Metals: If You Must

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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

November 12th, 2015

Metals – If You Must

  • Underweight has been the right call for Metals for the last three years and we would be in no hurry to change that view, despite share price lows for many. However, there is opportunity in a handful of names that have perhaps unjustly been pushed down by the overall group
  • At a broad Metal exposure level, aluminum has the best supply/demand profile and it appears that Chinese and global surpluses are moderating
    • That said, the low returns and estimate cuts at primary aluminum producer CENX and the negative sentiment toward AA from its aluminum operations suggest serious disbelief
    • China is still copper deficit and this has provided relative pricing support
    • Steel should continue to see long-term pricing pressure as, unlike aluminum, Chinese surpluses continue to grow
  • Worthington Industries (WOR) is one of two Metals company with a positive sloping 10 year return on capital trend (the other being CENX, which has “improved” from a negative base to its current 2%)
    • Has the best blend of margin stability, estimate resilience and near term debt freedom
    • Diversified – 30% of sales from manufacture of pressure cylinders
    • Valuation reflects this – WOR is the least inexpensive stock in the sector, but still cheap
  • Compass Minerals (CMP) is mainly a salt producer
    • Easily the highest ROC in the group (19%), with only a modest downward slope
    • Also no immediate debt concerns
    • Only NEM has higher margins, and stability is far greater for CMP
    • Estimates have held in well
  • US Steel (X) has several factors working against it
    • Worst revision profile
    • Upcoming debt maturities dwarf FCF (trailing, 12 months forward, 2017 estimates)
    • Limited availability of self-help (SG&A at 3% of sales)
    • Lowest margins in the group; greatest volatility, and the worst 10 year trend
    • Occasional bankruptcy is practically part of the business model

Exhibit 1

Overview

At a sector level we have been underweight the metals space since we launched coverage three and a half years ago, and it has been the right call. The sector has had the longest period of consistent underperformance and disappointments in decades and for the most part it is hard to see an end to the troubles, particularly on iron ore and steel, but also possibly for copper. There are some bargains – and we are more neutral today, but at the same time there is still plenty to avoid

Metal exposure by stock is summarized in Exhibit 2, but with most metals under price pressure it does not really matter where the exposure lies today. We remain more bullish on Aluminum only because we still believe that this is the one metal with fundamentals that are close to balanced and that the World could run short of the metal quickly (12 to 18 moths). Prices remain very weak, but historically most positive supply/demand shocks occur when at the very bottom of a pricing cycle.

Exhibit 2

All of our valuation work is driven by return on capital trends and what industries and companies are doing to improve return on capital. As shown in Exhibit 3, this is not the sector with an attractive returns story. Not one company in the group has a positive ROC trend and some of the trends are extremely negative. This is partly explained by very weak metals prices, but also because of the spending spree that went on in the early part of the decade – raising almost everyone’s capital base.

Exhibit 3

Source: Capital IQ, SSR Analysis

With the chronic oversupply of both Steel and Iron Ore, we do not see an end to this problem for a while for companies focused in these areas, and copper is also looking fairly bad. Over-mining, chasing infrastructure and housing led growth in China has created a huge glut as China demand growth has diminished and in the case of Steel, recently declined. Both Steel and Aluminum have seen further price declines because of lower China coal prices, which have driven production costs down in China. It is still likely that marginal China base sellers are losing money, but if you look at a simple ratio of aluminum to coal prices – they are likely not losing as much money as they were – Exhibit 4.

Exhibit 4

Source: Capital IQ, SSR Analysis

We analyze debt levels in this piece, which in turn led us to contemplate a more comprehensive EV/EBITDA valuation metric. Interestingly, while on a normalized EBITDA basis the companies predictably look significantly undervalued, using historical forward estimates over the past five years we see that some of the Metals stocks do not look like good values at all – Exhibit 5. We show EV/Normalized EBITDA in Exhibit 6 for comparison.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Oversupply Contributing to Lower Metal Pricing

The most consistent long term pricing data exists for copper and aluminum. These tracked closely until the financial crisis, and copper has appeared comparatively insulated relative to aluminum – Exhibit 7. The 2009 period was also marked by a noticeable step up in Chinese copper consumption, filling the gap left by developed economies – Exhibit 8. China’s still deficit position in copper has also offered some support.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Bloomberg, SSR Analysis

Aluminum, by comparison, has long endured varying levels of Chinese surplus entering the global marketplace Exhibit 9. The recent production surge in 2013 was nearly fully offset with a surge in consumption in 2014 (albeit to satisfy increasing aluminum parts exports), and a general trend of smaller Chinese base aluminum surpluses over the past decade supports our view of an eventual demand driven balance in aluminum (sooner rather than later).

Exhibit 9

Source: Bloomberg, SSR Analysis

On a similar basis, it appears that steel is a few years behind aluminum, suggesting that a turn in steel pricing may be several years away – Exhibit 10. In Exhibit 10, the chart does not account for China steel production that is exported – it is just the capacity not used and how that compares with global demand – exports continue to rise.

Exhibit 10

Source: Bloomberg, SSR Analysis

Standout Stocks, Positive and Negative

The revisions picture for the Metals sector has long been a profoundly negative one. Estimates for CMP and WOR have been notably resilient – Exhibit 11.

Exhibit 11

Source: Capital IQ, SSR Analysis

Worthington Industries (WOR) sells most of its steel products into the auto industry (63% of steel sales). The company is diversified beyond a simple steel manufacturer. Sales of pressure cylinders into the LPG, CNG and industrial gas markets represent 30% of net sales – Exhibit 12. WOR appears to be the least volatile company in our Metals group on a number of metrics. Margin volatility is the lowest in the sector – Exhibit 13. The stock is cheap on our framework, but the discount is the lowest seen within our Metals index. WOR had the best 10 year return on capital trend in Exhibit 3, only somewhat an end-point specific result, as the longer term trend has a modest downslope – Exhibit 14.

Exhibit 12

Source: Company Presentations, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Compass Minerals (CMP) is mainly a salt miner and marketer with a small potash segment (20% of sales). Operations are limited to the US, Canada and the UK. Most of the company’s sale volumes are sold into the highway deicing market, the remainder going to consumer and industrial applications. Volumes are obviously very seasonal and tied to weather events, but annual operating margins are fairly stable around 20%. The “Plant Nutrition” segment has seen strong pricing trends over the past year (Exhibit 15) and its share of operating earnings is greater than its sales weight in the portfolio. Pricing gains in the salt segments were robust in the midst of extreme weather conditions last year, and so far CMP has mostly held onto those gains – Exhibit 16.

Exhibit 15

Source: Company Presentations, SSR Analysis

Exhibit 16

Source: Company Presentations, SSR Analysis

There is little more than a decade of public history for CMP, over which time the return on capital trend has been essentially flat, with a brief period of weather-inspired outsized earnings in the ’07-’08 period. Similar to WOR, the relative benefits of CMP result in a discount that is considerably smaller than that of sector peers – Exhibit 17.

Exhibit 17


Source: Capital IQ, SSR Analysis

US Steel (X) looks about as cheap as it ever has on a normalized earnings basis (Exhibit 18) but appears to have the makings of a value trap. Self-help levers seem to be limited – Exhibit 19. Negative forward free cash flow estimates do not bode well for impending debt payments, though the major maturities do not come due until 2017 and beyond (~$600 million in ’17 and at least $1 billion in ’18 and ’19). Realized steel prices are down significantly in 2015, and Q3 saw a marked deterioration in the Tubular segment which had previously been well insulated – Exhibits 20-22.

Exhibit 18

Source: Capital IQ, SSR Analysis

Exhibit 19

Source: Capital IQ, SSR Analysis

Exhibit 20


Source: Company Presentations, SSR Analysis

Exhibit 21

Source: Company Presenta2ions, SSR Analysis

Exhibit 22

Source: Company Presentations, SSR Analysis

Stocks at Risk of Failing to Meet Obligations

CLF and ATI are the most levered Metals companies in our index, relative to their trailing cash flows (Exhibit 23), but the near-term concerns are minimal with only a small portion of debt maturing by 2017 for ATI, and no significant obligations at all for CLF over the next two years. Here is where the solvency of US Steel comes into question. The extreme percentage in the left chart of Exhibit 24 is partly a function of a very low FCF figure (7 million trailing versus nearly 600 million in debt due by 2017), but the situation only looks worse if we look at forward estimates – Exhibit 24 right chart. We also note that FCX will have a significant amount of cash flow freeing up from the completion of several major capital projects – $2.6 billion of FCF in 2017 is not accounted for in these exhibits. $5 billion of debt matures in 2018-2019 however, with another $3.6 billion in 2020. Also note in Exhibit 12 that WOR and CENX do not currently have consensus estimates, but these companies have no debt maturing until at least 2020.

See the Appendix for full debt maturity tables.

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24


Source: Capital IQ, SSR Analysis

The question is whether to believe the estimates – free cash flow estimates have come down significantly across the group year to date (Exhibit 25), and the trend since we have initiated coverage has been one of sustained negative revisions.

Exhibit 25

Source: Capital IQ, SSR Analysis

Valuation and Skepticism

Our long standing favorite in the Metals space, AA, is the standout on both our normalized earnings valuation and skepticism work – Exhibits 26 and 27. Alcoa is historically cheap, particularly relative to its current return on capital which is much closer to trend then the extreme discount would suggest. The skepticism toward Alcoa is centered on its commodity aluminum business, which is understandable but, we believe, somewhat misplaced given that metal’s relative positioning and its demand growth profile.

Exhibit 26

Source: Capital IQ, SSR Analysis

Exhibit 27

Source: Capital IQ, SSR Analysis

The scatter diagram on the next page (Exhibit 28) plots the components of the skepticism index. WOR and CMP again screen well here, as discounted but over-earning stocks. AA’s position on this chart suggest that investors expect the company to fail, and it is very hard to see a scenario under which that would happen – this is the clear value opportunity in the sector with a very positive risk/reward profile.

Exhibit 28

Source: Capital IQ, SSR Analysis

Appendix

©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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