Industrials and Basics Q1 So Far – Some Tears, Some Laughter, No Real Conviction

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Graham Copley


April 30th, 2012

Industrials and Basics Q1 So Far – Some Tears, Some Laughter, No Real Conviction

  • 80 of the 132 companies that comprise our industry group indices have reported earnings for the first calendar quarter of 2012. On average we have seen positive surprises (67 companies), but at the same time we have seen negative near-term revisions (34 companies). Caution around demand outside the US is broadly evident – the group that has reported has underperformed – though only slightly – since reporting.
  • However, results are very mixed with negative surprises as well as positive in every sector except Packaging – which has underperformed anyway. Conglomerates, Capital Goods and Electrical Equipment have had the biggest upside surprises; Paper the smallest.
  • Performance has for the most part tracked either the surprise or the guidance, with very few incidences of investors looking through the numbers and ignoring the near-term noise. Relative performance has for the most part been directional but not volatile and as a consequence we do not see any moves that would cause us to change our overall stance of caution towards the Paper space and interest in Metals and Mining
  • We have had only one report in the commodity chemicals space. This confirmed our view that March was a disproportionally large part of the first quarter and that the outlook for Q2 mirrors March, but surprised negatively on how very poor Europe was relative to the US.

Exhibit 1

Source: Capital IQ and SSR Analysis – Performance is Since Reporting

Investment Conclusion – Uncertainty Centers around Issues that are Hard to Predict

Bullish but cautious, cautious but optimistic, more certain about the US than other regions, focusing on cost control, focusing on balance sheets. These are some of the themes that we have heard so far and our sense is that in general businesses are doing well, but the macro environment is so mixed and so potentially volatile that companies are appropriately guarded in what they are willing to project. There is a consensus view that demand in the US is quite robust – there are even some signs of a positive turn in housing related demand. Autos, aerospace and energy are the clear end markets that are doing well and some of the biggest surprises have been from companies with those focuses.

China, for the first time in years is in danger of playing second fiddle to Europe. While there are clearly concerns about slowing economic growth in China, voiced by many companies in all sectors, eyes are on Europe where not only is there demand weakness, but the degree of weakness we see today may be small compared with what might come. Note that in 2008/9 many of the companies in these industries saw revenue declines higher than 25% in Europe. The US may be the point of positive focus, as much because of relative attractiveness as because of absolute attractiveness as an end market today.

One trend that drove positive surprises in Q1 but has driven negative revisions for Q2 has been a very early planting season in the US because of the warm weather. Agriculture related businesses have done well, but there is no illusion that this is more than demand pulled forward and this is where we have seen the most aggressive negative revisions for Q2. This provides some basis for the negative Q2 revisions seen so far, but the bulk has been more caution on growth outside the US.

The nervousness is evident in the knee-jerk reaction to earnings releases and particularly guidance. As seen in Exhibit 2, the correlation between revisions and relative performance is pretty clear, but has a negative relative performance bias. In other words you have seen more downside from negative revisions than you have seen upside from positive revisions.

Exhibit 2

Source: Capital IQ and SSR Analysis

In this environment we strongly advocate making investment decisions based on compelling valuation arguments, where you are essentially not really paying for any of the “hope” in the stock or the sector and where trough valuation support will limit your downside.

We still only see compelling value in the Metals and Mining space today. Here we have seen quite aggressive negative revisions post the Q1 report (more than 9%) but the absolute and relative downside in valuation has been small, suggesting that this is now mostly priced in. Other sectors are seeing greater punishment for negative surprises, in our view, because the valuations are higher. The Packaging sector is yet to see one negative surprise and yet the average is down versus the S&P 500.

At the high end we still see Paper as the most overvalued, and confirming this view it has been punished more severely than Metals & Mining as negative revisions have played out. There is pricing weakness in the pulp market and while there may be evidence that pricing is recovering we do not see a pricing environment in the paper industry that justifies giving the group the benefit of the doubt that mid-cycle returns have improved to a level that is as much as 450 basis points above the longer-term trend.

The Bulls and Bears have similar Ammunition

With the results so far you can probably draw whatever conclusion you like. As shown in Exhibit 1, the average company in our universe has produced a positive surprise of 11% yet has slightly underperformed the broader market, despite this. This is a straight arithmetic average and takes no account of market cap. However, there is a lot hiding behind the average, as the variability is extremely high with one standard deviation of earnings surprise 22% suggesting that you could quite easily have owned a basket in this space that on average missed meaningfully. The same is true of performance – only 56% of the stocks that surprised on the upside have outperformed since the reporting date.

Looking at this by sector, you were safest in Conglomerates where you had the combination of positive surprises and positive guidance. The other sectors that have shown better performance than the S&P 500 post results are Capital Goods, E&C and Chemicals, where you have had positive surprises but slight negative revisions. That being said, all the movements are small at the sector aggregate level and surprisingly so.

Metals and Mining – Valuation trough looking more apparent.

Clearly we have not yet hit the bottom of the revisions decline for Metals and Mining yet, as so far we have seen an average 9.3% decline in Q2 estimates post earnings releases. However, we have seen a much more muted response from the stocks, with relative underperformance of only 1.7% from the group which has reported – Exhibit 3. This more muted performance would support the idea that we are close to a relative valuation trough. Valuation in this space continues to discount the sort of demand and price downturn that we saw in 2008/2009 and we do not see enough evidence to support this view (Exhibit 4). We like the risk/reward profile offered by this group. The downside appears limited and the potential return from a restoration of confidence is very high.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Commodity Chemicals – US momentum on-track, Europe weaker than expected

Dow Chemical, the only company to report in the commodity index so far, confirmed the near-term momentum in the US and indicated the relative strength of March versus February and January. PPG confirmed the cost opportunity in basic chemicals when questioned on its energy intense businesses, glass and chlor-alkali. We are happy with these confirming data points.

The more concerning comments related to Europe, where Dow Chemical suggested that its basic chemical business was losing money because of high energy costs. We have also heard Total blame its worse than expected numbers on European petrochemicals – again focusing on high costs of raw materials. The Dow comments are interesting in that Dow probably has the lowest average cost base of any major European ethylene producer (some others have pockets of low cost, but higher averages). This is not an encouraging sign for others with European based capacity, which includes LyondellBasell (LYB).

The commodity chemical space remains attractively valued relative to the earnings momentum that we believe will become increasingly evident over the course of the next 12 months and the greater the leverage to US ethane based capacity or US low cost electricity, the greater the upside. We would maintain an overweight here. The group has outperformed since out report identifying the US opportunity on April 11, and now sits exactly at mid-cycle or “normal” value (Exhibit 5). We would expect further upside throughout the year, but the next catalyst may be second quarter earnings, unless there is a significant fall in ethane pricing in the US over the next month or so.

Exhibit 5

Source: Capital IQ and SSR Analysis

©2012, 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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