SSR Industrials & Materials Monthly Review, June 2016: Brexit Risk Not Yet Reflected in Performance, Revisions

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Graham Copley / Nick Lipinski



July 1st, 2016

SSR Industrials & Materials Monthly Review, June 2016:

Brexit Risk Not Yet Reflected in Performance, Revisions

  • Performance was mixed for the Industrials & Materials sectors in the wake of the Brexit
    • Most negative for Chemicals and Machinery, most positive for Conglomerates and Metals; revisions largely unchanged
  • We expect Brexit to trigger a European recession with possible knock-on effects everywhere else
    • Industrials & Materials should broadly underperform on that basis – particular concerns are levered names that appear most susceptible to an economic shock: DE, CNHI, CC, TROX, HUN, and X
  • Continued developments in the Ag space
    • MON earnings underwhelmed but management indicated the possibility of options beyond Bayer and the $122 cash offer on the table has supported the stock – we think this deal gets done.
    • We published a comprehensive piece on the agricultural industry, encompassing fertilizers (we are broadly positive though higher natural gas poses a risk for CF as the urea cost curve flattens to the detriment of margins), seeds (positive – still value to be seen in the MON story) and equipment (cautious – valuations and debt levels relatively elevated)
  • Other research over the past month has included:
    • DOWDD risk analysis – ethylene the most significant quantifiable risk but macro (germane given the Brexit) and regulatory risks could also be significant
    • Comparative work on CE and EMN – portfolios are broadly similar and traditional valuation metrics are comparable, but EMN shows greater potential on normal earnings
    • Natural gas – we noted early in June that pricing appeared to be anticipating a supply shock
  • Even while natural gas supplies have continued to grow and remain at the high end of the normal range, pricing saw strong gains in June as inventory growth slowed relative to expectations
    • Year to date gains (+23%) still trail the gains seen in crude (+35%)
    • The rise in natural gas and NGLs is pressuring ethylene margins and we have seen some negative guidance – we expect more, and possibly some Q2 earnings misses – WLK, DOW, LYB
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW and DD remain our longer-term favorites in the Chemical space and Industrials & Materials generally, though we clearly have a positive view of MON near term
    • If our “Brexit” take is correct and if natural gas keeps rising, all could get cheaper near-term

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


The Brexit is a big deal, for the uncertainty and knock-on effects if not for the direct implications – the impacts were not immediately apparent but will undoubtedly be felt for a long time as the actual mechanics of the departure are hammered out and other euro-skeptic nations weigh similar movements. Our central fear is that a leaderless Europe (it was never really set up to be led) and the political vacuum in the UK cause a drop in both consumer and business confidence resulting in a dip in economic growth and probably recession – which could spread.

The Industrials & Materials performance results in the immediate aftermath of the event were mixed – Metals and Conglomerates quickly recouped gains from earlier in the month, while other sectors managed only a middling comeback – Exhibit 5. We have very little confidence in the rebound and expect negative revisions and guidance to drive US stock performance from here.

Exhibit 5

Source: Capital IQ and SSR Analysis

Domestically, natural gas pricing continues to rise to the detriment of US chemical producers. Prices have risen sharply (+32% in June) despite inventories that remain elevated – Exhibit 6. The pace of additions, however, has come in below expectations recently. The associated higher ethane prices combined with returning ethylene capacity are likely to squeeze margins for US ethylene producers. Higher natural gas has a larger and more direct impact on CF – gas based North American urea producers will take a margin hit as the cost curve flattens (Chinese coal based production remains the marginal producer).

A rise in natural gas pricing, while crude remains stable, coupled with a dip in global confidence could cause what we had expected to be a slow decline in polyethylene margins through 2H 2016 to become a steep drop over the summer – bad for LYB, WLK and DOW/DD.

Exhibit 6

Source: Capital IQ and SSR Analysis

Elsewhere in the Ag space, companies remain active. MON indicated it is in talks with others beyond Bayer, and so not beholden to Bayer’s standing offer – whether this was a ploy to distract from an underwhelming earnings report remains to be seen, but we continue to see upside potential for the stock. AGCO made a mid-sized ($340 million) purchase of a grain handling equipment maker. We are mostly positive on the subsectors of the Ag industry (fertilizers and seeds in particular), but equipment would be our main concern – valuations are least attractive on an industry-relative basis, and debt levels are elevated to a point of concern for DE and CNHI particularly. Year to date gains in corn and soybean pricing offer indications we may be bouncing off the bottom of an extended trough, although news of significantly higher than expected US corn plantings have recently wiped out much of the price gains for corn.

The market was volatile as the Brexit story developed, but the S&P ended June little changed from where it started it. At the stock level, AXLL was the big winner as the WLK deal was finally announced. The other top performers in June were stocks that would not be expected to outperform in the event of a macro shock – CLF, JOY, NEM, X, OLN, MOS, UPS, CAT, MMM and GE were all among the top 15 performers for the month. On the other end of the spectrum, CF was the worst performer, due more to the impact of rising natural gas as indicated above than the Brexit. R was a close second on the underperformers list, curiously punished by the Brexit given the company has just 5% of its sales in Europe and 85% domestically. Other underperformers predictably were stocks with high European sales exposure (AGCO, HUN, LYB, BGC, OI) or that are reliant on European expansion for future growth (UFS). We show the 25 best and worst performing stocks in our coverage for the month in Appendix 1.

Exhibit 7

Source: Capital IQ and SSR Analysis

Sector performance relative to the S&P for the month is shown in Exhibit 8, along with performance results through the first half of 2016. Note the monthly results in Exhibit 8 are market cap weighted versus the simple average used in Exhibit 5.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 summarizes discount from normal value by sector. The Metals sector is off its highs but still the cheapest in our group, which is broadly cheap outside of the Conglomerates.

Exhibit 9

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 10 (see our skepticism work for more detail). Positive revisions in recent months have brought returns closer to trend for the Metals group, which continues to discount earnings weakness. Paper & Packaging also appears to be discounting negative revisions.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11 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.

Exhibit 11

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.

To begin 2016, and particularly in recent months, commodity stocks rallied and our portfolios benefitted accordingly – June was down month for these picks but the year to date results remain positive.

Exhibit 12

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 27 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 13.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14 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 14

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.

The slowdown in US Q1 GDP was not as sharp as initially predicted. Q2 is expected to see a rebound but growth estimates for the second half of the year are now being called into question after the Brexit. Consumer and construction spending have continued to trend higher but core capex has come in below estimates in recent months and generally has been less robust. Business spending has seemingly shifted away from tangible equipment and toward software and R&D – expenditures on the latter were estimated to have risen 4.4% in Q1.

Free market globalization was dealt a blow with the UK’s decision to exit the EU. Perhaps the most concerning implication of the result is the fact that there are likely a half dozen nations in the EU that have demonstrated a higher level of Euro-skepticism than the UK had.

Exhibit 15

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

Commodity Pricing

Another month of gains in metal pricing, but steel (+2%) trailed aluminum (+4%) and copper (+3%) for a change. Year to date gains in steel (+58%) dwarf those of copper (+2%) and aluminum (+7%). The big commodity move on the month came in natural gas, with pricing up 32%. Crude was up marginally, but the year to date gains (+35%) have outpaced natural gas (+23%) despite the strong June result.

US commodity and energy prices are indexed in Exhibits 16 through 20.

Exhibit 16

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

Exhibit 17

Source: IHS, Bloomberg, SSR Analysis

Exhibit 18

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 19

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 20

Source: Capital IQ, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 21 we look at expected net income growth by sector, and in Exhibit 22 we plot the growth figure against each sector’s current skepticism index value. We note that the Metals result is higher than the chart indicates and reflects a very low 2015 base. Electrical Equipment fell to the rear, ousting Capital Goods as the sector showing the least optimism in forward estimates. The ordinal rankings are otherwise unchanged over the past month.

Exhibit 21                                                                               Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows the change to these longer-term net income estimates over the month. Positive revisions in the Metals space were driven by NEM and NUE. A modest 1% decline in EMR’s net income estimate was amplified in the cap weighted results for the Electrical Equipment space. Chemicals revisions were mostly attributable to the Ag space – MON and CF.

Exhibit 23

Source: Capital IQ and SSR Analysis

Exhibit 24 shows 2016 EPS revisions over the past month and Exhibit 25 plots these revisions versus performance results on the month. Revisions were marginal in June except in the Metals space where broad based gains contributed to a strong sector result. STLD (+28%), NUE (+16%) and WOR (+12%) were the big movers, offsetting FCX’ 10% negative revision. Even X saw its $2.54 expected loss trimmed to a loss of $2.29.

Exhibit 24                                                                              Exhibit 25

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

Mid-Cycle “Normal” Valuation

In Exhibits 26-35 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

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

Exhibit 35

Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 36 through 46.

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

Exhibit 46

Source: Capital IQ and SSR Analysis

Research Published in June

June 27, 2016 – Brexit: This Could Be a Very Big Economic Shock – Levered, Europe-Exposed Companies Most at Risk

June 24, 2016 – DOW-DD: We’ve Discussed the Upside, Now What Are the Risks?

June 22, 2016 – Agriculture: Likely at a Low, Seeds and Fertilizer Look More Interesting than Equipment

June 16, 2016 – Chemicals Monthly: The Deals Keep Coming – Expect More

June 14, 2016 – CE vs. EMN: Similar Current Valuations but EMN has the Potential

June 7, 2016 – Natural Gas: Rising as Inventories Build – Anticipates Supply Shock – Not Good for US Chemicals


In Exhibit 47 we show a screen of stocks with low value, high Skepticism and high dividend yield. IP dropped out of the skepticism and valuation screens, leaving three holdover companies from the past several months: HUN, OLN, and PKG.

Exhibit 47

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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