Grossly Different – Gross Margin Trends Speak (Offset) Volumes

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

September 7th, 2012

Grossly Different Gross Margin Trends Speak (Offset) Volumes

  • The components of our Industrials and Basic Materials universe have very different gross margin (GM) trajectories and volatility. Some are appropriately priced into current valuation, some not – suggesting a long-term relative trade into Metals, Conglomerates and possibly Capital Goods and out of Paper and Chemicals.
  • Improving GMs are a sign of a more robust business model, with either sustained product differentiation or sustained and improving cost advantage – this is best demonstrated in the Electrical Equipment, Conglomerates and Transport sectors.
  • Paper is the only sector with a negative long-term trend to GM, and only Chemicals shows greater historical volatility.
  • Degree of volatility is generally a function of how much exposure an industry has to volatile raw materials and how commoditized a business is. Basic Materials are generally more volatile than Industrials, and have slower GM growth (Paper has a declining trend – see recent research).
  • Electrical Equipment and Cap Goods have seen the lowest historical volatility. Cap Goods looks interesting on the basis of both current valuation and the improving and less volatile GM picture.
  • Current valuation for the Paper sector suggests that investors are ignoring both the historic direction of GMs and the historic volatility. While more recent history for Paper looks better, Chemicals, E&C, Conglomerates, Metals and Packaging all had longer improving trends at some point in the last 30 years that looked like the beginning of something new, but turned out not to be.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Gross margin trajectories explain much of the positive earnings momentum that we have seen in Basic Materials and Industrials over the last few years despite a fairly lackluster volume environment. They also provide a basis for optimism looking through the next 18-24 months where we can be comfortable that the GM trend is not driven by movement in a product price or raw material that has had and is expected to have significant volatility. Companies and sectors growing earnings in a low growth environment without gross margin expansion are pulling on levers that have very limited range, given decades of cost cutting below the GM line, while those that have found the means to expand gross margins might have more success in sustaining the better earnings.

The cyclicality shown in the gross margin charts for Paper, Chemicals, Metals (Exhibit 2) is almost always driven by movements in raw material prices or product prices. What we are more focused on here is the trend rather than the cycle. Improving trends suggest better market structure; leading to more rational pricing, a shift in raw material costs relative to whoever or whatever sets pricing, greater product differentiation (again leading to pricing) and/or relative production innovation.

The other relevant point here is that we are more likely to see companies with flat or declining GM trends on the acquisition trail. If the only cost lever is below the GM line then economies of scale become the primary driver of strategy.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3 shows the aggregate data by sector that formed the basis of the charts in Exhibit 1. It also shows a couple of valuation metrics; the first being our discount from normal value analysis and the second a simple forward PE for the sector (market cap weighted).

Exhibit 3

Source: Capital IQ and SSR Analysis

The interesting take-aways from this table are best shown in a couple of scatter plots, where we look at GM trend growth and volatility against the two valuation metrics – Exhibits 4 and 5. Not surprisingly Paper is the big outlier on our “reversion to mean” based valuation, but it is also the outlier in the forward PE analysis. Note that the forward PE for Paper, even on a cap weighted basis, is biased by a very high forward PE for LPX. IP has a forward PE of around 11.5x which, while still a slight outlier, looks more reasonable. In
our recent piece on the Paper sector
we noted the significant degree of negative revisions that IP has experienced so far this year and there is a risk that the E in the forward PE is too high.

Exhibit 4

Overvalued

Undervalued

Source: Capital IQ and SSR Analysis

Exhibit 5

Undervalued

Overvalued

Source: Capital IQ and SSR Analysis

Sector Breakdowns

GM trends for Capital Goods and Chemicals are summarized in Exhibit 6. The increase in margins for the Capital Goods group over the last 30 years is not that significant – 300 basis points, but the trend is fairly robust. The industry had a static period from the mid 1990s to the middle of the past decade, and it could be argued that the sector is on a steeper curve today, but from a low point in 2001. However, you could have made the same claim in 1993 and it would have been wrong.

Chemicals has a GM trend that is almost flat and when you break it down by sub-sector, which we will do in coming research, there is tremendous variability and some sub sectors that have very negative trends. Diversified Chemicals would be the positive stand-out. Chemicals has greater volatility to its GM than any other sector, but it is few very significant swings rather than lots of cycles. The cycles mirror the “high crude low crude” periods and the recent data suggests little from the much discussed US natural gas advantage.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 shows the GM trends for Conglomerates and E&C. The Conglomerate analysis excludes GE which has a very irregular GM trend driven by the expansion of its finance business and some of the large acquisitions and divestments. The strong GM growth and limited volatility for Conglomerates suggest that the sector should command a valuation premium over the rest of the sector (ex-Electrical Equipment). Today it does not show that premium.

E&C is both low margin and volatile, though at least the margins have a longer term upward trend. One concern however is that margins peaked in 2006 and have shown no signs of recovering back to the trend line. With all of the energy, chemical and infrastructure investment predicted for the US in coming years we would expect to see margins recover and valuations are not out of line with the trend.

Exhibit 7

Source: Capital IQ and SSR Analysis

Electrical Equipment has the most impressive GM growth and the least volatility (Exhibit 8), with the spike and the dip in the late 1990s a function of a couple of transactions. The growth and the consistency help explain the premium multiple being paid for the sector today, but do not necessarily support much further upside.

The Metals sector has a great deal of volatility, as you would expect and the most recent downward leg in GMs is consistent with other swings historically. The sector is priced even more conservatively than it has been in other downturns, so unless you believe that the historic trend is highly unrepresentative of the future, the sector looks attractive.

Exhibit 8

Source: Capital IQ and SSR Analysis

We have discussed GM trends for Paper in
separate research this week
.

Packaging has an upward trend (Exhibit 9), but it could be argued that GMs peaked in the late 1990s and have been on the slide ever since. This is a sector that has seen a great deal of recent restructuring and consolidation; perhaps driven by the poor GM trend and a relatively low absolute GM. Volatility is not that extreme and valuation is attractive if the sector can get back to trend. If the last 15 years are the start of a different and negative trend, valuations are less compelling.

Exhibit 9

Source: Capital IQ and SSR Analysis

Last but not least – Transports (Exhibit 10). A strong upward trend over 30+ years, but a much stronger and more compelling trend from the late 1990s as the rail industry emerged from years of margin deterioration. This is a series of well structured sub-industries and the chart shows the effect of both pricing power and growth. The sector is in aggregate appropriately valued for both the growth rate and the consistency.

Exhibit 10

Source: Capital IQ and SSR Analysis

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