Evolving China Risks – Where to Be Cautious

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 6th, 2015

Evolving China Risks – Where to Be Cautious

  • Following on from our thematic piece on China, we look for companies most exposed to the secular trend of Chinese export dominated commodity – and potentially downstream derivative – markets
  • We suggest a cautionary stance toward:
  1. Expensive companies that fall in the least insulated group on our multi-factor framework
  2. Commodity-exposed companies which, while not expensive in absolute terms, still could have relative or absolute downside should commodity pricing weaken further
  • Of the companies least insulated to Chinese competition, only LECO, PCAR, and IEX look materially expensive – all Capital Goods stocks
    • Trade data shows a sustained downtrend over the past several years that has turned the US surplus in metalworking machinery into a deficit – a bad sign for LECO
    • PCAR looks somewhat less concerning given the US retains a surplus in special purpose vehicles and motor vehicles for transport of goods, but the trend over the past three years is pronouncedly negative
    • IEX has a product offering (industrial pumps) that does not appear very well insulated from Chinese competition, but its Health & Science Technologies segment likely has significant quality and regulatory barriers
  • At a broader sector level, we see the following industries as most exposed and highlight stocks within them that have relative incremental downside even after recent weakness
    • Aluminum – This is the commodity that has the best global supply/demand profile in our view (even though Chinese exports account for ~17% of global supply); in AA specifically, downstream operations offer some protection compared to a primary aluminum play (CENX)
    • Titanium dioxide HUN has more than 50% downside to its all-time valuation lows; there is limited history for TROX and CC, but we think there remains downside at both
    • Caustic soda/PVCOLN and AXLL also could fall 50% and only just approach historical valuation troughs; OLN has doubled down in what could be a very weak business; WLK has exposure here, but offset to a degree by the US cost advantage in ethylene and the more protected polyethylene markets
    • Steel – Of these names, WOR has the most relative and absolute downside, having seen a nice run up through mid-2014 while peers largely saw share prices remain subdued; ATI and X have the least valuation risk, but could each still see a further 40% downside
    • Iron ore VALE shows only 15% downside to its 10 year low, but relative valuation on our normalized framework implies 50% to trough levels (~$2.50 a share )
    • Electrical equipment parts and componentsRBC screens with only a modest premium, but lacks scale and is competing in an industry which has a sizable and deteriorating trade balance; this space has seen significant pressure recently (BDC, FELE)

Exhibit 1

Source: Capital IQ, SSR Analysis

Expensive Companies Least China-Insulated on our Framework

A Few Expensive Capital Goods Names, Possibly at Risk

  • Lincoln Electric (LECO) makes welding equipment, primarily for sale in the US (65% of sales) but with an international footprint – sales in Europe, Asia Pacific, and South America
  • Returns are currently at historical peak levels, and the extreme valuation premium has eroded somewhat as the US trade balance in metalworking machinery has moved from surplus to deficit
  • Corporate culture has been a historical differentiator for the firm, which itself has been the subject of numerous case studies

Exhibit 2

Source: US Census Bureau

Exhibit 3

Source: Capital IQ, SSR Analysis

  • PACCAR (PCAR) is a specialty truck manufacturer – on and off highway vehicles for transporting a variety of industrial goods (freight, petroleum, wood products, construction materials)
  • Trade data suggests China is becoming more self-sufficient in this niche

Exhibit 4

Source: US Census Bureau

Exhibit 5

Source: Capital IQ, SSR Analysis

  • IDEX Corporation (IEX) is an industrial pump manufacturer – not an obviously insulated product, but the Health & Science Technologies segment likely has significant regulatory and quality barriers

Exhibit 6

Source: Capital IQ, SSR Analysis

Commodity-Exposed Industries & Stocks with Relative Downside

Aluminum – Best of a Bad Commodity Bunch

  • We see Alcoa (AA) as an outlier here – the stock is currently discounted more like a pure primary aluminum company (Century Aluminum for instance – CENX) and we believe investors are missing the potential of Alcoa’s concerted move downstream
  • Alcoa’s current discount is approaching its lows of 2012-2013, and with base aluminum less and less of an earnings driver for the company as the value-added portfolio is built out, it appears that downside is limited at current levels
  • Aluminum more generally has the best supply/demand outlook in our view

Exhibit 7

Source: Capital IQ, SSR Analysis

Titanium Dioxide

  • Huntsman (HUN) has traded at a discount for the better part of the past five years
    • Separation of pigment segment could be challenging in the current TiO2 environment and this business could drag down what is otherwise a quite good portfolio.
    • HUN is a much more interesting stock without pigments, but watching Chemours, HUN must be questioning whether a separation is possible.

Exhibit 8

Source: Capital IQ, SSR Analysis

Caustic Soda/PVC

  • OLN has doubled down in a potentially weak market with the $5 billion deal for DOW’s chlor-alkali business – we believe that the downside for OLN is greater than for any other chlor-alkali exposed name despite the current valuation discount
  • WLK’s exposure to PVC is countered by the polyethylene business, which among the best insulated from Chinese competition

Exhibit 9

Source: Capital IQ, SSR Analysis

Iron & Steel – Already Cheap but Downside Risk Remains

  • Starting with iron – Vale (VALE) has been trending down for five years now, yet on our normalized framework the stock is still not at its all-time trough valuation ($2.50 per share, ~50% downside from here)

Exhibit 10

Source: Capital IQ, SSR Analysis

  • The majority of domestic steel makers have been flat to down over the past five years or so – Worthington Industries (WOR) had a better run than most but has come in significantly in recent months
  • Only US Steel (X) and Allegheny Technologies (ATI) are within distance of their historical lows
  • Similar to the situation with aluminum, there appears to be plenty of room for steel pricing to move lower if we look on a relative basis to coal pricing.

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Electrical Equipment Components & Parts

  • The US Electrical Equipment space has seen its trade deficit gradually widen in recent years
  • RBC is the most expensive of the non-insulted stocks in this sector
    • The upswing in return on capital is based not on forward estimates (there is no 2016 consensus for the small cap name) but on prior quarters’ sale growth continuing
    • This appears to be an aggressive assumption as organic growth slowed markedly in Q2 (even adjusting for currency effects)
    • RBC cited weak Chinese demand as a headwind – China may indeed be slowing but perhaps this is also a signal that the country is also becoming more self-sufficient in RBC’s electric motors, generators and controls

Exhibit 16

Source: US Census Bureau

Exhibit 17

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Company Presentations, SSR Analysis

©2015, 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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