Schnitzer Steel (NASDAQ:SCHN): A Potential Slowdown in China Could Affect Ferrous Scrap Demand

Morgan Stanley is making a negative call on Schnitzer Steel (NASDAQ:SCHN) based on potential slowdown in China:

Impact on our views: Last week we saw some early indicators that Chinese construction steel demand could be slowing at the margin. Construction steel prices declined nearly 10%, the first weekly price decline since May. In addition, inventories ticked up 2% and China switched from a slight net importer to a slight net exporter of steel in July. While a major deterioration in Chinese steel fundamentals is not our base case, we would like to highlight how a modest slowdown could affect shares of underweight SCHN. Of the companies we cover, SCHN is the most directly levered to steel demand in China. In Q2, 85% of the company’s ferrous scrap sales fed the export markets, and we believe a significant portion of their export sales were to China, as China became the largest importer of scrap globally in the first half of 2009. A decline in Chinese scrap imports could potentially offset any volume gains from domestic mill demand and weigh on pricing.

Our July downgrade was based on our view that margins could compress below historical norms and that valuation appears rich. We believe there is excessive scrap processing capacity relative to scrap demand and scrap generation levels in the current weak economic environment. Scrap processors will need to compete for a reduced amount unprocessed scrap, driving up buy prices, as fixed asset lives extend. Similarly, scrap processors will face increased competition when selling to mills since mill operating rates are likely to remain below normal, leading to reduced pricing and margins Finally, valuation appears expensive. The stock is trading at 8.2x 2010 EBITDA and 6.9x 2011 EBITDA. The group is trading at 6.9x and 5.3x, respectively. SCHN historically trades at 6.5x forward earnings.

Action: With stocks in China selling off again today and futures indicating weak start for the US markets as well, one is bound to look for potential shorts off that setup. Morgan Stanley provides us the stock and the catalyst. The stock is heading lower today, potentially cracking the $50 mark.. unless the market turns around once again - all the bets are off then.