Scrap Becomes Money at Metal Management

Steel and iron companies are widely represented on my current screening system, and I have looked at a number of these as potential investments. One of the most attractive valuation metrics now is shown by scrap metal recycler Metal Management (MTLM - commentary - Cramer's Take). Although the stock has above-average risk mainly because of the industry segment in which the company operates, the potential rewards are also very high at current levels.

Metal Management acquires scrap metals either from industrial companies that have material left over from their own manufacturing operations or from companies and dealers in what is known as "obsolete scrap," including junk automobiles and appliances. The company then processes this scrap metal by shredding, cutting, baling or breaking it. Then it sells the material primarily to foundries and metals manufacturers.

The profitability of this business is driven primarily by pricing. During periods of weak demand in the U.S. and abroad, pricing suffers and profits can disappear. That's what happened in 2000, when some of the company's customers went bankrupt and Metal Management itself was forced into bankruptcy because of weak demand and a highly leveraged capital structure. Conversely, when demand is strong -- as it is now -- profits soar.

But there is more to the story at Metal Management than volatile pricing and a feast-or-famine future. Some of the longer-term trends are very positive for this company. First, the company's biggest customers are those that operate mini-mills with electric-arc furnaces. This type of steel production has been gaining market share, increasing from 38% of total domestic steel production in 1991 to 49% last year.

Second, Metal Management operates in a highly fragmented environment where, according to the Institute of Scrap Recycling Industries, there are 1,200 member companies representing 3,000 facilities. By implementing a national strategy of making regional acquisitions, the company continues to increase its economies of scale, its product offerings and its competitive position.

Finally, growth in developing economies like China might serve to give the scrap metals business a somewhat higher secular growth rate, albeit with continuing cycles around the trend.

Since emerging from bankruptcy in 2001, the company has completed two full fiscal years of operations. (Its fiscal year ends in March.) In fiscal 2003, the company recorded sales volume of $770 million and diluted earnings per share of 99 cents. Last fiscal year, ended March 2004, the company reported an increase in sales of 40.7% and an increase in diluted earnings to $2.27 per share. Most of these increases in sales were a result of higher prices, but there was an increase in tons shipped in the ferrous metals category (71% of total sales) of 6.4%.

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At time of publication, Moore was long Metal Management, though positions may change at any time.

Richard Moore, CFA, is the owner of QB Accounting Service in Angel Fire, New Mexico. Prior to that, Moore was manager of Taos Financial Strategies, working with a varied client list doing investment management, accounting, financial planning and taxes. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Moore cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].