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Scope's investment increases risk, but the potential is still great


From: TheMarker, 22 January 2007

Ami Ginzburg


Scope Metal’s investment in working capital increases risk, but the potential is still great. The past few years have been good for Israel’s Scope Metal Trading and Technical Services Ltd. (TASE: SCOP).

The past few years have been good for Israel’s Scope Metal Trading and Technical Services Ltd. (TASE: SCOP). Over the past four years, the share has soared from NIS 16 at the beginning of 2003 to NIS 83 today, giving a market cap of NIS 900 million. In the past year alone, Scope Metal’s share price has risen 55%. The jump in value has helped Scope Metal’s share to recently join the Tel Aviv Stock Exchange’s second most important index, the Tel Aviv 100 Index.


The jump in the company’s value has boosted interest in its activity, and IBI Investment House Ltd. published a review of the company for the first time last week. Although the conclusion of IBI analyst Yuval Zehira was lukewarm, summarized with a “Neutral” recommendation, his target price of NIS 92 per share is still 11% above Scope Metal’s present share price.


In his argument, Zehira said that Scope Metal has great potential, whose realization depended on continuing growing demand for metals in the global market, a scenario that is quite reasonable. “We see great potential in the company in view of the success of its business model and aggressive management,” said Zehira.


The basis of Scope Metal’s business model is to make the company a one-stop shop for all kinds of metals for industry. The company provides its customers with inventory storage, cutting, sawing and delivery within 24 hours. Scope Metal supplies nickel, stainless steel, aluminum, steel, copper and other metals. These metals are intended for a range of industrial uses.


Scope Metal’s high level of service gives substantial added value for its customers, and gives the company an important edge over its main competitors in Israel, Packer Plada Ltd. (TASE: PKER) and Kaman Holdings (Mendelson Group) Ltd. (TASE: KMNH). For this reason, Zehira says that Scope Metal keeps an inventory of over 40,000 items worth NIS 500 million, over half the company’s market cap.


A 289-day inventory


Zehira says that maintaining such a large inventory is a significant risk for Scope Metal. The need to hold a large inventory involves a heavy investment in working capital and paralyzes part of the company’s financial resources. So long as the company is growing, the strategy works well, but if the business climate deteriorates, the large inventory, together with the extensive credit given to customers is liable to cause problems.


“The main risk at the company is a change in trend in the metals industry,” says Zehira. He adds that the commodities markets, including metals, are cyclical. He says, however, that the present positive cycle shows no sign of reversing at this time because of heavy demand for metals in Asia, especially by rapidly growing China.


Zehira stresses that the high level of automation that Scope Metal uses enables the company to provide its customers with a high level of service. Scope Metal is trying to leverage these advantages and copy its business model in its overseas activities. Most of these activities are in the United State, the Czech Republic, Romania, and China. Scope Metal launched its Chinese operations through a partnership with its customer, Iscar Ltd., which has a factory in China.


Zehira is somewhat worried about Scope Metal’s large inventory. The pace of inventory replacement is quite slow – 289 days – a figure that jeopardizes the value of the inventory. Scope Metal’s customer credit days are also fairly high, at 134 days.


The large inventory and long credit to customers therefore require Scope Metal to invest in working capital. Working capital is defined as inventory and customer credit days, less credit received by the company from its suppliers. This figure tends to rise among rapidly growing companies. The question, of course, is how much it rises compared with the company’s growth rate.


Zehira says, “With the growth in international activity, the replacement rate of inventory will improve and customer credit will substantially reduce the amount of working capital as a proportion of the growth in revenue.” Despite Scope Metal’s growing profitability in recent years, the investment in working capital has resulted in a negative cash flow from this activity.


Scope Metal posted a net profit of NIS 42 million in 2005, but invested NIS 117 million in working capital, which resulted in a negative cash flow from current operations of NIS 61 million. The company posted a net profit of NIS 62 million and a negative cash flow of NIS 73 million in January-September 2006. Zehira predicts that the turnaround will come in 2007, and that in 2008, the company will begin to generate high cash flow from current operations.


Zehira predicts that Scope Metal’s main source of growth will come from its international business. This activity generated NIS 260 million in revenue for the company in 2006, 25% of total revenue. He believes that revenue from international activity will grow by 65% in 2007 to NIS 429 million, amounting to a third of total revenue. He predicts overall revenue growth for the company at 23% to NIS 1.28 billion in 2007, and 14% growth in 2008 to NIS 1.47 billion, of which 37% will come from international business.


Zehira predicts that Scope Metal will post a net profit of NIS 99 million in 2007, 10% more than the NIS 90 million net profit predicted for 2006. He predicts that cash flow from current operations will reach NIS 34 million in 2007. He predicts that the company’s net profit will jump to NIS 120 million in 2008, and that it will have a positive cash flow from current operations of NIS 82 million.