Industrials and Materials – Expectations Challenging the Fundamental Signals

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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

February 10th, 2016

Industrials and Materials – Expectations Challenging the Fundamental Signals

  • Despite January’s significant negative revisions to 2016 EPS estimates, we are concerned that expectations have not fallen far enough for the Industrials and Materials sector (we have in fact seen estimates come down incrementally over the course of our work on this piece)
    • We saw a similar pattern last year when January 2015 estimates were revised downward to an average of 10% growth – actual EPS for 2015 came in flat or negative
    • Currently, EPS estimates imply an average of 5% growth for 2016 at the sector level, an improvement from 2015’s growth, despite a weakening macro backdrop
  • We prefer companies that combine low earnings expectations and supportive valuations based on our normalized framework
    • Low expectations suggest less vulnerability for earnings estimate cuts
    • Low valuations based on normal earnings suggest lower chance of multiple contraction
  • EMN stands out as a company with low expectations with upside valuation potential
    • Valuation discount not influenced by recession or commodity surplus fears as in other inexpensive stocks, but rather by the company’s inability to clearly communicate key business drivers or demonstrate the value of its specialties businesses
    • Unlike other economically sensitive companies, upside potential is almost entirely in EMN’s hands
  • Conversely, we would avoid those stocks with high valuations driven by high expectations
    • SHW may meet high estimates but we continue to prefer PPG in the Coatings space for valuation and diversification
    • Likewise SNA may achieve the 11% EPS growth implied in estimates but is pricing in perfection – recent negative performance post-earnings highlights the stock’s vulnerability

Exhibit 1

Source: Capital IQ and SSR Analysis

Revisions in January ’16 Similar to a Year Ago

With reporting season in full force by the end of January, earnings expectations began to be reset downwards as companies disclosed fourth quarter results and offered guidance for 2016. One takeaway was that the earnings revision pattern mirrored the results seen last year – slightly less negative in Capital Goods, Chemicals and Metals, slightly more negative in Electrical Equipment, Paper/Packaging, and Transports – Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

Implied EPS Growth from Estimates Still Positive

Despite the cuts, 2016 earnings estimates are still implying growth of 5-10% in most sectors. While the implied growth is more moderate than we saw a year ago, expectations still may not be conservative enough, even for Capital Goods which has negative growth expected but perhaps not negative enough if the general industrial overbuild in China is as bad as is feared – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Bloomberg, ISM, and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Limited Top Line Growth Suggests Cost Measures Needed to Meet Growth

With revenue estimates outside of the Conglomerates showing minimal topline growth (Exhibit 6, left chart), it will need to be a year of tight cost focus – possible but not sustainable. Furthermore, if 2016 estimates see a similar progression as in 2015 (Exhibit 6, right chart) companies will be hard pressed to cut their way to 5% growth while dealing within a declining top line for the second year in a row – despite lower energy inputs.

Exhibit 6

Source: Capital IQ and SSR Analysis

Normal Earnings Highlight Inexpensive Stocks with Reasonable Estimates

In the context of this environment we would look for stocks where the risk of negative revisions is already embedded in current valuations, using our normal earnings framework as a guide. The table below lists the cross section of stocks that are at least one standard deviation cheap on our normalized earnings framework and also have earnings estimates that are at or below current “normal” earnings as suggested by return on capital trends. We flag those stocks where commodity exposure is a drag on valuation as well as those domestic focused companies that appear to be pricing in the risk of a US recession. We also highlight companies with plus-market dividends that we believe to be sustainable and balance sheets that provide flexibility.

We comment on our preferred stocks in the table (highlighted in gray) and will look to publish pieces on each individually.

Exhibit 7

Source: Capital IQ and SSR Analysis

AA has seen some strong positive momentum recently, and we still believe the stock could double from current prices below $8 per share. Alcoa continues to win large contracts from major aerospace firms, speaking to the company’s offering but also to the continued trend of increasing aluminum components in aircraft. This business remains weighed down by the commodity aluminum business, which itself is likely undervalued in the current structure. This is the only Metals stock on the list that we can currently get positive on as we think the combination of (relatively) strong aluminum demand growth and the value likely to be realized from the pending split makes for a compelling investment.

Exhibit 8


Source: Capital IQ and SSR Analysis

EMN is highly diversified from an end market perspective, making the prospect of a recession less relevant in explaining the stock’s valuation discount. While there may be some risk to 2016 estimates we do not believe that the risk is more than 25% in the very worst case and with the stock trading at only 11 times this worst case number we see a very attractive entry point. The company does have a very high debt load and quite a bit of debt maturing in 2016 and 2017, but has very strong cash flows.

Exhibit 9


Source: Capital IQ and SSR Analysis

IP has greatly reduced the volatility of its earnings over the past half-decade – Exhibit 10 – but is being valued at a lower multiple versus the market than at any point during the last 45 years (excluding ’08-’09) – Exhibit 11. The reduced volatility is the result of a concentrated portfolio shift away from its legacy freesheet business and towards a variety of paper-based packaging applications. The stock is yielding more than 5% at current levels and cash flows are strong enough to support the dividend.

Exhibit 10


Source: Capital IQ and SSR Analysis

Exhibit 11


Source: Capital IQ and SSR Analysis

KSU faces some near-term challenges in 1H but the stock has been easily the best performing rail in 2016 year to date, suggesting that investors are looking beyond the short term headwinds to the major thematic tailwinds that should bolster the company in 2017 and beyond: energy and autos in Mexico, chemicals and crude in the Gulf Coast. More immediately, two of the rail’s main auto customers in Mexico are retooling their factories in the first half of 2016, which will put a crimp on what has been a key source of growth for the company. Coal remains a concern – while this is a proportionally smaller portion of KSU’s revenues than for other Class I US Rails, there is a greater degree of customer concentration, not surprising given the company’s topline is roughly 25% that of its peers.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13


Source: Capital IQ and SSR Analysis

PKG has become a GDP play – it is clear at this point that the company requires an economic tailwind to see meaningful upside. That said, the extreme valuation discount in the stock makes it one of the most levered to a possible upside surprise in the US. The company’s cash flows remain strong and with its balance sheet in good shape it is reasonable to expect to see resumed deal activity as synergies from the Boise deal have now been nearly maximized.

Exhibit 14


Source: Capital IQ and SSR Analysis

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