SSR Industrials & Materials Monthly Review, July 2017: Best Earnings Trends Since the Early 2010s Offset by Poor Guidance

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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

July 31st, 2017

SSR Industrials & Materials Monthly Review, July 2017:

Best Earnings Trends Since the Early 2010s Offset by Poor Guidance

  • More Industrials & Materials stocks are beating revenue expectations and posting year over year growth in earnings than at any time since the early years of this decade
    • This is perhaps the result of expectations finally being tempered enough to allow for upside surprises, but results from several of the most geographically diverse large cap companies in our space have indicated consumer-led growth
  • It has nevertheless been an underperforming month for the Industrials & Materials sectors
    • Guidance has generally underwhelmed and the worst performers have been in Transports (particularly the Rail space and FDX), Conglomerates (GE – see below), and Capital Goods (despite a strong month for CAT)
    • Bucking the trend were several miners (FCX, NEM, CLF) as well as AA in the Metals space, the ethylene plays (LYB, WLK) and Ag names within chemicals, and CAT most notably among large caps
  • Research since our last monthly:
    • GE – we were hoping to see a quick turnaround for the incoming CEO’s organizational review and possibly a reset of earnings – neither happened and we have removed the company from our favorites list for the time being
    • Ethylene – in what is certain to be a volatile period for the ethylene market, we see LYB and WLK as cheap enough to offset the associated risks – though LYB’s recent decision to add propylene oxide capacity is a questionable use of capital in our view
    • Trends in 1H ’17 – following on our June monthly, we found a significantly greater frequency of meaningful change (activism, M&A, new CEO) in the top performers in 1H compared to the worst
    • Clariant – investors have come out to question the strategic rationale of a deal that ostensibly moves Clariant’s portfolio away from its specialty base – we have our own concerns about a deal that combines two of the most complex and difficult to model portfolios in the Chemicals space
    • PX/Linde – combined company should have ample cash available to deploy for capital expenditures, likely to win share from APD and Air Liquide
    • Akzo – underwhelming Q2 results are poised to be the norm as the stock struggles to meet aggressive targets and we see little upside to the stock absent a renewed PPG deal
  • Exhibit 1 summarizes our preferences by sector and stock
    • We see no reason that the trends from the first half should not follow through for the duration of 2017, and continue to see potential for strength in commodity chemicals – remain bullish on DOW/DD
    • Metals and Paper & Packaging stocks show some of the largest discounts within the I&M sectors – favorites and concerns within sectors are primarily value motivated – Paper & Packaging positioning will be a topic of more detailed future research
    • With GE off our favorites list, we are most positive on PX, DOW/DD and SWK, in the large cap space

Exhibit 1

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

Q2 earnings reporters to date have shown a continuation of a trend that began in earnest in Q4 ’16 – a greater frequency of revenue surprises and year over year growth than we have seen since the early part of this decade. It is clear that global growth remains slow and, where it is strongest, led by the consumer – what is less clear is whether expectations have finally been tempered enough to allow for the upside surprises we have seen or if the inching level of growth has seen an incremental boost. CAT’s results certainly seem to suggest the latter (though the stock has more than doubled since 2016 and we see more risk than reward in the name currently).

Exhibit 5

Source: Capital IQ and SSR Analysis

Some other takeaways from notable earnings outliers:

  • The cluster of companies posting modest revenue and EPS beats (top right quadrant) include several large cap diversified Industrials (HON, IR, SWK, DHR, ITW, DOW) and indicate there is some depth and breadth to the trends in Exhibit 5 above
  • Of the few companies that failed to meet top-line expectations, the group of coatings and adhesives companies (PPG, SHW, FUL, RPM) in the bottom left quadrant of Exhibit 6 below underscores the challenges facing that industry, and the strategic logic behind the drive for M&A in the space
  • Railcar manufacturing and services is another notable laggard with WAB and TRN struggling to generate top-line momentum after several years of strong orders have left customers with a large pool of idled resources

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month of July is shown in Exhibit 7. We show the 25 best and worst performing stocks in Appendix 1. July has proved the inverse of June, when the I&M sectors nearly universally outperformed. Reported numbers largely met or bet estimates in the Transports space, but guidance disappointed and the large caps underperformed significantly, and particularly the rail space – UNP, NSC, and CSX all among the 10 worst performers on the month with FDX, GWR and CHRW additionally in the worst 25. The two worst performers were in the Capital Goods space (WAB -18%, FLS -11%), working against the gain in CAT. Conglomerates again fare worse when inclusive of GE, which was down another 5% in July, in an up market (S&P +2%).

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. GE’s underperformance continues to drive the valuation divergence between the Conglomerates inclusive and exclusive of the mega cap.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 9 (see our skepticism work for more detail). Valuations and returns are in-line for several sectors (SI close to 0) and the only relative extreme value continues to be in Metals.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index component – valuation versus ROC. We see a broad range of valuations despite returns that are mostly within half a standard deviation of trend. Coatings remains the prominent outlier – SHW’s runaway return on capital is influencing the group but PPG’s returns are also near an all-time peak above trend.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

Every month we take the top and bottom 25 stocks on our normal valuation and skepticism index frameworks (summarized in Exhibit 2) and track the results, which have typically been robust, particularly for the overlap of the two. 2016 was a strong rebound year for this portfolio selection methodology after 2015 failed to live up to the record established in 2013 and 2014 – Exhibit 11. Results in 2017 to date have been roughly flat on average.

Exhibit 11

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. This month we have 28 stocks that currently fall in these historically outperforming ranges, one more than last month – Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 shows the historical forward performance of the stocks meeting the criteria in Exhibit 12 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 13

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.

US GDP growth came in at 2.6% year over year for Q2, and the first half of 2017 showed a similar pace of expansion to that seen in 2016, excluding some noise around inventories and trade figures. While Q1 was revised down slightly, the consumer component saw positive revisions and continues to be the main driver of growth. There is little in the data to suggest the current growth trajectory is anything but stable and healthy, and though consumers, corporates, and the Trump administration would prefer a faster pace of acceleration there is considerable skepticism that a +3% breakout is around the corner. A European pick up to something approaching even the 2% growth levels seen domestically would be a boon – the weakened state of the peripheral nations was underscored by Spain’s 0.9% GDP gain in Q2, which rivalled the highest pace of growth the country has seen since before the crisis of 2008-09.

Exhibit 14

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

Commodity Pricing

US commodity and energy prices are indexed in Exhibits 15 through 19.

Exhibit 15                                                                        Exhibit 16

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

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18                                                                                   Exhibit 19

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 20 we look at expected net income growth by sector, and in Exhibit 21 we plot the growth figure against each sector’s current skepticism index value. Significant positive revisions on the month – Exhibit 22 – have pushed Capital Goods above Paper & Packaging in Exhibit 20. Conglomerates, conversely, saw significant negative revisions (mostly GE) and now show essentially flat estimates for 2018 versus 2016 actuals.

Exhibit 20                                                                                  Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows average 2017 EPS revision over the past month and Exhibit 24 plots these revisions versus performance results on the month. Note these revision figures are a simple average versus the cap weighted revisions shown in Exhibit 4.

Exhibit 23                                                                                  Exhibit 24

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

Mid-Cycle “Normal” Valuation

In Exhibits 25-34 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 25

Source: Capital IQ and SSR Analysis

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

Source: Capital IQ and SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 45.

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in July

July 27, 2017: VSM: A Beat and Raise Coming Up!

July 25, 2017: Akzo – Everybody Loses When Management Does Not Have a Clue

July 24, 2017: Lyondell – A Poor Capital Allocation Decision

July 21, 2017: The Friday Findings – July 21st 2017

July 17, 2017: Ethylene: A Tough 12 Months to Model – Likely Very Volatile

July 17, 2017: Stirring the Pot – Change Was Good in 1H 2017

July 16, 2017: Chemicals July – No Story, No Gain

July 14, 2017: GE – The Flannery Manifesto!

July 5, 2017: PX/Linde – Hard To Quantify, But Possibly The Largest Opportunity – CAPEX

July 5, 2017: Clariant – We Are Not Alone in Questioning This Complex Deal

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. CF has dropped out of the valuation screen and UPS is back in, joining holdovers EMN, and OLN as the only three stocks to appear in the top 25 on all three metrics.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Appendix 1

Appendix 2


Appendix 3


Appendix 3

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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