SSR Industrials & Materials Monthly Review, November 2015: Is It Deal Time?

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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

December 1st, 2015

SSR Industrials & Materials Monthly Review, November 2015: Is It Deal Time?

  • In a flat market, most of our sectors outperformed, led by E&C stocks (+6.6%) on generally strong earnings and positive (near-term) guidance for that group – 2016 revisions continue to come in to the downside
    • The two underperforming sectors, Transports and Paper & Packaging, have historically enjoyed seasonal headwinds in Q4
    • With one month remaining in 2015, only Electrical Equipment (+1.3%) and Conglomerates (+4.9%, mostly GE) are ahead of the S&P on the year
  • The buyout of Airgas (ARG) highlighted the environment of pervasively low industrial production growth
    • M&A talks have even spread to industries previously considered too consolidated for further moves – rails most recently, but seen also in metal can manufacturing earlier in the year
  • Forward estimates speak to the expectation that 2016 will be a year of headwinds for machinery and metals stocks
    • Transitioning growth in China from construction to consumer spending does not augur well for Capital Goods companies, and the corporate commentary on China turned universally negative in Q3 after a smattering of mixed to positive indications earlier in the year
  • In November we focused on the M&A active ag chemicals space, and also published pieces on Eastman (EMN) and positioning in the Metals sector
    • Our November 20 conference call drew on our prior work on Dow, DuPont and Ag Consolidation from the end of October, and also covered our later piece on Monsanto as news of the discussions evolved
  • Our preferences at the sector and stock level are shown in Exhibit 1
    • GE may continue its upward momentum but the stock is now looking slightly more than fairly valued – that it screens in the top 25 least attractive valuation names in Exhibit 2 speaks mainly to the fact that it is difficult to find expensive stocks in our universe at the moment

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

The M&A activity we are seeing, across the board but in Industrials & Materials in particular, speaks to the low growth environment and the limited levers available for companies after several years of right sizing their operations. The Airgas acquisition is a strategic move for Air Liquide but is reflective of the non-existent growth in the Industrial Gas business over the past few years. This is not specific to Industrial Gases. The demand slowdown associated with lower Chinese growth, in particular lower Chinese construction spending, is already presenting major headwinds for machinery and metal stocks.

Our industrial sectors (Capital Goods, Electrical Equipment, Conglomerates) are expected to suffer the most as the boom of Chinese construction spending gives way to a more consumer oriented economy. Forward estimates for the Capital Goods space show the least optimism of all sectors and the revision history is as negative as any outside of Metals. In our Chemicals monthly we showed the trend of sentiment and corporate commentary on China over the first three quarters of 2015, and we show the same summary for the major global Capital Goods companies in our coverages in Exhibits 5 and 6.

Exhibit 5

Source: Capital IQ, Company Presentations, and SSR Analysis

Exhibit 6

Source: Capital IQ, Company Presentations, and SSR Analysis

At the stock level, individual Metals stocks continue to see pressure – the worst performers in our group on the month represent a list of what have become the usual underperformers. X and FCX were each down 30% and CLF lost another 18%. The top performers in November were event driven. ARG led the way as Air Liquide’s buyout offer amounted to a 35% premium. In the rail space, Canadian Pacific’s offer for Norfolk Southern (NSC) was less public and will certainly be subject to intense regulatory scrutiny, but the target stock still gained 18%. Fellow Southeastern rails CSX (+5%) and KSU (+10%) gained in tandem, but UNP, operating west of the Mississippi and potentially facing a transcontinental rival, was among the biggest losers in November, down 6%. The 25 best and worst performers on the month are summarized in Appendix 1.

Sector performance relative to the S&P for the month is shown in Exhibit 7. Only the Paper & Packaging sector trailed the S&P in November, despite seasonal Q4 headwinds. Transports, another typical beneficiary of seasonality, was roughly flat to the market. Gains in the E&C space came as late reporting stocks posted solid earnings surprises, highlighted by KBR.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. E&C is marginally less attractive after a strong month. Similarly, the Chemicals sector looks closer to fair value after outperforming the S&P by 2.5% in November. The Conglomerates (with the exception of GE) and Transports continue to trend cheaper. The discount in Paper & Packaging appears marginally more attractive than the similar discount in Capital Goods given the possibility of an extended slowdown in construction markets in China (and Brazil) and the proportionally greater US exposure for the packaging players.

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). The move higher in E&C has brought valuation and returns more in line. Paper & Packaging and Metals are now the standout sectors. For the Metals sector the SI value is mostly driven by valuation – for Paper & Packaging it is an even split of over-earning and under-valued. See Exhibit 10 on the following page.

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. Valuations are discounting further weakness in Agricultural Chemicals, Capital Goods, and E&C. Commodity Chemicals reflects a dichotomy within the group – the discount is driven by OLN, AXLL, and HUN, the above trend returns are driven by LYB and DOW.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

The overlap of our traditional valuation and skepticism based portfolios produced cumulative monthly gains of 15.6% in 2013 and 9.8% in 2014, but we have noted the significant volatility associated with these results – Exhibit 12. These screens also have tended to include commodity exposed names that we would view as value traps given our thesis on secular Chinese oversupply (partially explaining 2015’s poor results).

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. 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 24 stocks that fall in these historically outperforming ranges – these are summarized in 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 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 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 emerging market narrative is transitioning. Growth is slowing significantly in Brazil on weak demand, a condition unlikely to be remedied by the Rio Summer Olympics next year. It is expected that third quarter Brazilian GDP will show a contraction, marking the first run of three successive negative growth quarters since at least 1996. China got its yuan a place in the IMF’s special drawing rights basket, but India is now growing faster (in Q3 at least).

Domestically, all eyes are on the Fed. The jobs market is making apparent progress but the actual rates are undoubtedly worse than the official statistics as labor force participation remains at a multi-decade low. Construction spending has been steadily on the rise but focused on commercial and multi-family construction, with plenty of slack left in single family homes. A modest rise in interest rates, and the indication that further hikes are coming, could actually spur investment decisions, which would be a needed boon to a US manufacturing sector that just fell into contraction levels.

Exhibit 14

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

Commodity Pricing

Metal pricing remains subject to volatile swings – Copper was down 12% on the month. Aluminum held in best with a 2% gain in November while Steel pricing was off 2%. Natural gas closed the month just about $2.00 per mmbtu, at a level not seen since March of 2012 – inventories are plentiful and heating demand is tepid given the mild fall weather. Crude oil supply continues to outstrip demand and Brent ended November below $45 per barrel – the last time prices were this low was December 2004.

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. 2016 is expected to be a year of headwinds for machinery and metal stocks. Much of the apparent net income decline for the Conglomerates is a result of GE’s divested businesses.

Exhibit 20                                                                                                      Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows the change to 2016 net income estimates over the month. Only the Conglomerates avoided some level of downward revision to forward estimates. E&C stocks saw positive revisions to 2015 estimates, but revisions came in negative for ’16. Estimates for Paper & Packaging stocks, collectively the worst performers on the month, were better insulated than most.

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows EPS revisions over November for both this year and next (calendar year 2015 and 2016). Though the calendar year is fast closing, we still saw some significant revisions to 2015 estimates over the past month – notably positive for E&C, notably negative for Chemicals. KBR was the main beneficiary in E&C (+13%) but estimates for FLR and ACM were also marginally higher. The Chemicals figure excludes a 75% cut to AXLL’s 2015 EPS estimate, and even excluding that company’s 32% cut to 2016 estimates, the Chemicals sector saw negative revisions equal in overall magnitude to Metals and Capital Goods. The 2016 Metals figure does not account for the fact that US Steel was expected to post a $0.50 gain in 2016 as of the end of October, and is not expected to take an $0.80 loss. November performance showed a better correlation with 2015 EPS revisions than with ’16 revisions – Exhibit 24.

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 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 November

November 6, 2015 – Eastman: Time to Change the Messaging (and Possibly the Strategy)

November 12, 2015 – Metals: If You Must

November 15, 2015 – Chemicals Monthly: China on the Ropes, Europe on the Mend

November 17, 2015 – Monsanto: Left Out in the Cold? (blog)

November 20, 2015 – Dow, DuPont, and Consolidation in Ag Chemicals (conference call, replay available)

November 22, 2015 – Industrials & Materials Small-Mid Cap Rankings

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. The same four stocks appears on all three lists as last month: BGC, HUN, OLN, and PKG.

Exhibit 46

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2



Appendix 3


Appendix 3

©2015, 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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