Looking Among the Small Cap Rubble to Find Opportunities

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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

October 20, 2014

Looking Among the Small Cap Rubble to Find Opportunities

  • Small cap Industrial and Material companies have significantly underperformed their larger cap peers and the broader market year to date.As aresultthe valuation spread between the two groups (in favor of the small caps) has widened to a 20+ year peak.
  • Within both the small and large cap groups performance has been mixed, leading to above average valuation dispersion.
  • Concerns of slower global growth are likely to encourage continued stimulus and low interest rates, particularly from a notably accommodative US Federal Reserve. US focused companies should be prime beneficiaries and also offer some protection against any further strengthening of the dollar.
  • In Exhibit 1 we highlight the most attractively valued small cap companies (between $1 and $7 billion) with more than 40% of sales generated in the US, adding the additional screen of a dividend yield above 2%.
  • We publish this list as possible fertile ground for those seeking ideas in the small cap names within Industrials and Material sectors. We offer a few notes of our own on some of these names within this call.
  • In addition, in the chemical space we like Axiall (AXLL), which only fails to make this screen because its yield is only 1.6%. Otherwise the stock is cheap and very US centric, though does require PVC exports to operate its facilities at optimal rates (see recent research).

Exhibit 1

Screen Notes: US sales above 40%, dividend yield above 2%, market cap between $1 and $7 billion

Source: Capital IQ, SSR Analysis

Performance Divergence

Starting in 2013, the smaller cap stocks in our universe have been underperforming both their large cap peers and the S&P 500, a notable shift from historical norms (for our purposes, we have cut our universe of 130 companies in half by market cap to arrive at the “small” and “large” cap distinctions). Year to date, 2014 has seen this small cap underperformance continue, and worsen considerably – Exhibit 2. This in turn has driven the valuation spread between large and small cap stocks to record levels. Exhibit 3 shows average discount from normal value since 1990 for each group and Exhibit 4 shows the divergence in valuation is over two standard deviations from the 20+ year average. What is notable in Exhibit 4 is how the valuation spread closes almost as quickly as it opens, and in this case it has opened quite quickly.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Dispersion Elevated – Opportunities at Either End

Amidst the general small cap underperformance, there have been clear winners and losers, which has driven valuation dispersion steadily higher over the past two years – Exhibit 5. This means there should be opportunities at either end of the valuation spectrum, and there are indeed cheap and expensive stocks across all of our sectors. Note the slightly higher level of dispersion within small caps.

Exhibit 5

Source: Capital IQ, SSR Analysis

Dollar Strengthening and Weaker Global Outlook – Look Domestic for Now

Exhibit 6 is not new to anyone – the dollar’s strengthening has received a lot of airplay in recent weeks. Yet even as the dollar has stabilized we have seen increased market volatility amid concerns about the health of global economies. The prospect of continued stimulus appears poised to bolster the markets yet again, as Fed Chairwoman Yellen has well established her accommodative stance. US focused companies should be the prime beneficiaries here, and also offer some protection against further dollar strengthening.

Exhibit 6

Source: Capital IQ, SSR Analysis

Taking all these factors together, we are looking for inexpensive small cap names with a high percentage of domestic sales – we repeat Exhibit 1 below and offer specific commentary for those companies we feel comfortable discussing.

Exhibit 7

Screen Notes: US sales above 40%, dividend yield above 2%, market cap between $1 and $7 billion

Source: Capital IQ, SSR Analysis

PKG

Our preferred name in the containerboard space, we wrote
about PKG in August
. The stock has come a long way in the past few years but valuation is still attractive relative to peers. The Boise acquisition has gone very smoothly thus far and barring any complications with the conversion of a newsprint machine to containerboard production in Q4, PKG should be well situated for continued growth in 2015. The company is very highly integrated and the flexibility of its facilities and strategy of targeting regional accounts give PKG the highest returns in the industry. All indications are the box market has been flat in 2014, and could remain so in the coming year, but PKG has historically been able to grow even as industry growth has been flat to down. As a primarily virgin-based containerboard producer, particularly relative to industry peers, the company stands to benefit disproportionately from a rise in recycled-fiber (OCC) prices – Chinese demand will ultimately be responsible for driving prices higher if the anticipated global OCC shortage is to occur. In the more immediate term, delays with the Deridder mill conversion would be a negative surprise.

BRC

BRC is organized into two segments: Identification Solutions (manufacturing patient monitoring wristbands for hospitals, label machines) and Workplace Safety (“Do Not Enter” type signs for facilities and various related light safety equipment such as goggles and gloves). The company’s failure to adopt digital distribution channels in the Workplace Safety segment (only 13% of sales are generated on the internet, compared to 61% via traditional catalogs and telesales) has resulted in two-fold margin compression – not only are they losing share and volumes to online distributors, they are also getting lower prices on remaining sales as the proliferation of competitors who are more effectively utilizing e-commerce has led to more transparency in pricing and thus less pricing power. The company’s current plan to address this issue has sales via digital channels rising to 19% of net revenue by 2016 – margin expansion was evident in the latest quarter’s results. Valuation is looking attractive after a sustained move down and since the stock took another leg lower following a kitchen sink FQ4 report there has been insider buying activity. This is one of the smallest cap stocks in our coverage, but the dividend yield is considerable (3.7%) – this reflects the strong underlying cash flows, and the company is not highly levered (net debt/equity of 24%). New CEO J. Michael Nauman, hired from privately held electronics component maker Molex Incorporated, has ample opportunities for cost savings, as SG&A/sales has risen 5% since 2007 and stands just below 40% over the last twelve months.

Exhibit 8

Source: Capital IQ, SSR Analysis

OLN

The company could win in a couple of ways over the next year:

  • The DOW chlorine divestment could involve OLN directly, but even if not we expect to see either some consolidation in the space and/or a more disciplined competitor in the market, hopefully more focused on returns that DOW appears to have been.
    • We might also see some other consolidation/JV type moves in the US to help deal with the current caustic soda over-supply
  • Divestment on the Winchester business – a great cash flow generator, but very unpopular with investors and a drag on valuation in our view.
  • Lower US ethylene pricing in 2015 (see recent research) would increase opportunities to increase PVC exports – this would boost chlorine demand and while perhaps adding to the caustic surplus should at the same time create export opportunities for caustic.

UFS

Domtar Corporation’s main business remains paper – the uncoated free sheet symbolized in its ticker. This is obviously a declining business, but remains highly cash flow generative and the company is using this to fund a healthy dividend and pursue growth opportunities in tangential businesses that utilize the company’s pulp expertise (so absorbency products namely). The stock spiked up last September when IP announced the closure of one of its large capacity facilities, which effectively trimmed nearly 10% of North American UFS capacity and ostensibly boosted near term industry fundamentals – two consecutively dismal earnings reports have taken away most of this optimism and left the stock where it started, trading in the low $30s. Most recently, higher maintenance costs and “lack-of-order downtime” weighed heavily on Q2 EPS results, which came in 29% lighter than consensus on 6% higher revenue. Full year EPS has been trimmed by over 20% since mid-July. UFS is still generating enough cash to raise its dividend nearly $0.20 this past quarter, in addition to funding its continued transformation to a more personal care products oriented business. Downside could remain as Q3 is also expected to be impacted by high maintenance costs but the 4% yield could offer support for the only non-mining stock in our coverage that is trading below book value.

Exhibit 9

Source: Capital IQ, SSR Analysis

BMS

We recently wrote about Bemis as we expanded our coverage of the Packaging space to
the flexible/plastic packagers
. The company has the lowest margins in its peer group. With the divestiture of its paper packaging operations in early 2014 and its pressure sensitive materials segment more recently, BMS is now more of a plastic packaging pure play, with broad exposure to a variety of end markets from the lower margin snacks and candies, to the relatively more attractive dairy & liquids and healthcare products. The company is actively seeking to drive sales in its higher margin segments, and to this end will modestly increase R&D spending in targeted growth markets over the next few years. Forward revenue growth is negative, however – volumes are expected to remain weak with consumer spending even though management sees potential for growth as the packaging mix in a variety of products shifts from rigid to flexible containers. The company still generates good cash flow and uses it to fund its dividend yield (currently 2.9%). Valuation metrics are mixed, however, and give little reason to be excited on either the long or short side. The stock has been range-bound for the better part of the past two years, bouncing between $37.50 and $42.50, and at current trading levels around $38 a share, with a positive catalyst hard to see, we believe there is a greater likelihood of a breakdown than a move higher above this range – at least until the desired mix shift is reflected in margins or if lower plastic prices in 2015 provide a meaningful tailwind (our views on
ethylene in 2015 can be found here
).

The Other Side of the Coin – Short Screens

Here we have looked for expensive stocks in the large cap domain, but we have paid as much attention to the “non-US” business component and looked for those most exposed to a global slow-down or stronger dollar – Exhibit 10. We comment on a couple of the names below.

Exhibit 10

Screen Notes: US sales below 40%, market cap over $7 billion

Source: Capital IQ, SSR Analysis

SEE

Like BMS, SEE was also included in our look at the plastic packaging companies in our space. Sealed Air diversified from its packaging roots in 2011 with the $4 billion acquisition of Diversey, a provider of hygienic services and products – everything from institutional laundering to cleansers and sanitizers used in food service. This, the company hopes, is the key overlap, given that their packaging operations are tied heavily to the meat packing industry and the multitude of sanitary concerns therein. The Diversey acquisition proved to be dilutive in the immediate term, and Jerome Peribere, a 25 year Dow Chemical man, was brought on as CEO in March 2013, likely due to his experience leading the integration of the Rohm & Haas acquisition. Results had come in above the beginning estimate in each of his four quarters at the helm until a slight

overestimate in the most recent report and revisions have been coming in positive while peers are seeing downward pressure on their estimates. The stock’s current valuation, while in line with returns, appears to be pricing in a continuation of the improvements seen under Peribere, and there is a risk that the low hanging fruit has already been picked. Management could continue to execute well as it appears there is ample room for cost cutting (SG&A at 23% of sales is far and away the highest in the packaging space), the final settlement of the WR Grace asbestos liability removes a considerable interest payment ($48 million in 2013) moving forward, and valuation could follow returns higher – at current levels, however, we would prefer to see this demonstrated before it is priced in as fact. SEE looks expensive on our valuation model and its relative PE and EV/EBITDA multiples are at all-time highs.

Exhibit 11

Source: Capital IQ, SSR Analysis

SIAL

Sigma Aldrich is in the process of being acquired by Merck in an all cash deal, and will be removed from our coverage upon deal completion. In the meantime the stock could be an interesting source of cash rather than an active short, as upside is all but eliminated and given the premium paid, the stock could plummet in the event that the deal falls through – note that Apollo walked away from a cash deal to buy Huntsman after the market collapse in 2008. Further market weakness adds incremental risk to the SIAL deal. It is possible that by now it is no longer feasible to short SIAL given likely special situation fund involvement.

©2014, 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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