Inventory/Sales – Follow Up

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley

203.901.1629

graham@ssrllc.com

June 5, 2012

Inventory/Sales – Follow Up

  • We respond to questions following our piece last week and conclude that our analysis is broadly supported by Bureau of Economic Analysis (BEA) data. BEA data also shows that the Manufacturing Inventory to Sales ratio in the US is at a 25 year high.
  • BEA data shows inventory moving from consumers to manufacturers over time. This makes sense as consumers improve “just in time” inventory management and this may explain much of the manufacturing increase – however, we see scope to reduce manufacturing inventories, as we are above trend today.
  • Lower manufacturing activity in the US over the March/April period has likely driven an inventory correction in Q2 2012. This will result in some negative surprises for the quarter as companies cut operating rates to manage inventory. We would expect revised guidance from some companies as May numbers are finalized.
  • All of the sectors we cover except Metals and Mining look overvalued on a relative basis ahead of any potential inventory correction and the impact that it will have on margins and operating rates. Most exposed are Chemicals, Electrical Equipment and Paper. Capital Goods underperformed meaningfully in May, but still has some downside.

Exhibit 1

Source: BEA and SSR Analysis

Overview

Our
most recent call
highlighted the Inventory/Sales ratio for the companies comprising our covered sectors. Our analysis showed this measure to be at a 25 year high – Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

As a reminder, this is a bottom up I/S ratio for the 130 companies in our coverage. The ratio for each company was market cap weighted and the ratios were then aggregated.

Our analysis was based on annual data through 2011. An analysis of quarterly data confirmed that a correction had not occurred in the first quarter of 2012; Inventory/Sales showed a 70 basis point increase from Q1 2011 to Q1 2012.

Government Data – BEA

In response to several questions that we received after publishing the research, we compared our data to government (BEA) data to identify any possible discrepancies.

We did not expect an exact match for two reasons:

  1. Our data is firm specific and will therefore include global inventories and sales – the BEA data is national in scope and should reflect only US inventories and sales
  2. Our sample set of 130 companies is far from exhaustive – the BEA numbers certainly reflect a larger sample

The overall BEA data shows no marked increase in I/S but when broken down by segment, there is a clear rise in Manufacturing – Exhibit 3.

Exhibit 3

Source: BEA and SSR Analysis

The BEA only posts annual data back to 1997, but has a much longer history of quarterly data. As a sanity check on the longer time frame of our initial data we took a rolling 4 quarter set of the quarterly BEA data from 1989 – Exhibit 4 below.

Note the similarities to our sub-group chart from Exhibit 2.

Exhibit 4

Source: BEA and SSR Analysis

The second chart in Exhibit 3 clearly shows the impact of customer “just in time” inventory management with an increase at the manufacturing level as inventories have declined at the merchant and retail level. However, looking at the broader and longer-term data in Exhibit 1, we are currently above trend on an overall basis and well above the recent average for manufacturing.

The anecdotal evidence in the market is that inventories increased further in March and April as demand slowed and that demand remains weak and is expected to weaken further.

Sector by Sector

On a sector by sector basis, the increase in the inventory ratio over the last three years is most pronounced in Capital Goods, but Chemicals and Metals are higher as well. The analysis does not apply to E&C firms, whose inventories are negligible.

From a quarterly perspective, the significant positive swings Q1 2012 versus Q1 2011 are Capital Goods, Conglomerates, Paper and Metals. Electrical Equipment is up marginally, Chemicals is flat and Packaging is down slightly.

The quarterly data is summarized in Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Note that the ratios are higher here because we are using quarterly sales as a denominator. Quarterly sales give us the most meaningful quarter to quarter comparison. There are issues with trying to create annualized numbers from Q1 because of seasonality in some sub-industries. Additionally, deals completed in 2011 make annual sales or trailing 12 months problematic for quarterly comparisons.

Chemicals

In our analysis, the chemicals increase was all in 2008 and the ratio has been declining slowly since then. The BEA data is consistent with this and it is summarized in the chart below – Exhibit 6. Our data does not show such a sharp decline in 2010 and 2011, but we have a small sub-set in that we do not have the oil company data. Our subset does show the same level of peak in 1999-2001. BEA is essentially flat Q1 2012 versus Q1 2011. Our data confirms the same story. Anecdotally IHS is reporting that US polypropylene inventories rose 300 million pounds in March and April. This is around 4.5% of annual demand – for perspective, to correct that increase the industry would have to run at 50% of capacity for a month.

Exhibit 6

Source: Capital IQ and SSR Analysis

Capital Goods

In Exhibits 7 and 8 we show the BEA Machinery index and our own Capital Goods Index. These are not directly comparable as the Capital Goods companies make more than just machinery and there are companies outside our index making machinery in the US. However, they show the same upward swing in 2009 and overall upward trend. Interestingly, the BEA Electrical Equipment data shows an upswing in 2009 and 2010 while our data does not, so it is possible there are some mix effects here.

Our data shows a major upswing in Capital Goods inventories in Q1 2012 versus Q1 2011, and the BEA data confirms this.

Exhibit 7

Source: BEA and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Other Sectors

Other sectors are not as significant to the overall data but BEA data confirms our analysis that Paper product inventories have increased (more so in the last quarter), as have those for Conglomerates. Metal and Mining companies have seen some volatility but no meaningful increase and the same for Packaging. Our analysis shows that Electrical Equipment inventories have not risen, except in the last quarter – BEA data suggests that they have risen since 2008 but peaked in 2009 and have declined slightly since then – Exhibit 9.

Exhibit 9

Source: BEA and SSR Analysis

Valuation Concerns

Here we have simply copied the work that we published last Thursday – relative valuations are slightly lower than they were on Thursday in most cases, and we will publish an updated review of our valuation work in a May summary in the next 48 hours.

In Exhibit 10 we look at where the sectors were trading relative to mid-cycle “normal” value at the end of December 1991 and where they are trading today. In 1991 the group was much cheaper than it is today and was discounting expected declines in earnings. Only the Packaging and Paper sectors were trading above normal value, if we exclude GE from the Conglomerates analysis. Metals and Mining is at a significant discount today and while it was also at a discount at the end of 1991, today’s position is much more extreme. If fundamentals play out as we expect, and as they did in 1992 and 1993, only the Metals and Mining sector looks like it is adequately discounting the scenario.

Exhibit 10

Source: Capital IQ and SSR Analysis

In 1992 every sector underperformed the S&P500 (except Chemicals and Metals and Mining), despite their relative cheapness. Within Chemicals, commodities underperformed. Exhibit 11 shows the data in Exhibit 6 in tabular form and includes data for the end of 1992. Where a discount is increasing, the sector is underperforming. The biggest underperforming moves in 1992 were in Capital Goods, Electrical Equipment and Conglomerates; all of these sectors are much more expensive today than they were in 1992.

Exhibit 11

Source Capital IQ and SSR Analysis

The Packaging space looks to be the most interesting on the upside. This group has been trading well below mid-cycle value, though not at a statistical extreme. This is partly because we have seen significant restructuring activity, that has yet had time to play out, but mainly because, as buyers of plastic, glass and metals, they have been squeezed on raw material costs. As energy prices fall and basic material prices follow, packaging will be a beneficiary. In addition, most processes in packaging allow the companies to operate “just in time” inventory practices, much like their primary customers. Consequently, this group has not seen a meaningful change in inventory over the last few years. We could see as much as a 30% positive move in this group if raw materials move in its direction and this results in positive earnings surprises. A 30% relative move would take the group as far above normal value as it is currently below normal value – Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

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