Materials, Industrials and Housing – Making Our Best Ideas Better!

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

October 21st 2018

Materials, Industrials and Housing – Making Our Best Ideas Better!

  • Following the launch of SSR “Consumer and Home” vertical this week, we follow up with piece on the possible impacts of the conclusions on Industrials and Materials names.
    • We are qualifying some of our recommendations as many of our favored names have significant housing exposure and consequently risk of further negative revisions if our housing expectations are right or too conservative on the downside.
    • With the recent correction for all exposed names and it now becomes a function of picking through to identify those that may have overshot and already look interesting and those that may have more downside.
  • October has been a bad month for the group, with many companies including HD and LOW down 10% or more – Exhibit 1. On a year to date basis, however, the home improvement stores have done much better that their suppliers – Exhibit 2
    • The further upstream you go the worse the performance YTD, with the paint ingredient companies underperforming the paint companies, etc.
    • SWK has the additional issue of tariff concerns to deal with and has been one of the worst performers despite strong forecast earnings growth and negative revisions for 2019 that still expect strong year over year EPS growth.
  • Stock performance is suggesting worse fundamentals than currently reflected in consensus earnings and skepticism levels for most companies are very high, implying either bargain stocks or meaningful negative revisions/surprises – probably the latter.
    • On a normalized basis, WLK and EMN are cheap enough to buy today, though a case could be made for PPG and for DWDP and both have other potential catalysts.
    • Stocks cheap on an absolute basis include all of the TiO2 names – we can come up with reasons to own and reasons to avoid all of them. Also cheap, ASIX, WLK and HUN
    • If our housing projections are right – SWK is likely not cheap enough yet, neither is SHW.

Exhibit 1

Source: Capital IQ and SSR Analysis

Exhibit 2

Source: Capital IQ and SSR Analysis

If the Housing data gets Worse is Anything Worth Buying?

Selfishly, it is great that SSR now has a voice on housing. As a major part of the consumer spending wallet, housing is critical to the economy and a significant consumer of materials as well as a large business segment for many Industrial names. In Exhibits 1 and 2 we include the more obviously exposed names, but there are many more in our universe and this will not be the first piece we write.

Despite our general stock favoritism for many companies with housing exposure this year, which has clearly not been the right recommendation, we have had some concerns about housing for a while, more anecdotal than empirical, but we have managed to convince ourselves that many of our favorite companies are less exposed to some of the concerns than their stock valuations or trajectories would suggest. While this was supported by year-to-date revisions for many – Exhibit 3 – October has clearly seen a more negative trend in revisions for those companies that have seen changes – Exhibit 4.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

While we still believe there are opportunities in the group, it is hard to fight a general sell-off, and we now expect to see a group of companies that fare much better from an earnings perspective than is implied in stock direction today and a group that really are in trouble. For example; while OC, MAS and SWK have direct leverage to potentially slower home remodeling and new home construction – SWK has synergies and growth from acquisitions as an offset that the other two companies do not. OC and MAS look more risky.

If the younger generations are less interested in home ownership and more interested in mobility – which, in today’s economy, is hard to argue against, especially as interest rates rise, the demand for new home ownership may stagnate or fall, but the demand for rental will rise and where-ever they live they will still need furnishing/appliances etc. Plus, the younger generations are more particular about quality and options, because they are bombarded with what is good and bad on social media every day. Rental yes, but high quality, locationally convenient, and safe all factor into the decision.

Anecdotally, over the last 7 years – since we set up SSR in Stamford, CT – the number of new apartment complexes that have been built in downtown Stamford seems extraordinary. Yet they all appear to be mostly full and they are not that cheap.

We are assuming that the new housing era may trend to look something like this from a Materials and Industrials perspective:

  1. More urban or integrated suburban (workplace, living, shopping, restaurants, movie theatres all in one walkable or easy Uberable location). Less remote suburban housing demand – where you must drive everywhere.
    1. Still demand for building products but maybe limited growth or no growth as square footage needs per person may fall.
      1. Not so good for demand for lumber, paint, insulation, flooring, roofing etc. OC, VMC, new Dow at risk.
      2. Opportunities for the obvious consolidators – SHW, SWK, FULL, WLK, PPG(?), new Dow (?). But everyone else needs a new strategy – such as RPM (restructure and likely sell to a consolidator)
  2. High quality expectations from renters or condo buyers.
    1. New properties need to look good – higher quality paint, appliances etc. Polyurethane demand should remain robust for furnishing – may lose ground in insulation. OC most levered to a weaker insulation market
    2. Rentals turning over need a good refresh – demand for home improvement products continues – leaders do well
    3. More contractor-based remodeling and “fixing-up” than home owner over time – better for the contractor focused seller of materials and supports the push by the big box retailers to attract the contractors.
      1. If they can provide both the service and better prices, HD and LOW may win share from independents – marginal negative for SHW, PPG and Benjamin Moore “own store” business – SHW seems best positioned to capitalize on both market channels as a hedge – pushing the Valspar brand heavily through the big box channels.
  3. Weaker paint demand (because of lower square footage per person) would be a longer-term negative for TiO2, if slower growth in the West is not offset by stronger emerging market growth.
    1. Incremental negative for other paint ingredients such as acrylates and other binders and additives – negative for new Dow, EMN and BASF.

Even if what we have assumed above is only partly correct, we still have a group of stocks that are inexpensive and on an absolute basis (note that we have included both Covestro and BASF in this analysis as we still see them as very attractive) we would look at almost anything to the left in Exhibit 5 – from OC to 1COV, as the price to cash flow for these companies must make them interesting consolidation targets in an industry that must see further consolidation. VMC is relatively well placed as a buyer from a multiple perspective even if it is close to a recent historic low.

Exhibit 5

Source: Capital IQ and SSR Analysis

From a relative perspective, we cannot do the analysis well for many of the companies on the list as they do not have much history, or their models have been adjusted because of recent acquisitions where consensus has different views on how much synergy/growth will be achieved – i.e. more faith in SHW than FUL. We would highlight the following as attractive enough today to take a look, with the caveat that valuations can always come down further – WLK (Exhibit 6) – EMN (Exhibit 7) – BASF (Exhibit 8).

As we progress through Q3 earnings and Q4 guidance we would focus on the low EV/EBITDA names and WLK, EMN and BASF: SWK, SHW, PPG and DWDP are also interesting – see PPG research and read todays weekly when published. Much as we like SWK, based on the chart in Exhibit 9, we think it could see a little more weakness with a disappointing Q3 report.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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