutor Technology, read Check on China: Sutor Technology Group.

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