After The Storm Clouds Clear – What to Buy On A Dip

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 13th, 2014

After The Storm Clouds Clear – What to Buy On A Dip

  • We expect many of the companies in our coverage universe to miss first quarter estimates – either choosing to guide down proactively over the next few weeks or simply coming up short when they announce. This will provide some incremental buying opportunities for some companies and may undermine (over)confidence at others.
  • The misses will mostly be US weather related, reflecting either weaker demand or the cost pressure caused by higher energy prices. While this should be largely expected, the market has for the most part ignored the risk and estimates really have not fallen that far.
  • Those that have offered guidance have taken a valuation hit, and where these are reasonably priced companies levered to the broader recovery in US manufacturing and general economic growth we see a buying opportunity. We would focus on HUN, OLN, OI, BLL, SWK, DE and AGCO, but include a longer list of interesting names in the report, including several in the transport space.
  • Equally, companies that are discounting very lofty earnings expectations may have the marginal confidence knocked out of them if they miss Q1 materially, regardless of the excuse. Here we would be most concerned about SHW, CYT, SEE, GNRC, HON, RPM and GWR. These names are more likely to see a more permanent exit from non-traditional holders, and further downside.
  • The other downside risk sits at the commodity chemical group, where the higher costs in Q1 have been dismissed as a short term distraction. If natural gas prices stay high – $4.50-5.00 (perhaps because of an expected hot summer and low inventories), this group has the most significant downside in our view; LYB, WLK and DOW.
  • For the medium term, we continue to see the Capital Goods space as the most attractive from a weighting perspective and would add ETN and CMI to CAT and SWK in the table below. Outside Capital goods we are much more selective.

Exhibit 1

Overview

It is clear that Q1 2014 is going to be a disappointment for many companies with a US consumer or manufacturing focus. In some cases we have seen specific guidance – particularly for those that reported late enough in the quarter to have a view. As companies get their February results we would expect guidance – hopefully more helpful than from DuPont – where companies are sure that they are going to miss estimates significantly. Outside our Industrials universe, Dollar General and Williams and Sonoma have talked down first quarter estimates this week, blaming the weather.

While the market is broadly ignoring the effect of the severe winter in the US, expecting most of the losses in Q1 to be made up later in the year – a view supported by DuPont this week – we are going to see some pullback in those companies that announce negative revisions or ultimately miss the numbers in April. The purpose of this note is to look for the opportunities – where companies are exposed to the improving US economy, could see some pullback and still offer attractive value. Conversely we identify names where valuation is pricing in perfection in our view and where one blemish may be enough to change the sentiment direction.

As we think about those groups subject to Q1 problems, we think of them in the following buckets;

  • Those who will have suffered a business interruption – Trucking, Rail, Car Rental, Home Building
    • This can then be further divided into business that will likely be recovered and business that is lost permanently. Home building will likely be recovered – car rental; not.
  • Those exposed to the retail market that will see lower demand because retail volumes have been impacted
    • Again this can be divided with staples perhaps more of a permanent loss than durables.
  • Those impacted by higher energy costs – most obviously natural gas and NGLs in the US.

We have then identified long ideas based on companies that are exposed to what we believe to be a slow but steady rise in US economic and manufacturing growth in addition to discounting a decline in earnings and returns which seems unlikely, even with the slower Q1.

Exhibit 2

At the other end of the scale we highlight companies with very high expectations – where valuations are anticipating positive rather than negative revisions. These are also companies exposed to US Q1 risk: SHW, CYT, SEE, GNRC, HON, and GWR.

Weather or not it matters?

The most significant revisions we have seen so far for the first quarter based on the weather came from Axiall, where its first quarter number was cut from almost 80 cents per share to 22 cents after guidance. Roughly two thirds of this was attributed to the weather in all three of the buckets identified above – lost demand – some direct and some the result of lost retail demand, and higher energy costs. Otherwise we have seen some comments or warning from a few companies – DD, WLK, PX, ARG, EMN….

We have shown some of the “degree day” data
in prior research
and the chart is updated again below. This correlates well with lost production and the possible impact on manufacturing and GDP and gives a sense for how severe the quarter has been so far. Based on the data below the winter to-date has been 14.2% colder than the 1998-2012 average.

Exhibit 2

The degree day chart is also an indicator of how energy demand looks and the second chart we have shown regularly is the level of US natural gas inventories.

Exhibit 3

Source: EIA

Buying Opportunities – Or More Permanent Risk

So the backdrop remains the same – demand weaker in Q1, energy higher and no real movement in estimates or valuations to reflect it – so no one cares! Of course this is not really true because there is always a sub-set of investors/analysts that have either denial, or have been in Florida all winter – so some are genuinely surprised when the guidance comes or when the earnings miss.

DuPont threw a cautionary flag in the ring this week – albeit very vague and lost 2.7% of its value. After Axiall gave Q1 guidance it lost 4.2%. DuPont is recovering and Axiall has more than recovered. These are inexpensive stocks on a relative basis and are exposed to a US manufacturing and general economic recovery. The dip, driven by a focused Q1 opportunity presented/presents an opportunity.

We would look for similar opportunities in the following names:

HUN, MON, SMG, OLN, OI, BLL, AGCO, DE, CAT, SWK, GTI, UNP, CSX, R

We choose these names partly because earnings estimates are not heroic and current valuation is discounting more trouble ahead than we think likely. Our primary tool for measuring what valuation is discounting is our skepticism methodology – which looks at the relationship between current earnings, expressed as return on capital, and current valuation relative to normal. A positive skepticism number suggests that either earnings are going to fall or valuations are too low.

Obviously given the headwinds of the first quarter we expect earnings near-term to surprise on the downside and so we avoid companies where the skepticism index is only barely positive.

In Exhibit 4, for each company we show how far 2014 estimates would need to fall for our skepticism index to equal zero today.

Exhibit 4

Source: Capital IQ and SSR Analysis

On the downside we have a shorter list, and have included only those companies where we can demonstrate that current 2014 estimates are already too low to support current valuation. As shown in Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Commodity Chemicals

The other pocket of downside risk sits with the natural gas and NGL buyers, mainly the commodity chemical companies. There is a real belief that the US has plenty of natural gas and a tap that can be turned on and off at will. Despite the very low level of natural gas inventory in the US, natural gas prices are falling, with a clear expectation that inventories can be rebuilt inexpensively. The very exposed names – LYB, WLK and DOW continue to trade as if first quarter is an anomaly, and even though estimates appear too high for Q1, the group has momentum.

IF, however natural gas prices remain at current levels for the rest of the year – or creep back up, there is real downside risk in the group as negative revisions for the year would be quite significant. Higher prices could be caused by a slower than expected replenishment of inventories, either because of inadequate production or because of an unusually hot summer. LYB, WLK and DOW could lose more than 20% of their value and would still look expensive in our view.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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