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There's Gold in Scrap Metal

There's nothing better than stumbling across a really intriguing company that's off the beaten track.

I spend a lot of time scouring for just these kinds of investments. They're often value-priced and growing at a significant clip, but get overlooked because they are involved in a boring or distasteful business.

In the case of Darling International (AMEX: DAR  ) , which I wrote about a while back, I found a business that dealt in something so gross (chicken rendering and grease traps) that only investors with the strongest stomachs could give it a serious look. Then there's Copart (Nasdaq: CPRT  ) , which auctions wrecked cars to a variety of customers. These are the kinds of businesses that nobody would ever think existed, but they do and, in fact, they fill necessary roles. They also tend to be very profitable.

In the case of Metal Management (Nasdaq: MTLM  ) , I've discovered a business that does something similar. They also recycle things -- but instead of chicken parts, it's scrap metal, putting them out of the limelight afforded to sexy metal outfits (OK.sexier metal outfits) like Nucor (NYSE: NUE  ) , U.S. Steel (NYSE: X  ) , and International Steel (NYSE: ISG  ) .

Metal Management's operations primarily involve the collection and processing of ferrous and non-ferrous scrap metals (more on that in a second). To get more specific, the company's 10-K states that its operations "collect industrial scrap metal and obsolete scrap metal, process it into reusable forms, and supply the recycled metals to (Metal Management's) customers, including electric-arc furnace mills, integrated steel mills, foundries, secondary smelters and metal brokers." The company will also drop by and demolish obsolete buildings and other structures to salvage the metal.

Metal Management looks for major metropolitan areas, where industrial and obsolete scrap metals are in large supply, and buys out regional scrap companies to gain entry into the market. This isn't too hard to do. The Institute of Scrap Recycling Industries, the trade association of the scrap metal and recycling industry, represents approximately 1,200 member companies operating nearly 3,000 facilities throughout North America and the world. Many of these companies are family-owned and operate only in local or regional markets, so there's no lack of acquisition candidates. Of course, Metal Management needs to manage cash flow and debt to keep this strategy from sinking them. Fortunately, it seems to be doing that well.

Ferrous, non-ferrous? What's ferrous?
If you remember your high school chemistry, "ferrous" means metals that contain iron. This is where the company's regional scrap-procurement strategy comes into play. Because of its low price-to-weight ratio, raw ferrous scrap is generally purchased locally from industrial manufacturers, demolition firms, railroads, scrap dealers, peddlers, auto wreckers, and various other sources, typically in the form of automobile hulks, appliances, and plate and structural steel.

Non-ferrous scrap refers to aluminum, copper, brass, stainless steel and other nickel-bearing metals, titanium, high-temperature alloys, and other exotic metals. The geographic markets for non-ferrous scrap tend to be larger than those for ferrous scrap because non-ferrous metals sell for higher prices, which justify the cost of shipping over greater distances.

There is no shortage of metal available in the world, and one would think that a company like Metal Management would always have a place. But it isn't quite that simple.

Commodities: A risky business
If you have a look at the company's 10-K -- which is quite clear and readable as 10-Ks go -- you'll see the major risk with Metal Management. It's something that fellow Fool contributor Stephen D. Simpson discussed in a recent article -- this is a commodity business based on other commodity businesses. Specifically, the 10-K states: "Ferrous scrap sells as a commodity in international markets which are affected by relative economic conditions, fluctuating currencies, and the availability of ocean-going vessels and their related costs." In 2001, there was an increase in scrap metal imports by the U.S.; export opportunities were reduced as a result of a strong U.S. dollar. In 2002 and 2003, export opportunities increased as a result of the weakening U.S. dollar. To make things even more dicey, demand for processed ferrous scrap is dependent on the strength of the domestic steel industry.

On the non-ferrous side, things aren't much simpler. Non-ferrous metal sells on a spot basis, just like gold and silver, on the COMEX or London exchanges.

What this means for investors is that if the stars are aligned properly, as they have been for the past two or three years, this kind of business can be tremendously profitable. But when the tide shifts in the other direction, the result can be catastrophic.

Let's examine exactly what I mean.

Good times, bad times
From 2002 to the present, all the factors that influence Metal Management's business model have been working in its favor. Check out these growth rates (in millions of dollars) for each fiscal year):

2002 2003 2004

2005 (projected)

Net Sales 630 770 1083 1600
Growth Rate -20% 22% 41% 48%
Net Profit -23 20.5 51 98
Growth Rate N/A N/A 151% 92%
(Amounts are in millions of dollars.)

For the first fine months of the 2005 fiscal year, the company has already pulled in $1.2 billion in sales, and $76 million in net income. If the Wall Street analyst following the stock is correct in assuming $400 million in revenue for the final quarter of FY 2005, along with $.90 per share in earnings for the same (which comes to just under $22 million in firm earnings), 2005 figures will look as they do in the chart above -- showing extremely strong sales and profit growth.

Clearly, business has been going gangbusters. The stock price reflects it, too. Over just the past two years, Metal Management's stock has soared seven-fold. Everything has been working in its favor. In addition, management has paid down $30 million in long-term debt over the past nine months. Price-to-sales ratio for the company is only 0.45, it trades at a P/E of 7.16 vs. a far greater earnings growth rate, and management has even decided to start paying a dividend of 7.5 cents per share -- currently a 1% yield -- for the first time in company history.

Makes it all sound like a screaming buy, doesn't it? A solid-growth stock trading at value prices, right? Well, yes and no. Look closer.

The perfect storm
What happens when export opportunities decrease, when the steel industry's economics aren't so great, when the dollar starts to strengthen, and when commodity prices aren't so favorable? Unless Metal Management circles the wagons and shores up its financial position, it could be in trouble. How much trouble? Well, the last time the steel market went south, back in late 2000, Metal Management went bankrupt. Yes, as in Chapter 11. There are a host of other risks, too. These include commodity, interest rate, and foreign currency exchange risk. There are also environmental laws and regulations that can affect the company unfavorably.

At the end of the day, this is a cyclical business that is highly dependent on commodities. That makes it a very volatile, high-risk enterprise. Investors looking for this kind of commodity-based business may find huge returns. But they need to stay closely attuned to the commodity markets, and this is the kind of company whose 10-K is an absolute must-read.

Tread cautiously. There's plenty of room for growth and profit in the metal recycling biz. But beware -- things can turn on a dime, and leave you hunting for soda cans to recycle to make up for your losses.

For related coverage, see:

Lawrence Meyers owns shares of Metal Management, but has sold February covered calls against them. He also owns shares of Darling International. Do your own research, though. He's just a guy with his own opinion. The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2014, at 1:42 PM, thiagorulez wrote:

    One of my friends is big in the scrap metal industry. He's made a lot of money from it; it's a huge supplement to their income. So yeah, I have no doubt that there's "gold" in scroll metal. Thiago |

  • Report this Comment On August 21, 2014, at 11:17 AM, amberjohnson3620 wrote:

    I didn't realize that you could get money for scrap metal if you take it to the right place. That is exciting to find out because my husband has a lot of scrap metal from his job. I think it is a great way to make some extra cash so thanks for sharing!

    Amber |

  • Report this Comment On December 08, 2014, at 10:08 AM, 17nathansouza wrote:

    I learned a lot about scrap metal from this article, so thank you. I do think that this could be a good business to invest in since metal is a limited resource. Eventually, most metal will need to come from recyclers. I do not know how long it will be until this moment comes, but I would be willing to invest in this industry.

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