Large Cap Value – Where to Look if Santa Comes to Town

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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

December 4th, 2014

Large Cap Value – Where to Look if Santa Comes to Town

  • Having explored our small cap universe in recent research, we turn now to the large cap space, highlighting undervalued names that could outperform in the case of a December “Santa Claus” rally. We supplement our valuation work with 2015 EPS estimates (how they have changed over the year and what consensus is expecting above 2014), a look at quarterly earnings surprises since 2012 (who is most likely to beat those estimates), and geographical exposures (US vs non-US) – see Appendix for full tabular results.
  • This analysis supports our view on another of our Capital Goods favorites, SWK – valuation is still compelling, 2015 estimates do not appear overly optimistic, and have held in well over the course of the year.
  • On a pure valuation basis, FCX screens as the cheapest large cap name – the stock offers a sizable yield (4.8%) but revisions continue to be negative and see downward pressure as the global mining industry remains in flux. Overall we lack sufficient conviction on any of the commodity markets to endorse the discount in the respective names (MOS and NUE).
  • CAT also stands to benefit from a turn in mining, but the company has successfully trimmed costs and improved margins in its other segments to counter the downturn there. This is the only cheap large cap stock where 2015 EPS estimates have been revised higher during the current year, with the majority of the upside coming before the recent news of Chinese stimulus.
  • Several other names that we have written about favorably (DE, PX and EMN) also screen here. See our recent piece on Praxair and our previous work on Eastman and Deere. DE may experience further negative revisions but we believe these are largely priced in today.
  • ETN has underperformed significantly in 2014, the result of second quarter guidance that took down estimates significantly for both the current year and 2015. The stock held in well during the market selloff in October, outpacing the S&P since October 1 and suggesting valuation support. The yield is above average (2.9%) but Europe (23% of sales) is a risk, particularly given management’s pessimistic outlook there.

Exhibit 1

Source: Capital IQ, SSR Analysis

2015 EPS – Growth & Revisions

In the exhibit below we plot the discount from normal value as measured by our return on capital based models (seen in Exhibit 1) versus consensus EPS growth for 2015. DE will see lower earnings on lower farm incomes and as inventory works its way through the system following a run of peak demand years – we believe there may still be further downside to estimates, but downside in the stock price is likely limited as evidenced by the relative strength shown during the October selloff. Consensus EPS growth for SWK seems very attainable. FCX is the cheapest large cap name in our coverage at the moment, and while 11% EPS growth is not overly optimistic in absolute terms, it must be viewed with some skepticism for a company that has seen its actual EPS come in at least 30% below the beginning estimate in each of the past three years. The same can be said for the optimism toward NUE, where cuts to initial earnings estimates were over 40% in both 2012 and 2013, and MOS has a similarly poor record of overconfidence. Overall we lack sufficient conviction on any of these commodity markets to endorse the discount in the respective names.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3 looks again at valuation, here compared to the change in 2015 consensus EPS over the course of 2014. CAT sticks out here as the cheapest large cap stock to see positive revisions during the year (LYB fits this description as well but we have a much shorter historical data set for the company and our view here is impacted by
our outlook for ethylene in 2015
). EMN, which we have recently written about in detail, has maintained its 2015 estimate throughout 2014 – we see the company as a value play that is perhaps not fully understood by investors. IP is generating healthy and increasing cash flows but,
ever the optimist
, initial 2015 EPS estimates have proven to be nearly 20% too high. We see PKG as a better play in this space. KSU has been the recent laggard within a very strong rail group. A 6% Q4 ‘13 earnings miss drove the stock lower in January, but it has moved steadily higher since and still screens as expensive. Growth expectations for KSU are the best among the rail stocks, partly due to the company’s significant Mexican exposure (~50% of sales). The opening of the Mexican energy market should be a boon for the company in the years to come.

Exhibit 3

Source: Capital IQ and SSR Analysis

Earnings Surprises – Who Consistently Beats

We looked at the recent history of earnings surprises to determine which companies are most likely to meet or exceed estimates – Exhibit 4. ETN is trading at an attractive valuation for a company with strong cash flows that has grown dividends per share by over 13% annually over the past decade, but its earnings results have on average done little better than meet expectations since 2012, considerably worse than the group average. This year, notably, a Q2 guide-down has driven the stock’s significant underperformance. PX too disappoints on this basis (though APD does not fare much better). CAT, DE and EMN are all above average. SWK is in the lower half, but these results are influenced by the company’s struggles integrating a large European security acquisition – we believe these difficulties are in the past and expect SWK to continue its strong recent earnings momentum (since 2013 Stanley’s average beat has been above 4%). Note that in this exhibit we have omitted some volatile Metals names (AA, FCX, NUE, and MOS) where several instances of negative earnings distorted the results.

Exhibit 4

Source: Capital IQ and SSR Analysis

Geographical Sales Exposure

We recently published a Capital Goods-focused piece on
the outlooks for China and Europe
– recent stimulus measures (or speculation thereof) in those regions underscore increasingly weaker growth. The US has been the best house on a bad block (pick your analogy), third quarter GDP was just revised strongly upward and there is little reason to think this relative strength will not continue into at least the first half of 2015.

The stocks with heavy US exposure skew to the expensive side of Exhibit 5. Of the cheaper names, NUE has a primarily domestic focus and ample valuation support but again, you need to believe in the industry fundamentals and/or have faith that this is the year the company doesn’t lower estimates by a third. CSX looks like the most fairly valued of the rail stocks, which as a group should continue to perform well in 2015. DE and SWK offer the best combinations of valuation and reasonable US exposure (over 60% for DE, slightly above group average and just under 50% for SWK, slightly below average).

Exhibit 5

Source: Capital IQ and SSR Analysis

In the Appendix below, we have summarized these factors in tabular form, with the additional factor of dividend yield. We grouped the 40 companies analyzed into quartiles for each metric (excluding 2014 performance which is included for reference), and then equally weighted each factor to arrive at a final indexed value for each company (the smaller the number the better – it has been in the higher quartiles). NUE screens with the best rank, but the healthy growth estimates for the company may be more of a negative than a positive, as we have expressed. Our Capital Goods favorites, CAT, SWK and DE (in that order) are all within the top five. PX falls more towards the middle of the list due to its significant non-US exposure, market average yield, and lower tier 2015 growth estimate but this latter factor could be viewed positively as a lower hurdle to earnings beats. If we assign a heavier weight to valuation (50%), the company falls closer to the top.


Appendix

©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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