SSR Industrials & Materials Monthly Review, October 2016: Global Growth Disappoints Versus Modest Expectations

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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 1st, 2016

SSR Industrials & Materials Monthly Review, October 2016:

Global Growth Disappoints Versus Modest Expectations

  • Earnings for Q3 in Industrials & Materials indicate continued productivity gains as the global economy remains spotty
    • With 75 companies in our coverage now reported, two thirds have missed revenue expectations but nearly 70% have managed to register EPS beats
    • Guidance from large caps reflects the mixed industrial environment – GE, HON, MMM, CAT lowered outlook, UTX, DHR, ITW, IR raised outlook
    • Spottiness extends to the end market level – UTX and HON had varying experiences in aerospace
    • Consumer and housing trending weaker with PPG’s negative guide and SHW’s disappointment mirrored in negative outlook from WHR and recent downgrades of home improvement retailers
    • Global growth generally underwhelming against even modest expectations
  • Q3 results have in large part been greeted negatively as all of our sectors (ex. E&C) have underperformed the market over the past month
    • Electrical Equipment most negative due to focused weakness in large cap stocks (EMR, AME)
    • Conglomerates were significantly weaker excluding GE which recovered somewhat from disappointing guidance following the announcement of the Baker Hughes deal
    • Transports among least negative as underwhelming Rail earnings were offset by better results from Truckers, despite what appears to be oversupply in the trucking market, resulting in idled units.
  • October research included:
    • Chemicals M&A – proliferation of deals signals corporate discomfort with current environment – expect more activity throughout the sector in the remainder of 2016, with ethylene a likely focus area in 2017
    • China Coal – location of industries (coastal versus inland) a key distinction as nominal rise in coastal pricing obscures elevated inventories at China’s inland mines
    • RPM – looking more attractive after recent dip – consolidator with stability offers safe spot from European weakness that has affected PPG
    • VSM and ASIX – valuations interesting as legacy investors dump these spin off stocks – VSM looks best given cash flows
    • Paint – heavy discounting pointing to elevated inventories, pricing challenges – SHW most at risk
    • Recommendations – inverse performance relationship between sell-side recommendations and stock performance evident in the Chemicals space
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW and DD posted some of the best results in our coverage and remain our longer-term favorites in the Chemical space and Industrials & Materials generally – the companies signaled optimism about closing the deal in Q1 ’17 – the outcome has a significant bearing on MON

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

Pre-announced negative guidance from HON and PPG early in the month (and from SHLM earlier in the quarter) proved portentous for most of the Industrials & Materials space – Q3 earnings reports have led to negative revisions in aggregate and several significant guide downs. Where positive surprises came in, the magnitude was far smaller than the aggressiveness with which some company estimates were cut. Currency movements were a factor but not wholly predictive – HON has a comparably low foreign sales exposure, but began the run of negative guidance with its pre-announcement. Overall it seems that the global economy disappointed even versus the ~2% growth widely expected, and absent a position in the sweet spot of a market (IR in HVAC) or sub-market (UTX in certain aero segments, DOW in packaging polymers), lower volumes weighed heavily on results. Exhibit 5 summarizes guidance changes for some of the larger cap stocks in our space, and one (WHR) which is outside our purview but has a read-through for several relevant consumer markets.

Exhibit 5

Source: Capital IQ, Company Filings, and SSR Analysis

Exhibit 6 summarizes Q3 earnings and revenues versus expectations. DOW and DD continue to take aggressive actions leading up to their merger close. DD posted an impressive EPS beat on a smaller revenue gain compared to DOW (as well as a smaller base EPS figure) – we would prefer DD in the scenario the merger is rejected or otherwise falls through, as there appear to be more value creating opportunities relative to DOW. Transports results have lagged, especially in the Rail space – UNP, WAB, TRN, and KSU. Both CAT and GE have pointed to idle locomotives, indicating the current struggles in rail transportation. CSX and NSC actually fared better in this group despite continuing declines in coal volumes. Metals results somewhat surprisingly disappointed, given the recent optimism around trade cases and improved pricing that has been reflected in stock valuations – earnings were mixed but guidance has generally been to the downside, driving particular and significant underperformance in ATI and CRS.

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance relative to the S&P is shown in Exhibit 7. Two of the larger cap Electrical Equipment stocks (EMR and AME) were down sharply on the month to drive the lagging result in that sector – neither had reported as of the end of October, but both traded down with the market early on and never recovered. The lone E&C stock to have reported Q3 – EME – boosted its sector with better than expected results on the top and bottom lines. Negative results at the aggregate sector level mask pockets of strength within sectors. Conglomerates show divergent results including and excluding GE, which was up after the BHI deal countering previous guidance related declines. In the Transports space, truckers ODFL and LSTR were among the best performers on the month, but were outweighed by Rail results (UNP most notably) We show the 25 best and worst performing stocks in our coverage in Appendix 1.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. Having updated our models through October to reflect most of another year of significantly sub-market multiples in the Metals space, the sector remains an inexpensive outlier, but less so than in prior months even after this month’s 3.5% underperformance. Negative earnings-related moves from HON and MMM have the Conglomerates looking less expensive this month – this group had previously been the expensive outlier.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 9 (see our skepticism work for more detail). At the extremes we continue to see Metals and Paper & Packaging discounting earnings declines, while Electrical Equipment and Transports are getting a valuation benefit beyond that which current earnings would imply.

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. All things being equal, you want to buy sectors in the top right corner and sell those in the bottom left. Coatings remains an outlier because of SHW – within the sector we are more positive on RPM and AXTA.

Exhibit 10

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.

For a second straight month, gains were as much a product of weakness on the short side as strength on the long side.

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 a list of 16 stocks that fall in these historically outperforming ranges – Exhibit 12. OLN looks far cheaper than it would if we adjust its capital base for the goodwill associated with the Dow deal and we remain negative on the stock despite its apparent discount – see recent research on the topic.

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.

The Q3 US GDP figure showed accelerating growth but the consumer portion underwhelmed. Business spending also remains subdued, underscored by recently weaker than expected core capex orders, but inventory builds and trade flows picked up the slack. China GDP, meanwhile, held eerily steady for a third consecutive quarter at a likely generous 6.7%. This consistency has brought the validity of reported Chinese statistics back into question, particularly given the size and scope of the figure and its underlying components.

With less than two weeks until US elections, the markets are notably demonstrating a preference for a potential President Clinton, though her seemingly strong case for office took another hit with the recent reopening of the FBI probe into her leaked emails. Both candidates have expressed interest in infrastructure projects that would be a welcome boost to US construction spending, which has plateaued in 2016 after several years of strong growth.

Exhibit 14

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

Commodity Pricing

The announced OPEC output agreement is getting bogged down by the actual mechanics of who will cut production, with conflict among the members and no consensus reached with other major producing nations including Russia. Brent traded above $50 before falling at month’s end as the output curb sputtered. Gas pricing continued to trend higher, settling above $3.00 to end a month for the first time since late 2014. Pricing moves for metals have been subdued over the past month – modest 3% gain in aluminum countered by 1% declines in copper and domestic steel – further pricing gains are possible if higher coal pricing induces lower Chinese output.

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

Exhibit 15

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

Exhibit 16

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 19

Source: Capital IQ, 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. The Electrical Equipment figure partly reflects Emerson’s divestiture of its Network Power business, but the overall growth in machinery is modest as demonstrated by the broader Capital Goods figure. Also note that the Metals result in Exhibit 20 is higher than the chart indicates and reflects a very low 2015 base.

Exhibit 20                                                                                 Exhibit 21

Source: Capital IQ and SSR Analysis

Revisions were most positive in the Paper & Packaging sector – higher estimates for IP, WRK, and PKG signal strength in paper packaging.

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions over the past month and Exhibit 24 plots these revisions versus performance results on the month. 2017 estimates saw bigger moves as 2016 winds down. The negative E&C revision for 2016 was entirely KBR, which had its forecast slashed by over 50%. In the Metals space, cuts were widespread, but focused particularly in CLF, X, CMC, and CRS. Small caps IIVI and GNRC contributed to the rare positive revisions in the Electrical Equipment sector.

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 October

October 24, 2016 – When is a Sell a Buy? When the Sell-Side Says So

October 17, 2016 – Paint Wars! Sending Negative Signals

October 17, 2016 – Chemicals Monthly: Bracing for a Likely Difficult Q4

October 14, 2016 – Versum and AdvanSix: Smaller Portions at Attractive Prices

October 10, 2016 – RPM: Not All Chemical Stocks Only Look Attractive When They Are Cheap

October 5, 2016 – China Coal: Not Out of the Petrified Forest Yet

October 3, 2016 – Chemical Deal Mania: When to Hold Them and When to Show Them

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. EMN has narrowly dropped from the dividend screen leaving four holdover companies from last month: CF, HUN, OLN, and PKG.

Exhibit 46

Source: Capital IQ and SSR Analysis

Recommendations

This month we include an exhibit showing the 10 stocks with the most bullish and bearish changes to recommendations – Exhibit 47. Research published this month showed an inverse relationship between recommendation and forward performance in the Chemicals space – the results hold generally in the Industrials sectors as well, with individual examples of varying adherence to this trend.

Exhibit 47

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2



Appendix 3


Appendix 3

©2016, 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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