The Hidden Exit Cost of Scrap Metal
Date October 2016
Scrap metal has long been viewed as “boot collateral,” extra security over assets not specifically financed. But recent low prices have created an environment where scrap may no longer be an asset but a liability. Lenders need to remain vigilant and consider ways to manage the risk just like any other part of the collateral base. Following are some strategies to keep you ahead of this frequently overlooked risk.
Under the right conditions, scrap metal can add significant value to a bank. While not typically a direct source of collateral, it can mean an additional seven figures to recoveries. Heavily process-oriented facilities such as chemical processing plants, oil refineries, petrochemical processing facilities, paper mills, automotive assembly, foundries, and steel mills often have installation-intensive equipment. Costs to dismantle, transport and reinstall certain assets in these types of facilities can make them uneconomical to move. Absent a buyer willing to operate the facility as a going concern, much of this equipment may be destined for the scrap yard. Even in situations where major pieces of machinery can be remarketed, significant process piping, electrical wiring, and support structures may still remain on site. In some sales, these remnants may be the most valuable asset in the plant.
This was the case in 2006 when Gordon Brothers marketed the machinery and equipment of a paper mill in the Midwest. The most valuable lot in the plant was the scrap, which fetched more than a $1 million dollar bid from a demolition company/broker that had lined up a buyer from China. While situations like this have led many lenders to presume scrap always has some value, recent transactions have proven that is not always a safe assumption, particularly in the current environment.
The international market for scrap has changed dramatically during the past decade. U.S. scrap exports dropped to a nine-year low in 2015. Sluggish international demand, competition from alternatives (i.e., Chinese billet), and the strength of the U.S. dollar are among the factors contributing to the difficult market for domestic producers. As a result, metal prices have been volatile. From the beginning of 2014 through the third quarter of 2016, aluminum solids scrap prices slid nearly 20%, solid stainless steel scrap prices fell more than 25%, light copper scrap dropped more than 40% and No. 1 heavy melt prices nearly halved.
An uncertain calculation
These oscillations show how quickly scrap values can swing from an asset to a liability. In October 2015, Gordon Brothers was hired to value the machinery and equipment of a food processing mill that was being wound down so the site could be redeveloped. A year earlier, the company had received seven-figure bids to demolish the site. While we were appraising it, scrap prices dropped to a break-even point, and shortly after the appraisal the client informed us that the number was negative. In less than 18 months, a multi-million dollar asset became a liability, completely changing the calculation for exiting the plant.
In another example, Gordon Brothers began the sale of a foundry in late 2014 that attracted bids from numerous scrap dealers. However, by the time the removal process was underway the following month, scrap prices had fallen to a level where it no longer made economic sense for the dealers to remove the equipment. In this case, it took less than 30 days for the math to reverse.
These examples illustrate just how challenging it can be for lenders to manage potential scrap liabilities. Most appraisals do not include scrap unless specifically requested, meaning that the positive or negative value is often overlooked. In current market conditions, buyers of distressed assets will factor these costs into bids, potentially resulting in an unanticipated discount off appraised values.
Protecting against risk
First, lenders need to recognize how volatile metals prices are and how quickly pricing can shift. Assets can turn into liabilities in as short as one month. If your portfolio includes process-related, installation-intensive groups of assets most at risk, consider the following precautions:
- Discuss the risk with your appraiser at the onset of the project. When deemed appropriate to include in the scope of the assignment, we work with a qualified demolition or scrap expert to estimate value. These experts will inspect the plant with our appraisers to help determine if there is positive value in individual machines, process lines or systems, or other key areas. Special equipment also will be utilized to determine types of metals present. The experts will estimate quantities or weights of each recyclable material and the cost of removal. That cost will be measured against current scrap-metal prices to determine what value can be realized. For borrowers at higher risk, it may be wise to include scrap prices into regular portfolio monitoring.
- Pay attention to the exit strategy. Lenders should be aware of how exit strategies might need to change based on scrap price fluctuations. If you find yourself selling at a time of historic lows, it may make sense to wait it out until prices recover. To alleviate yourself of the cost and risk associated with continuing operations, consider finding a buyer with the capability to operate the assets on an interim basis. In doing so, recovery will be maximized, as will the bid received for the assets. In other situations, look for consortiums of buyers who seek to maximize value not only of the scrap but of all personal and real property. When machinery buyers, scrap dealers and real estate developers partner together on bids, they are often willing to pay a premium because of their vested interest in maximizing the value of all assets versus just turning a profit on scrap. Because they control the real estate, they are better positioned to manage scrap price fluctuations, oversee the orderly removal of machinery, and ultimately redevelop the real estate.
- Consider lowering advance rates. In certain higher-risk situations, it may be appropriate to think about how discounting the advance rate could insulate your company from risk. To maintain competitiveness, look for a lender willing to partner with you and assume the riskier secondary position.
Scrap value is calculated into the actual disposition of every process-oriented facility, though it is not typically included in most appraisals. Lenders must remain aware of when it is an asset and when it is a liability and how changing circumstances affect how portfolios are managed. When in doubt, ask your appraiser how significant your exposure is and strategies to minimize it.