Favorites for 2015 & Industrials & Materials Methodology Review

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

January 12th, 2015

Favorites for 2015 & Industrials & Materials Methodology Review

  • The mission of the SSR Industrials & Materials franchise is to provide a group of high conviction ideas by identifying valuation anomalies that are not consistent with underlying fundamentals.
  • We continually explore our pool of 120+ names – our framework is refreshed monthly to be sure we do not miss shorter term opportunities. In our universe of stocks, our current long ideas include: DD, CAT, DE, SWK, AA, EMN, PKG, and PX.
  • At the heart of our valuation framework is the calculation of “normal value” from assessing a company’s long-term return on capital (ROC). The ROC profile drives “normal” earnings, which combines with an historic average or trend relative multiple (S&P) to derive a normal value based on the company’s own history. Current discount or premium to “normal” value coupled with several other factors identifies ideas for further research.
  • Our Skepticism Index tests whether valuation and returns are in line with each other – i.e. is a valuation swing from normal explained by an earnings swing from normal. The normal value framework is a screen to identify cheap/expensive outliers; the Skepticism methodology helps understand what is priced in and when things might change.
  • Exhibit 1 summarizes our top ideas for 2015 – these are all stocks where valuation anomalies on our framework initially caught our attention, leading to deeper research, and ultimately a constructive view. Note that our convention is to use discount from normal value, measured in standard deviations from the historic norm on our model – a positive number indicates a cheap stock. The Skepticism Index combines this number with an equivalent figure for return on capital – the higher the SI, the greater the degree of skepticism (for instance, a stock is cheap but returns are above trend – the market is skeptical that returns can be sustained).

Exhibit 1

Source: Capital IQ, SSR Analysis

Review of Methodology

The basis of our framework is valuation – anomalies at the cheap or expensive end of the spectrum are candidates for future research as we try to justify/disprove the market sentiment embedded in valuation.

Return on capital trend (or average) underlies our valuation models. We prefer a trend to an average if it is pronounced and compelling – averages can mask secular changes driven by:

  • Scale or technology gains/losses
  • New cost opportunities
  • International new players/consolidation
  • Better or weakening market structure from sellers or from buyers

Trends can be different for companies in the same industry – the industry trend can be upward sloping while a company trend is downward sloping (the Chemicals sector and DOW provide a good example of this). We show historical return on capital trends by sector in Exhibit 2.

Exhibit 2

Source: Capital IQ, SSR Analysis

We use a company’s trend or average return on capital to drive a “normal” earnings figure. This in turn is combined with a normal earnings multiple that we relate to the S&P to derive “normal value” based on the company’s historical averages. Extreme premiums or discounts from this normal value give us a broad opinion on valuation and indicate opportunities/areas for deeper research. We show the return on capital profile for DOW, and the familiar valuation chart derived from that ROC below in Exhibits 3 and 4. With some of the very cyclical there are fairly obvious cyclical valuation buying and selling opportunities and it was compelling buy or valuation low signals that originally attracted us to AA, DD, CAT, DE and SWK. Today, of our group of eight, only EMN (and possibly SWK) is at a compelling low.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

We overlay our ROC based valuation work with our Skepticism Index, which measures the extent to which valuation and returns are in line with each other – i.e. is a valuation swing from norm explained by an earnings swing from norm. SEE for instance s currently expensive but this is mostly explained/justified by above trend earnings – Exhibit 5 on the following page. If a stock is cheap despite over-earnings (the top right quadrant in Exhibit 5), either:

  • The market believes returns will fall or;
  • The stock is undervalued

The reverse would be said for an expensive, under-earning stock (the lower left quadrant in Exhibit 5). Our normal value framework is a screen to identify cheap/expensive outliers – the Skepticism methodology helps understand what is priced in and when things might change. We recently published expanded work on our Skepticism Index – refer to the research for greater detail.

Exhibit 5

Source: Capital IQ, SSR Analysis

Current Top Ideas for 2015

DD

  • We have been following the developments at DuPont closely for two years now
  • Like the activist, we believe that the cost cutting opportunity is significant (Exhibit 6) as is the opportunity to make the story less complicated through break-up
    • As shown in Exhibit 7, the market places less value today on complex names than in the past.
  • The stock has performed well in anticipation of change and in the face of some disappointing earnings – upside from here will only come from activist inspired change – addressing the complexity problem

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

CAT

  • Remains a very clear value play with huge operating leverage to a recovering economy
  • Should see benefit from a mining recovery before miners as equipment is an incremental investment for miners rather than a large capital spend
  • Earnings are less volatile than in prior cycles because of a changed approach to production
  • The best bet (outside of Metals) if we see a global rebound

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

PX

  • A safe have in economic uncertainty: PX has much more muted volatility with economic cycles and has possibly the most disciplined and granular approach to maximizing return on capital than any company in our coverage – so much so that other are emulating.
  • Unusually cheap – growth at a bargain price not seen in years. The stock has been beaten down by some disappointing earnings in Latin America as well as greater interest in other names in the sub-sector (APD – Exhibit 10) and other subsectors – there is too much choice in the space today and PX has been ignored to a degree
  • Levered to global growth and has assets well placed to exploit any recovery – especially greater manufacturing growth in the US.
  • Best capital discipline in the Industrials and Materials sector – buyback replaces capex when the returns are not there.

Exhibit 10

Source: Capital IQ, SSR Analysis

SWK

  • The cheapest stock in a cheap Capital Goods sector – Exhibit 11
  • Market is not giving SWK credit for potential to return to past levels of return on capital despite ample historic proof that this is achievable
  • Security segment has weighed on the stock but margins have bottomed and tactical divestment of underperforming European geographies is likely
  • Core Tools segment (Construction & Do-It-Yourself) continues to realize Black & Decker synergies and gain share in Europe
  • Valuation looks particularly interesting versus SNA (a close comp for SWK’s Industrial & Auto Repair segment) – Exhibit 12

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

AA

  • Top performer in Industrials & Materials in 2014, one of our favorites for almost 2 years
  • Historic valuation discount corrected quickly – underlying demand growth drove improved aluminum fundamentals and increased prices
  • No longer cheap but we think the stock has further to go – aluminum itself has more upside and AA’s portfolio changes should yield better earnings – we still believe that the stock could double from here

Exhibit 13

Source: Capital IQ, SSR Analysis

DE

  • Wrote in August that further revisions were likely, but also priced in – pure valuation play
  • Stock has bounced at lows close to $80 several times and we would buy on weakness
  • Estimates likely still too high for 2015 – may get another entry point on full year guidance

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15


Source: Capital IQ, SSR Analysis

EMN

  • Valuation very compelling, but market is skeptical – company has made some bad feedstock hedging bets for 2015 and possibly 2016 and this is the primary focus of investor sentiment and a distraction from the core story and a strong portfolio.
  • Return on capital has turned a corner and is on a positive trend but the company will likely have to surprise on the upside with regard to merger synergies (Taminco) to get the stock moving in the face of lower propane prices and the nasty hedge.
  • We see this as an opportunity to buy a good company with a good product slate and a good valuation caused by an own goal – Exhibits 16 and 17.

Exhibit 16

Source: Capital IQ, SSR Analysis

Exhibit 17

Source: Capital IQ, SSR Analysis

PKG

  • Has outperformed well since we first highlighted, but there is still room for relative upside
  • PKG vs. IP – significantly higher growth, same multiple – Exhibit 18
  • Highest leverage to virgin wood pulp in the industry – longer term upside/cost advantage as China drives recycled prices higher – Exhibit 19
  • Long runway for Chinese consumption growth – recycling efficiencies close to maximum possible so more growth will need to be met from virgin wood pulp – Exhibit 20

Exhibit 18

Source: Capital IQ, SSR Analysis

Exhibit 19

Source: Capital IQ, SSR Analysis

Exhibit 20

Source: Capital IQ, 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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