Commodity Rally Rolls On, Does Not Extend to Ag -SSR Industrials & Materials Monthly Review, March 2016:

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 1st, 2016

SSR Industrials & Materials Monthly Review, March 2016:

Commodity Rally Rolls On, Does Not Extend to Ag

  • As the recent rally in energy and metals pricing has continued, Industrials & Materials stocks have continued to outperform
    • Only four stocks in our coverage saw a negative return in March and 75% outperformed the market
  • The broad based commodity rally has not extended to the agricultural markets, where weakness continues
    • Estimates for US corn acres planted in 2016 came in significantly above initial estimates (93.6 million versus previous estimate of 88 million)
    • Small cap maker of agricultural irrigation equipment Lindsay Corp (LNN) sounded a cautious note in its earnings release towards months’ end, and DE and AGCO traded down in tandem
    • Three of the four negative returning stocks in March have ag exposure – MON, DE, CF
  • Subsector performance was universally positive in March, and through Q1 only the Paper & Packaging group has trailed the S&P
    • Metals led the way, both on the month and one quarter into 2016, though given our view on Chinese overexpansion in industrial/construction markets, we believe any strength is more likely to be met with renewed selling rather than a yearlong continuation
    • Despite general weakness in the sector, our Paper & Packaging picks from earlier in the year have performed better than the sector overall through Q1 and are on average 4% above the market, led by UFS (+17%), OI (+17%) and IP (+6%)
  • Valuation discounts diminished accordingly
    • Conglomerates have had the best revisions picture of late and show the most forward optimism in estimates, and the group as been bid up recently – this is currently the most expensive sector in our coverage, and the only one with a significant premium
  • March research included:
    • Our view on coming weakness in ethylene markets and the implications for exposed stocks
    • An accompanying piece on the danger of LYB’s current strategy in the face of this downturn
    • Continued coverage of DowDuPont – trough earnings analysis highlights compelling risk/reward
    • An overview of opportunities for Monsanto
    • And a thematic piece on the need for corporate proactivity in general and consolidation in specific – SHW/VAL deal seems to confirm this mentality

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

Volatility was pronounced in the first quarter of 2016. The broad market has recovered from the sell-off early in the year but finished Q1 little changed from the end of 2015. Energy pricing continued to trend down but reversed course in mid-February. Through the noise, it appears little has changed fundamentally. Industrial production remains challenged by lackluster demand, both domestically and globally, and there are no quick fixes for the troubles facing emerging markets. US rail traffic remains negative year over year, and the previously positive change in the second derivate (change in the change) has turned negative. Consumer and construction spending show steady gains but a broad based economic surge continues to be elusive.

This recurring pattern of volatility and uncertainty highlights the need to take action. Internal strategy adjustments and complexity reduction can help but the trend in the market seems to be towards consolidation via M&A. The recent uptick in M&A spend in Exhibit 5 does not include the DowDuPont deal, Air Liquide’s acquisition of Airgas, or the pending SHW-VAL deal. We expect further deals to be announced – WLK/AXLL is one proposed deal that we think makes sense.

Exhibit 5

Source: Capital IQ and SSR Analysis

Industrial & Materials sectors have in large part rode the recent commodity surge to outperformance – Exhibit 6 shows year to date performance at the sector level. Much of this positive performance came over the past month. Only four stocks in our coverage posted a negative absolute return over March – three of them were ag related (CF, DE, and MON) and the fourth (IIVI) mostly took a rest after being among the best performers year to date (+17% versus the S&P). AGCO did not fare much better, posting a small absolute gain in a market that gained 6.6% on the month, and MOS was also among the 10 worst performers in our coverage, reiterating the theme of agricultural weakness. The big winners, both on the month and year to date have been former laggards – shares of US Steel for instance have more than doubled since the start of the year. CLF, FCX, NEM, ATI and AXLL are next on the list of top performers in Q1. Much of the positive sentiment in the Metals space and commodity exposed machinery stocks is the result of pricing gains that may prove to be short lived. We show the 25 best and worst performing stocks in our coverage on the month, and in Q1, in Appendix 1.

Exhibit 6

Source: US Census Bureau and SSR Analysis

Sector performance relative to the S&P for the month is shown in Exhibit 7. No sector was left behind, and Metals led the way, particularly steel exposed stocks as prices rose significantly. Conglomerates have been strong recently but the group ran out of momentum a bit in March. Transports were held back by rail stocks – US rail traffic took a downturn after a promising start to the year.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. GE is not yet materially expensive despite a recent rally, and without the mega cap the Conglomerates look significantly more expensive. The largest contributor to this result is HON – the stock is just off of its all-time high and screens with the highest premium in our coverage. Despite broadly rallying over the past month and a half, Paper & Packaging stocks remain the most inexpensive outside of the Metals space – PKG is the second cheapest stock in our entire universe, and IP is within the top 15 most attractive.

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). With valuations rising across the board and return estimates little changed, SI values moderated at the high end (Metals, Paper & Packaing) and grew more extreme at the low end (Electrical Equipment).

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. Most of our groups are currently concentrated around the blue dotted line, where valuation and returns are aligned (skepticism index of 0). Paper & Packaging and Metals have been the positive outliers, but have moved closer to equalization over the past month. Electrical Equipment, on the other hand, has moved towards the concern quadrant – stocks have gained without any material improvement in forward estimates, and there is a long way down for valuations to align with the current level of under-earning.

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. The commodity rally that began in February continued in March and lifted these stocks again, driving our portfolios to another month of solid performance. The short side stocks have not been a major help, but have also not moved against us, suggesting some are running out of momentum.

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 9 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 12. The negative revisions picture continues to trim this list, which numbered as many as 25 stocks in late 2015.

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.

Despite the volatile start to the year, there is little change to the status quo of recent years. Europe seeks stimulus to little effect. Emerging markets, China in particular, struggle with growing pains. The US chugs along, with an uneven recovery unable to break 3% GDP growth. Sensing the fragility of sentiment, the US Federal Reserve cut the number of targeted rate increases for 2016 to two from four in what appears to be mostly a palliative measure. The ECB is moving in the opposite direction with fresh stimulus, hoping to break a cycle of virtually zero growth. For the emerging markets, the problems are as much political as they are economic in the case of Brazil. The general impression seems to be that despite the shock of a presidential impeachment, the Brazilian economy would benefit from a change.

Exhibit 14 summarizes the most recent change in the global economic data.

Exhibit 14

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

Commodity Pricing

Metal pricing was volatile and mixed in March – steel up sharply (~20%) and aluminum down (-7%). Copper rallied 3% and is looking to pivot off recent lows. On the energy side, both oil and gas continued to rebound off the lows of mid-February. The gain in crude outpaced the gain in natural pricing – these rallies come even as supplies remain ample and demand constrained.

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

Exhibit 15

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

Exhibit 16

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Exhibit 17

Source: Capital IQ, SSR Analysis

Exhibit 18

Source: Capital IQ, Bloomberg, SSR Analysis

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. With full results for 2015 in, we now compare actual results in ’15 versus estimates for 2017. The Metals result extends well above the top range of the chart, due to the extraordinarily low base in 2015 (several steel related companies posted losses – FCX, ATI, X, CLF). Estimates for the machinery sectors show little improvement over the next two years. The picture is modestly more optimistic for Chemicals, Transports and Paper & Packaging. E&C benefits also from a low base but we have seen the optimism reflected in these exhibits fade consistently over the years as estimates get taken down – symptomatic perhaps of a broader dearth of engineering talent. The Conglomerates show solid forward growth with or without GE, another factor potentially boosting these stocks of late. The scatter in Exhibit 23 shows a reasonable trend in the expected direction – sectors with more optimism embedded in their estimates show generally lower skepticism values (higher optimism).

Exhibit 20 Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows the change to these longer-term net income estimates over the month. The Metals results have historically exhibited great volatility, and the uptick in March likely resulted from the surge in steel pricing – in reality there is still much uncertainty here. The Paper & Packaging results are mainly driven by IP (+1%).

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions during February and Exhibit 24 plots these revisions versus performance results on the month. The figures in Exhibit 25 are a simple average of companies in each sector, resulting in slightly different results from the cap-weighted figures shown in Exhibit 4. On either basis, revisions were modest in March with earnings season adjustments mostly accounted for. Capital Goods’ 0.3% gain is influenced by a 21% positive revision for JOY, partly reflecting incremental optimism for mining given the commodity bounce. Likewise the negative Transports result is a function of HTZ (-8%).

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 March

March 29, 2016: Lyondell – Over-Optimistic on Ethylene Means Over-Aggressive on Cash Return

March 29, 2016: Ethylene – Rewind to the ’90s

March 21, 2016: SSR Industrials & Materials Small-Mid Cap Rankings, March 2016

March 17, 2016: Chemicals Monthly – Commodity Rally Likely Unsustainable

March 14, 2016: Monsanto – A Round-Up of Opportunities

March 6, 2016: Enter BASF! – Spoiler or Another Consolidator? We Think the Latter More Likely

March 4, 2016: “Can We Talk” – Action Is Imperative… and an Opportunity

March 2, 2016: DowDuPont Trough Earnings – Risk/Reward Stacked to the Upside

March 1, 2016: Positive Performance with Commodity Relief Rally – SSR Industrials & Materials Monthly Review

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. After joining the green highlighted overlap group last month, BGC has fallen off the valuation screen after a strong month of performance. The four holdovers remaining from last month: HUN, IP, OLN, and PKG.

Exhibit 46

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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