Metals and Packaging – The Best Ways to Play The Most Interesting Sectors

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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 9th, 2017

Metals and Packaging – The Best Ways to Play the Most Interesting Sectors

  • Continuing our analysis of relevant factors for 2017, we extend this to Metals and Paper & Packaging – the two sectors which we identified as most attractive for 2017 in the work we published early in January.
    • We also look more closely at some of the valuation controversies and taking all inputs into account we come up with the following stock preferences:
    • Positive: AA, CMP, IP, NUE, PKG, WRK, FCX, ATI
    • Negative: ATR, BLL, CCK, GEF, SEE
  • Each of our indexes for these sectors has 13 constituent stocks, and we rank this group of companies on the following metrics (click to jump to a particular list):
  1. US sales focus – potential benefits from America First stimulus.
  2. High current effective tax rates – upside to lower corporate rates.
  3. High sales/employees (relative to the group) – less impact from potential wage inflation – more operating leverage.
  4. Offshore cash – favorable repatriation terms could result in large buyback/dividend programs.
  5. Performance since Election Day – those that have been missed, are down on earnings, or have the most potential upside remaining.
  6. Optimism – tendency of corporate optimism to manifest itself in poor capital allocation decisions and underperformance.
  • Companies appearing in the top five on three or more lists are summarized in Exhibit 1 – PKG and WOR tick the most boxes (four).
    • PKG has been a good stock and had been a favorite of ours before we recently removed it from our preferred list on valuation – the extent of its discount last year was such that after doubling since last February’s lows the stock is still marginally cheap on normal earnings.
    • WOR derives nearly 50% of its sales from the automotive industry – construction (16%) and industrial (13%) are other key end markets – valuation is not cheap but below prior peaks.
    • Metal can makers (BLL/CCK) have proportionally less US sales exposure versus the group, which diminishes their attractiveness.
    • IP appears in the top five only on valuation and skepticism, but is middle of the pack on the other metrics despite a 75% US sales focus – likely an offshore cash opportunity ($1 billion total cash at the end of fiscal 2016, though no disclosure of offshore holdings in 2015).

Exhibit 1

Source: Capital IQ, Company Reports, and SSR Analysis

Overview

In our early January sector preference piece, we identified Metals and Paper and Packaging as the two we would want to be overweight in 2017. This is based on a two-factor valuation process, which has driven considerable stock selection outperformance for us over time. The table is shown again in Exhibit 2. When we try and be a little cleverer with this analysis by looking at some of the possible Trump influenced factors – listed above – some of the sectors lower down in the table move around (less interested in Capital Goods – more interested in Electrical Equipment and Conglomerates) but Metals and Paper and Packaging retain their places and consequently warrant further analysis.

Exhibit 2

The Metals and Paper & Packaging sectors have historically been among the most volatile within Industrials & Materials – Exhibit 3 – potential for large upside with a similar downside profile to other sectors. In this context, the slightly above average trailing 6 month relative gains in these sectors are far from extreme. Despite recent moves we still have Metals stocks that are cheap and even those that are above “normal value” are far away from peak – Exhibits 4 and 5.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

At the stock level, the majority of the Paper & Packaging companies are on the expensive side of fair value. The discount at the sector level is driven by the paper and paper packaging sub groups in general and IP in particular which is still 25% of the cap weighting – WRK is an additional 13%, while SON/ATR/SLGN combined account for just 13% – Exhibits 6 and 7. Plastics packaging is growing quickly – in line with polyethylene demand growth and other packaging plastics.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

As in our SMID pieces we summarize a broader range of likes and dislikes using all factors and valuation in Exhibit 8. In this table we weight share of sales outside the US as a stronger negative than others and this pushes some stocks that may appear in Exhibit 1 (BLL/CCK) into the red box.

Exhibit 8

China

China is a major concern in metals and paper and packaging as it is for many commodity chemicals – with China major exporters of Steel, Aluminum and freesheet and a major importer of recycled containerboard. However, unlike commodity chemicals, Brazil, Indonesia, Australia, and Portugal are equal or bigger worries for producers of paper products as per recent trade cases, and no one country can significantly impact the highly consolidated metal packaging industry where economies of scale dominate.

On the metal side, steel and aluminum have been among the most oversupplied commodities due to Chinese surpluses. The cluster of Chinese steel production in the densely populated northeast suggests potential for curtailments if pollution reduction focus continues – Exhibits 9 and 10.

Exhibit 9

Source: China Metallurgical Industry Planning and Research Institute, and SSR Analysis

Exhibit 10

Source: National Bureau of Statistics of China and SSR Analysis

Aluminum production is more inland in less populated provinces and has been trending in that direction. There is however still capacity in the most polluted regions and as aluminum is one of the fastest demand growth commodities, China would not need to shutdown much of its capacity to swing the world from surplus to deficit. The aluminum process itself is not a big polluter, but it consumes very large amounts of electricity and the power plants are much of the problem.

Exhibit 11

Source: CRU Group, Light Metal Age, and SSR Analysis

Exhibits 12 through 14 summarize China’s export position in major commodities and the country’s coal fundamentals – see prior research for more detail.

Exhibit 12

Source: Bloomberg and SSR Analysis

Exhibit 13

Source: Bloomberg

Exhibit 14

Source: Capital IQ and SSR Analysis

US Sales Focus

CCK appears in the top five on three of the six metrics as summarized in Exhibit 1, but falls near the bottom here in terms of US sales exposure. Competitor BLL has a greater US presence – still below group average.

US exposure for NEM could be lumped into the 4% of sales characterized as “Other” in its 10-k, but the majority of its sales go to foreign banks – lots of exposure to the UK as opposed to the US.

Exhibit 15

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Tax Rates

The assumption here is that Trump will try to cut US corporate taxes and that those with the highest effective rates – often those with the highest concentration of US sales – will see the greatest benefit.

Tax rate concessions as well as repatriation of offshore cash, will likely come with strings attached in terms of the proportion of new free cash that companies have to reinvest, but as we have seen in past attempts to stimulate growth in this way, companies find ways to funnel the cash to buybacks, dividends and M&A, where the M&A generally results in fewer jobs and lower new investment than the opposite.

Clearly some of the higher tax rates shown in in Exhibit 6 are the result of special circumstances – either reflecting a translation – or lower reported income but taxes based on a GAAP income. This is certainly true for any company paying more than 40% tax in the last 12 months. Those with the higher US sales in Exhibit 5 are likely the companies with the most to gain long-term from sustained lower US tax rates.

Exhibit 16

Source: Capital IQ and SSR Analysis


NOTE: n/a indicates estimates not available, NM indicates a negative measure

Sales/Employee

We are using this measure as a sign of leverage – companies with high sales per employee often have the highest incremental operating leverage, benefitting the most from incremental sales. In addition, should Trump policies lead to inflation and wage rises, these companies are less exposed.

Exhibit 17

Source: Capital IQ and SSR Analysis


NOTE: n/a indicates estimates not available, NM indicates a negative measure

Offshore Cash

The potential repatriation of offshore cash holdings has received attention and there are a few companies here with significant cash in foreign jurisdictions. In Exhibit 8 we have expressed the amount of offshore cash as a percentage of the company’s current market cap – equivalent to a special dividend or the potential reduction in share count if the repatriated funds were used to buy back stock. We assume a 15% repatriation tax.

OI has the most offshore cash to make a difference, but the company remains constrained by an asbestos liability and does not pay a dividend – screens well on tax rates also, but has a low US sales exposure.

FCX likely has a much greater opportunity than represented here as there was a significant step up in cash in 2016 – waiting on the 10-k for offshore holdings.

Exhibit 18


Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Performance since Election Day

This is in part a momentum indicator, showing what stocks have run post-election in anticipation of gains derived from Trump policies – those are the companies at the bottom of the table. As habitual seekers of value we are more interested in those that have not run, hence the upside down table. It is important to note that there are likely no companies on any lists here likely to see direct earnings gains from anything the new Administration does before, at the very best, Q4 2017. Consequently, for the outperformers there is a risk that expectations get ahead of what is practical and we see some earnings misses before we see the gains.

Exhibit 19

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Optimism

We often reference our work on corporate optimism as a complement in our process of identifying investment opportunities – simply put, those companies that habitually guide to realistic earnings expectations and subsequently over deliver not only predictably outperform, but have been shown to exhibit expanding returns on capital relative to their more overly-optimistic peers – they make better capital allocation decisions. In Exhibit 11 we show the most conservative companies in the group – those that have consistently over-delivered and the measure is by how much annual earnings have beaten expectations.

The measure is called “Optimism” but we are actually looking for the least optimistic companies and the indicator can be confusing in its labeling if you have not followed our work here – in Exhibit 11 WOR has most consistently over-delivered and by the most significant level.

Optimism results are generally grim for the Metals space – X, FCX, CLF, and ATI would rank right alongside the very poor figures for CRS, NEM, STLD, NUE and CMC if not for their history of negative earnings which preclude relevant percentage calculations.

The other companies that do not have optimism measures – the new AA and WRK – do not have enough history or enough credible data to run this analysis yet.

Exhibit 20

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

©2017, 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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