Monthly Review November 2014 – Metals, Chemicals, E&C Left Behind in Market Rebound

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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

November 3rd, 2014

Monthly Review November 2014 – Metals, Chemicals, E&C Left Behind in Market Rebound

  • As the S&P retraced all of the mid-month selloff and more, the Metals, Chemicals, and E&C sectors did not keep pace in the rebound. All other Industrial & Material sectors outpaced the resilient market, with Paper, Packaging, Conglomerates, and Transports the most notable standouts.
  • Another predominantly strong earnings season has helped the quick recovery. With almost all of our companies now reported, revenue growth has been firmly positive everywhere outside of E&C. Transports have had the strongest showing (9.7% sales growth quarter over quarter), with Trucking (+14.3%) and Rail (8.5%) clearly confirming growth in the domestic economy.
  • More underperformance in the E&C sector has moved the group past Capital Goods as the second cheapest sector in our universe behind Metals. A down month for Chemicals stocks (commodity names in particular) has the sector looking cheaper than it has in recent months.
  • October research included further opinion on the ongoing DuPont breakup battle, continued coverage of the ethylene market, a screen of our most and least preferred small cap names, and expanded work on packaging (specifically the plastic packagers and a containerboard follow up).
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. DD continues to be a focus for us – we believe there is the potential for significant upside. DE’s resilience in the face of the market sell-off was encouraging – see recent blog.
  • The stronger US economy, together with a possible change in the makeup of consumer spending as gasoline prices fall should clearly benefit some of our sectors and companies more than others. Transports are an obvious pick here as consumer spending improves, but our packaging ideas, particularly PKG, should also work well. We also like SWK, AA and eventually some of the chemical names (after an expected inventory correction) on the same basis

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SSRSI measures current valuation versus current return on capital and what movement in returns on capital is implied in valuation.

Exhibit 3

Source: Company Reports and SSR Analysis

See
Appendix 3
for the data underlying this exhibit.

Exhibit 4

Overview

The Q3 earnings season has seen strong growth in revenues thus far, continuing a trend that has been evident throughout 2014. Numerous reports have indicated a backlogged US transportation system, and the rail and trucking companies certainly appear to be capitalizing on this development – these subsectors of the broader Transport group grew sales at the highest rates within Industrials and Materials. High single digit growth from the machinery/industrial sectors (Capital Goods, Electrical Equipment, and Conglomerates) also paints a picture of strong industrial production. Similar growth in the Packaging space speaks to healthy consumer spending trends. The Chemicals sector saw positive growth on the whole, but weakness in the Commodity space underscored downward stock momentum. Exhibit 5 summarizes revenue growth by sector and subsector, with the number of companies reporting in parentheses. Note the Capital Goods subsectors sum to more than the group overall, as some stocks are included in multiple subgroups.

The overall strength in the US, suggested by Q3 earnings highlights an issue that we have been discussing for some time and something that will be the subject of new research this month – why are the Industrial Gas companies not seeing this growth? Praxair and Airgas are particularly levered to the US manufacturing economy and yet their top lines continue to disappoint despite positive pricing for the most part. The answer is clearly in the mix of economic activity in the US and suggests that commercial construction is not keeping pace as well as general manufacturing.

Outside the US, Europe and Latin America remain drags, though Praxair’s Brazil numbers were better than expected. Asia is growing but not growing quickly.

Exhibit 5

Source: Capital IQ, SSR Analysis

From a company performance perspective, AXLL was a standout within the lagging Chemicals sector, up 12% as the fifth best performer in our coverage on the month. Paper & Packaging stocks continue to be buoyed by the prospect of MLP conversion. UFS gained 10% in a matter of minutes after management announced they were evaluating the structure, and was the best performing stock in our coverage. The stock has long appeared on our valuation screens (see our recent piece on
small cap stocks
). UFS’ pulp business would make the most sense as an MLP – paper (or in PKG’s case containerboard) would seem to be one step removed from the timber that would be classified as a natural resource, which is currently the main MLP qualifying factor. The mere mention of an MLP these days seems to provide an instantaneous stock boost, and similar to UFS, PKG enjoyed a strong move higher after making the first public comment on their consideration of this structure (+12.5% on the month). Diversified Capital Goods stock Trinity Industries (TRN) saw the biggest loss on the month, down over 20% after a ruling against the company in a litigation related to its construction products segment (which makes highway guard rails). TRN management indicated the belief that the company has done no wrong, noting that the product in question was licensed from Texas A&M University’s Transportation Institute. This is a well-diversified industrial name that has been on quite a run over the past year, largely due to its highly profitable railcar manufacturing and leasing operations which account for 80% of sales. The outcome of this lawsuit is obviously a key overhang but the positioning that drove the stock from $22 a share to over $50 remains intact. Best and worst performers at the company level in our coverage universe are summarized in
Appendix 1
.

Sector performance relative to the S&P is shown in Exhibit 6. As noted, only a few sectors failed to participate in the strong bounce back in the market. The Chemicals space was most hindered by the Commodity names, specifically WLK (down 18.7%), LYB (-16.1%) and to a lesser extent DOW (-6.7%). Ethylene has been a focus for us – refer to
our views for 2015
and
our most recent piece
from earlier in the month. Weakness in the Metals space was most pronounced for the miners, with FCX and NEM among the six worst performing stocks in our group in October.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes end-October sector discounts from normal value. Metals remains significantly, cyclically, cheap, even after a month of underperformance. E&C has overtaken Capital Goods for the second cheapest sector in our group – these stocks have been struggling for some time and we expect earnings reports will continue to disappoint.

Exhibit 7

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 8. As a reminder, our Skepticism Index measures how in or out of phase current valuation is with current returns on capital. A positive number suggests that either valuation is discounting a decline in return on capital or the stock has upside. On the flip side, a negative number suggests that returns have to rise to justify valuation, or the stock has downside.

On the whole, Industrials and Materials sectors are not fully being given valuation credit for what are by and large above average returns. Overall our skepticism index is the highest it has been since we began publishing.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 is a very busy chart but shows how each sector and sub-sector breaks down by SSRSI component – valuation versus ROC. All things being equal, you want to buy sectors in the top right corner and sell those in the bottom left.

Exhibit 9

Source: Capital IQ and SSR Analysis

Portfolio Performance

We again tracked our model portfolios over the month, one based on our normal mid-cycle earnings screen, one based on our Skepticism Index and one based on the stocks that appeared on both metrics. Effectively, we bought the cheapest/most Skeptical and we sold short the most expensive/least Skeptical, as summarized in Exhibit 2 of our October monthly.

In a very similar pattern to 2013, our portfolios are gaining momentum into the close of the year. The pure valuation and skepticism screens remain negative year to date but the overlap portfolio has a chance to match or exceed the robust 15.6% cumulative return produced last year. As our portfolios are skewed toward valuation, this noted second half outperformance suggests value plays have gained preference as the year winds down. In October, our long side portfolios were buoyed by the presence of PKG and UFS, two Paper & Packaging companies that saw significant gains after indicating they were seriously evaluating an MLP structure. Chemicals mainly drove the lower performance on the short side, in specific, Commodity components LYB and DOW.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

In
Appendix 2
we show the companies coming into our screens and leaving our screens.

Macro Environment

At SSR we are not economists, nor do we seek to be. We look at the economic indicators that are publicly available and put them into context relative to the drivers within the industries we cover. We examine trends or fundamental influences and we then look at these relative to valuation with the goal of identifying mismatches between what is implied in valuation and what is expected to happen.

The strength in the Transports space reflects the strength in the domestic economy – US third quarter GDP came in at a very healthy 3.5% gain. Other developed markets continue to sputter along without any real momentum. Europe appeared to be improving in the early part of the year but the tone in recent earnings calls has been decidedly more cautious. Japan remains the poster child for economic malaise in the face of endless monetary easing. With the US Federal Reserve finally ending its own easing program, it was encouraging to see stocks recapture the losses of mid-month, and continue their march to new highs.

Consensus for the near term seems to indicate a continuation of the “new normal” of the past few years – the US is a pocket of strength, China continues to slow (perhaps faster than many expected), Brazil likewise is enduring a period of weakness, and Europe is a middling wild card, seemingly just as likely to crash as to finally gain meaningful traction.

The most recent Macro data changes are summarized in Exhibit 12.

Exhibit 12

Source: Capital IQ, Government Publications, Bloomberg, SSR Analysis

Commodity Pricing

Crude at $80 a barrel has been one of the major stories of the past month – see
SSR’s energy initiation report
from our new colleague Grayson Andersen. Natural gas pricing has concurrently dropped, ending the month below $4.00 per mmBTU. Metal pricing was more stable, with aluminum the biggest mover, off its highs but posting a 5% gain on the month.

US commodity and energy prices are indexed in Exhibits 13 through 17.

Exhibit 13

Exhibit 14

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 15

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 16

Exhibit 17

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 18 we look at expected net income growth by sector, comparing 2015 estimates with 2013 actual net income. Chemicals fell behind Electrical Equipment and shows only a slightly higher level of growth than Capital Goods. Generally we can see that the Industrial sectors show the least optimistic outlook while Materials have the healthiest growth expectations (with the notable exception of Chemicals). E&C is anticipating the second highest growth of our sectors, though given the recent struggles of several companies to effectively gauge sales, forward estimates should be viewed with a grain of salt. Exhibit 19 shows a reasonable correlation between expected net income growth and our skepticism index, with Electrical Equipment the notable outlier.

Exhibit 18 & Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. Cuts in the Chemicals sector were widespread but most pronounced in the commodity names. The Metals sector was heavily influenced by its large cap components, specifically the miners FCX and NEM. Transports show strength here as well. E&C gains on the month reflect ACM’s rising estimates on completion of the URS acquisition.

Exhibit 20

Source: Capital IQ and SSR Analysis

In Exhibit 21 we show the change in 2014 EPS estimates over the past month.

Note that the numbers in Exhibit 21 differ from those in Exhibit 4 as the data is cap weighted at each index point in Exhibit 21 and a current cap weighted average of percentage changes in Exhibit 4. Revisions should moderate as we approach year end, but there were some significant moves accompanying Q3 earnings. The Conglomerates sector saw the most meaningful positive revisions, led by MMM, though Capital Goods was just behind. The cuts in the Paper space primarily reflect lower estimates for International Paper (IP), which has yet to report.


Exhibit 21

Exhibit 22

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal Valuation Analysis

Results of our valuation analysis for the end of May are summarized in Charts 23 through 33.

Exhibit 23

Exhibit 24 Exhibit 25

Exhibit 26

Exhibit 27

Exhibit 28 Exhibit 29

Exhibit 30

Exhibit 31

Exhibit 32 Exhibit 33

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 34 through 45.

Exhibits 34-36

Exhibit 34

Optimism High

Skepticism High

Exhibit 35

Exhibit 36

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Optimism High

Skepticism High

Exhibit 38

Optimism High

Exhibit 39

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 40-42
Exhibit 40

Exhibit 41

Skepticism High

Optimism High

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibits 43-45

Optimism High

Skepticism High

Exhibit 43

Exhibit 44

Exhibit 45

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in October

October 31, 2014 – The Power of Positive Thinking – APD and the DD Read-Through (blog)

October 29, 2014 – Containerboard Capacity Additions Unlikely to Affect Operating Rates: PKG Well Insulated

October 20, 2014 – Looking Among the Small Cap Rubble to Find Opportunities

October 16, 2014 – Commodity Chemicals: Overdone? Maybe Not

October 16, 2014 – Chemicals Monthly: A Whole New World

October 15, 2014 – Deere: The Floor Looks Robust (blog)

October 2, 2014 – DuPont Can Be a Bad Stock: If Trian is Right, But Gives Up

October 1, 2014 Plastic Packaging: A Wide Range of Markets & Valuations, None Overly Attractive at the Moment

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield.

Exhibit 46

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2


Appendix 3


Appendix 3

©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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