Positive Performance with Commodity Relief Rally – SSR Industrials & Materials Monthly Review, February 2016

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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

March 1st, 2016

SSR Industrials & Materials Monthly Review, February 2016:

Positive Performance with Commodity Relief Rally

  • The overall trend of outperforming expectations on the bottom line despite underperforming on the top line remained intact with nearly our full set of companies having reported
    • There were, however, several examples of companies beating both revenues and EPS, highlighted by MOS and a group of machinery and electrical equipment stocks (EMR, ROK, DOV, GGG, KMT LECO)
    • CF had the unusual distinction of beating revenues but missing EPS – at any rate, fertilizer stocks continued to see relative strength in February, with MOS up 12% and CF up 22% in a relatively flat market
  • The fertilizer sector has not been the only downtrodden group to see relief in early ’16 – the list of the top 25 performing stocks over the past months is filled with Metals exposed stocks led by FCX, ATI, CLF, X, JOY and NEM, with AA not far behind – all gained more than 20% in February
    • This may be a pricing-related trade rather than an absolute bottom, as the true extent of China’s excess capacity and demand slowdown is still not fully clear
    • Metals pricing has stabilized sequentially but at current levels the year over year comparisons will remain challenging through the summer
  • Nearly all of our sectors enjoyed positive performance in aggregate over the past month
    • Strength was most ubiquitous in the Transports space and most uneven in Metals, which was roughly flat as CMP, STLD, and NUE offset strong gains in the stocks mentioned above
  • Recession watch:
    • Orders of core capital goods (non-defense, ex. aircraft) rebounded strongly with the largest sequential gain in over a year after a weak December result
    • Rail traffic in the US is getting incrementally less negative as the difficult comps of early ’15 fade
    • Honeywell’s offer for UTX is an implicit admission of the near-term constraints on growth
  • February research included our thoughts on WLK’s proposed buyout of AXLL, a piece on the fragility of the polyethylene market and another look at EMN, where we believe a catalyst is coming, of the company’s own volition or otherwise
    • Our preferences at the sector and stock level are shown in Exhibit 1 – we continue to endorse DOW and DD – the former’s presence in the unattractive overlap in Exhibit 2 is merely a testament to the current state of valuations in the space

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SI 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

In Q4 our Industrials & Materials universe averaged a 5% EPS beat on 8% less revenue versus the prior year, excluding the effects of M&A and large outliers. Revisions came in firmly negative everywhere outside of the Conglomerates – even in that group Honeywell’s offer for United Technologies suggests growth will be hard to come by in 2016. Possible silver linings: revenue comps ease significantly in Q1 – Exhibit 5 – and while the macro outlooks remains uncertain, the most recent data point for orders of core capital goods in the US showed the strongest sequential increase in over a year, on the heels of a disappointing December result – Exhibit 6. Rail traffic is also turning incrementally positive, or at least the changes are becoming less negative – Exhibit 7. Rail stocks have responded, and it was KSU and UNP that drove the group leading February performance result for the Transports – strength here was broad based but less pronounced in Trucking and Logistics. FCX and NEM followed the price of gold higher, a bounce in iron ore helped CLF off its lows, and AA gained with aluminum pricing – the momentum extended even to select steel stocks even as pricing declined. Apparent risk-on trades also lifted laggards HUN (+25% in February) and OI (+15%). We show the 25 best and worst performing stocks in our coverage on the month in Appendix 1.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: US Census Bureau and SSR Analysis

Exhibit 7

Source: AAR and SSR Analysis

Sifting through the quarterly results for company bright spots with momentum on both the top and bottom line, we find Mosaic (MOS) as an outlier – Exhibit 8. The company reported that phosphate capacity has come out of China and expects Chinese exports to decline roughly 15% in 2016. Global inventories are mixed but availability of credit in Brazil remains a key headwind. MOS and fellow fertilizer producer CF have performed well year to date, and were up 12% and 22%, respectively, in February.

Exhibit 8

Source: Capital IQ and SSR Analysis

Sector performance relative to the S&P for the month is shown in Exhibit 9. Transports, Capital Goods, Conglomerates and Chemicals top the list, results that are not indicative of an impending recession. Strength was broad based in the Transports space – KSU (+16% relative) and UNP (+10%) led the rails and the group. FCX formerly was a heavy influence on the cap-weighted results in the Metals space, but at $7 per share, its moves are now less significant and this month its strength was offset by weakness in CMP, NUE, and STLD.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 summarizes discount from normal value by sector. The Conglomerates are looking more expensive following HON’s offer for UTX, which had been the least expensive component of the group. Elsewhere the trend was also broadly more expensive given the outperformance seen in February.

Exhibit 10

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 11 (see our skepticism work for more detail). Those sectors on the positive end of the spectrum trended toward equalization (SI value of 0) as stocks outperformed despite negative revisions that brought down forward estimates.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index 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. The Paper & Packaging sector is no longer over-earning after a month of negative revisions, and further cuts appear to be priced in.

Exhibit 12

Source: Capital IQ and SSR Analysis

Portfolio Performance

The overlap of our traditional valuation and skepticism based portfolios (see Exhibit 2) produced cumulative monthly gains of 15.6% in 2013 and 9.8% in 2014, but was far less successful in 2015. Our return on capital based models that produce the portfolio selections assume cyclicality and fail to capture the secular changes impacting an industry – a major issue for many Metals and Commodity Chemical stocks. FCX, CLF, HUN, and OLN were among the mainstays on the long side throughout the year and condemned our portfolios to a year of underperformance. Many of these stocks saw relief in February, which, combined with strength in beaten down rail (KSU) and packaging (OI) stocks contributed to strong gains for theses selections – Exhibit 13.

Exhibit 13

Source: Capital IQ and SSR Analysis

An alternative portfolio approach is based on our expanded skepticism index performance analysis which showed a very attractive risk-reward relationship for stocks with positive SI values, valuation discounts, and positive 3 month EPS revisions. We feel there is both a more defined holding period (our work is based on 6 month forward performance) and a greater likelihood of success in those names. This month we have a list of 12 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 14. The negative revisions picture has significantly cut this group, which is roughly halved from prior months.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15 shows the historical forward performance of the stocks meeting the criteria in Exhibit 13 at various ranges. We note that for all ranges where the SI is above 0.5, the average return is in excess of the variability (average > standard deviation).

Exhibit 15

Source: Capital IQ and SSR Analysis

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.

We noted earlier that core capex picked up in the US in the most recent data, a welcome sign given the recession fears clouding the market. In reality, with inventories drawn down, housing continuing to recover, and consumer spending bolstered by broad employment gains and $35 crude, there is little evidence to suggest the US will not continue to be the bright spot in a world of slowing growth in emerging markets and stagnation in Europe. Earnings related corporate commentary on China painted an uninspiring picture of the industrial environment in that country, while contaminated water in Rio should be towards the bottom of the list of Brazil’s concerns. Europe meanwhile remains stuck in a flat to 1% growth environment that is reminiscent of what has occurred in Japan for the past 25 years, making the pending “Brexit” referendum relevant as not only a political but an economic concern at heart.

Exhibit 16

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

Commodity Pricing

Natural gas finally broke below $2.00 per mmbtu, finishing the month at a 20 year low. Crude meanwhile stabilized sequentially – Brent up modestly, WTI down modestly. We are still more than 40% off prior year levels for crude. Metals pricing similarly continues to show signs of steadying but the year over year comparable figures will not ease until the summer. Aluminum is closest to flat year over year, down 11% – there is still some way to go for copper (-21%) and steel (-31%).

US commodity and energy prices are indexed in Exhibits 17 through 21.

Exhibit 17 Exhibit 18

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

Exhibit 19

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 20 Exhibit 21

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 22 we look at expected net income growth by sector, and in Exhibit 23 we plot the growth figure against each sector’s current skepticism index value. We will change the base year to 2015 and the forward comparison to 2017 next month when the remaining late reporters have announced results. Despite stock strength, estimates in the Metals continued to see negative pressure. Consensus sees 2016 net income for the Metals group at roughly a quarter of the 2014 base level, largely due to FCX which made $2 billion in net income in 2014 and was expected to post an equivalent figure in 2016 as recent as August – that estimate has been cut below 0. At the high end, even the sectors with the most optimism are considerably less so than in recent months. In Exhibit 23 Paper & Packaging is still an outlier but revisions are starting to reflect the weakness that is priced into the stocks.

Exhibit 22 Exhibit 23

Source: Capital IQ and SSR Analysis

Exhibit 24 shows the change to 2016 net income estimates over the month. Conglomerates and Transports show relative support here partly because the bulk of constituent companies are early reporters and estimates were mostly adjusted for earnings news by the end of January. The Paper & Packaging result is mainly a function of IP, which is an outsized component on both a cap weighted and absolute sales basis.

Exhibit 24

Source: Capital IQ and SSR Analysis

Exhibit 25 shows 2016 EPS revisions during February and Exhibit 26 plots these revisions versus performance results on the month. Estimates in the Chemicals space were impacted by a pronounced cut to AXLL’s 2016 EPS (from $0.63 to nearly $0), which contributed three percentage points to the sector result. We again note that the Metals figure necessarily excludes further cuts to already negative estimates (seen in February for CLF and X).

Exhibit 25 Exhibit 26

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

Mid-Cycle “Normal” Valuation

In Exhibits 27-36 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.


Exhibit 27

Exhibit 28

Exhibit 33

Exhibit 31

Exhibit 32

Exhibit 30


Exhibit 29


Source: Capital IQ and SSR Analysis

Exhibit 35

Exhibit 34

Exhibit 36

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 37 through 47.

Exhibits 37-39

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibits 43-45

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibits 46-47

Exhibit 46

Source: Capital IQ and SSR Analysis

Exhibit 47

Source: Capital IQ and SSR Analysis

Research Published in February

February 25, 2016 – WLK + AXLL: A Deal Makes Sense – WLK Attractive Regardless

February 23, 2016 – SSR Industrials & Materials Small-Mid Cap Rankings, February 2016

February 22, 2016 – EMN: Should You Try for 2nd Base?

February 16, 2016 – SSR Chemicals Monthly: Beating Lower Guidance is Not Really a Victory

February 10, 2016 – Industrials & Materials – Expectations Challenging the Fundamental Signs

February 9, 2016 – Polyethylene: The Fragile Last Line of Defense!

Dividends

In Exhibit 48 we show a screen of stocks with low value, high Skepticism and high dividend yield. This month BGC joins four holdovers from the past month: HUN, IP, OLN, and PKG.

Exhibit 48

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2



Appendix 3


Appendix 3

©2016, 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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