Only Select Opportunities in Industrials and Materials in 2016

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 4th, 2016

Only Select Opportunities in Industrials and Materials in 2016

  • We believe that 2016 is going to be a tough year to make money in the Industrials and Materials sectors
    • While inexpensive, the group is not cheap enough to buy and wait – even metals yet in our view, with the exception of aluminum – AA
    • Many of the cyclical and secular pressures which emerged in 2015 will extend into 2016
  • Most commodities are in serious oversupply and pricing and profitability sits close to historic lows
    • We think that the current strength in polyethylene is not supported by high enough operating rates and is tenuous at best – WLK, LYB – see recent research
    • Metals excluding aluminum look likely to be in oversupply for years and some chemicals; TiO2, PVC, polyester and caustic soda are in worse shape than metals – OLN
    • Levered names like TROX, CC, HUN, X and AXLL are beginning to trade like options – AXLL is a possible acquisition target – the others are not in our view
  • In these oversupplied areas, cheap stocks could get cheaper still as the metals group has now proved for 4 years
    • Cheaper materials in China could bring fresh pressure in some capital goods areas as China ramps up production further against a backdrop of disappointing domestic growth
  • Best 2015 performers were US centric or acquisition targets – we think 2016 will be a repeat
    • Transports and Paper and Packaging look more interesting as sector bets, as does coatings, though we have a distinct preference for PPG here
    • The consolidation in Ag will likely continue, though DD/DOW have the obvious first mover advantage here and remain our best relative idea for 2016
  • M&A will likely dominate the headlines in 2016 and we would not be surprised to see more mergers like the DOW/DD deal, given the risks of paying up in cash and the need to find other earnings growth levers in a stagnant global market
    • On our favorite list, we think that the DOW/DD, SWK, PPG and GE stories work absent further M&A, but could see everyone else on the list possibly involved in some way
    • We expect creative deals like RMT’s or mergers of equals given the uncertainty in the market and risks associated with paying premiums

Exhibit 1

Source: SSR Analysis

Overview

The Industrials and Materials groups have now mostly underperformed for the last couple of years, but it is entirely because of fundamental challenges rather than the strength of the rest of the market, and we struggle to see how these challenges do not continue into 2016, and possibly beyond – this is a sector issue and not a market issue. The S&P multiple is not low by historical standards – Exhibit 2, but it is nowhere near a peak either. Our tentativeness with regard to the groups is that relative valuation is not that attractive Exhibit 3 – with the exception of the metals space, which has been and will likely continue to be a value trap – so you are not yet being paid to wait in any sub-sector and in very few individual stocks. We would generally want to see discounts well above one standard deviation to think about recommending a cyclical sector on valuation alone. We have no group in that range today, even at the subgroup level outside metals, which has screened attractive for almost 4 years and underperformed in each of those years.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Where valuations are very attractive is where there is real risk, mostly in commodities where there appears to be a vast global oversupply and where lower export pricing from China (mainly) is creating cash flow issues for most producers.

The list is long, but is dominated by steel, copper, aluminum, PVC, caustic soda, TiO2, polyester and its raw materials, and where China continues to build and has slowing domestic demand we may add other materials and perhaps categories of finished products during 2016. The US has benefitted from a relative energy advantage, but that has eroded in 2015, initially by a collapse in coal prices in China and more recently by oils latest decline. The debt market is throwing up real red flags in steel and TiO2. In Exhibit 4 we show the cheapest stocks in our coverage today – the columns in Red are for companies impacted by significant global commodity surpluses – the others probably warrant further work, and EMN, PKG and BGC are companies that we believe have upside in 2016. Note that we do not have “normal value” models for CC and TROX because of their short trading history.

Exhibit 4

Source: Capital IQ, SSR Analysis

It is important to distinguish between what is cyclical and what is secular at this point. Past commodity overhangs have never been solved by broad industry closures, despite hope and in many cases compelling economics to support closures. Bankruptcies have often left facilities running, and emergences from bankruptcy, with restructured balance sheets, have generally resulted in better costs structures and further cost curve flattening for the industry concerned.
We generally get bailed out of cyclical lows by a period of limited investment and better demand growth. While have seen investment slow, which is good, it has not slowed enough, because borrowing rates are so low. Demand growth has been dismal globally despite aggressive stimulus in the major economies. The result is what we see in Exhibit 5: many commodities where operating rates are close to historic lows and where one or two years of good demand growth is not going to make much difference to the picture. China is surplus in all but polyethylene, copper and iron ore, but is the swing consumer of each. While aluminum has seen a material slowdown in capacity additions, polyethylene has a major wave of additions to come over the next three years. This chart clearly supports our continued belief that aluminum is the commodity that the world runs short of first, and that nothing else is even close.

Exhibit 5

Source: Capital IQ, SSR Analysis

All of these are cyclical issues – and we are just dealing with a longer anticipated down cycle in most than we have seen in the past. Market forces will win as they always do – poor profitability will curtail construction, force closures and eventually demand will catch up. We likely have a repeat of the early 1980s here – 4-5 years of misery!

What is secular, or at least likely to be secular, is the China oversupply and its current and expected repercussions. Abundant and lower priced raw materials in China will make the country even more competitive in finished goods that consume these raw materials – machinery, autos, auto and aircraft parts, etc. The country will become even more competitive in products it already dominates, such as consumer durables and clothing. As China has flipped from being a net importer to a net exporter of many of these commodities, there has been a step down in global pricing – in our view permanent. Slower growth in China means that these surplus appear more quickly and grow rapidly.

To get a rebound in commodity profitability in 2016 we need a couple of things to happen – much stronger than expected consumption growth (this could benefit all regions) and/or a quick rebound in oil (which would benefit North America). Today we would not bet on either and to a degree we see this view reflected in expectations – with revisions very negative – Exhibit 6 – and expectations for 2016 quite low in several sectors relative to the recent past – Exhibit 7.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Note that in the right hand chart in Exhibit 6 a high Skepticism index is an indication that the stock price is discounting a further decline in forward estimates – i.e. the investment community has no faith in forward numbers – even in the already discounted metals space. Simply based on that chart, it is only really GE where valuation is anticipating upside surprises today.

So what to do?

We sense that the aggregate level of “hope” is low at the corporate level also – oversupply leads to limited capital investment opportunities and limited growth means that existing capital installed does not really get the benefit of operating leverage – nowhere is this more evident than in Industrial Gases. “Wait and buyback stock” has been a strategy for many, but we think, that facing a third year of relative stagnation, more companies will go down the M&A route in 2016. We have seen a great deal of M&A in 2015, but we expect to see even more in 2016.

The best performing stocks in 2015 were those that were acquired, not surprisingly, or those actively restructuring – such as GE and DOW. The DOW/DD deal adds more complexity to how to frame 2016. Neither company was going to get acquired for a premium because of their respective sizes and because neither was particularly cheap. The merger, if executed well, could drive meaningful EPS and cash flow growth from synergies and better cost alignment. This is a route for others, though the DOW/DD deal benefitted from near equal market value, making the “merger of equals” approach easier.

Ideally, in 2016 we would like to pick those few companies that are going to get acquired for a premium, but absent that we look for companies with more than a hope of growth or a hope of oil price increases to drive upside. Dow and DuPont are the best of the bunch in the large cap space in our view, particularly given that we are likely at the bottom, or close to the bottom, of an Ag cycle. GE will likely remain a relative safe haven and we like the steady improvements at SWK.

At the sector and sub-sector level we don’t really like anything except packaging (if oil stays low) possibly Transports because of the US focus, and coatings, but probably only through PPG, given the high valuations elsewhere. We see most risk in those commodities with the most perceived surplus and pricing weakness and if you have to be exposed to one it should be aluminum – through Alcoa – as we believe that supply and demand will come into balance quickly here. As indicated in recent research, we think the current global tightness in polyethylene is fragile and likely temporary.

Absent some sort of global economic rebound, it is possible that both the Industrials and Materials groups underperform again in 2016. Please refer to our January Monthly Report – also published today – for more data on sector valuation, revisions, skepticism and fundamentals.

The Controversies of 2015 and How We Feel About them For 2016

Several things caught us off-guard in 2015 in the Industrials and Materials sectors and we run through these and give suggestions on how to think about them in 2016

  1. Slower Global Growth – Despite Stimulus

Demand surprised on the downside in most industries in 2015 and while the global economy was not string going into 2015, there was an expectation that low rates and an abundance of liquidity would help much more than it did. China and Brazil were major contributors to the global weakness, but Europe remains disappointing and growth in the US was still lower than lower rates and lower energy might have generated – showing just how big a part of the growth story in the US energy itself had become.

Consumer spending has not reacted to lower rates and lower gasoline pricing as expected, although China would be in much worse shape were it not for the consumer.

It is not clear to us what could change here on the positive side. Rates cannot really get any lower in the economies that matter, and the oil based windfall is likely done, given that oil prices cannot fall another $30-40 per barrel.

If you believe that demand growth will remain weak then these are the wrong sectors to invest in for 2016 – stagnation leads to price and margin erosion. The focus should be on very US centric companies focused on very US centric businesses.

  1. Energy Price Decline

The oil price decline was a surprise, but the China coal price decline has probably been more destructive. Lower China coal prices have dropped the cost of China electricity, chemical, steel, aluminum and many other products with a direct response in international pricing. Cost curves have flattened in every industry as a consequence and the benefit afforded to North America because of cheap natural gas has eroded. The 2015 fate of companies like CC, TROX, AXLL, OLN, HUN, X, STLD and CLF reflect this collapsing cost curve and China surplus issue.

If oil prices stay low we think that the pressure remains on all sectors relying on a US cost advantage and we see the greatest valuation vulnerability in the global ethylene/polyethylene chain where margins are most inflated relative to costs. Estimates for 2016 for LYB, WLK and DOW reflect the expectation of lower margins, but not a collapse to levels that are more reflective of current marginal costs. The other risks are most pronounced in the sectors and stocks that already appear cheap as the hope of higher pricing in 2016 will likely recede and a repeat of 2015 cash flows could be problematic for many – including CC, TROX, X and others. We think expectations are most inflated for OLN, which remains our favorite underweight.

If oil rises the ethylene, ammonia, urea, methanol and other direct natural gas consumers in the US will benefit but don’t see much hope for the metals, TiO2 or PVC/caustic players.

  1. The Weakness in Agriculture

Few expected 2015 to be strong for Ag, but most overestimated the decline, compounded by the currency and economic issues in Brazil. In part the seed companies have been victims of their own success – higher yields and more robust plants have resulted in high levels of production and surpluses, which have depressed prices and farm income. 2015 was a bad year for seed and chemical demand and it is unclear whether 2016 will be any better. The lower farm income levels impacted equipment demand, and here again the strength of the US dollar was an added headwind for DE and AGCO.

Valuations in the space reflect little expectation that 2016 will be much better, particularly for the equipment players, and the chemical and seed sector values would be much lower were it not for the M&A activity. We like the DOW/DD deal and see the synergy potential much more important than the level of organic growth at the portfolio level for the next 2-3 years. We think more M&A will follow, but see MON either missing out of overpaying so would stay clear.

  1. M&A

M&A activity was higher than expected in 2015 – culminating with the DOW/DD announcement and more active in the Chemical sector than in others. Outside coatings and industrial gases, the chemical space remains very fragmented and we would not be surprised to see plenty more deals in 2016.

Overall we struggle to see too many companies paying up, particularly for cash, given the economic and energy backdrop. Dow’s RMT deal with Olin and the merger of equals with DuPont look like structures that others will likely explore. We would expect the Capital Good sector to see heightened activity in 2016 because expectations are very low from a growth perspective – mostly negative – and competitive pressures from China (now) and possibly India (later) are mounting. The Electrical Equipment space has many of the same problems.

Playing this expectation is difficult as the market is likely to punish any company that pays up with this economic backdrop. Companies with managements that would likely be willing sellers tend to be those with very low valuations today and selling at a premium to current prices would mean selling below where valuations were 6-12 months ago; a hard pill to swallow. The more obvious take out targets in each sector are shown in Exhibit 8 and some off the wall merger ideas are shown in Exhibit 9. Exhibit 10 shows the upside of getting lucky by owning a take-out target. Note that the buyout offer from SIAL came in late 2014 and we show the return from that date.

Exhibit 8

Exhibit 9

Exhibit 10

Source: Capital IQ, SSR Analysis

©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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