Monsanto the Standout as Metals Retreat: SSR Industrials & Materials Monthly Review, May 2016

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 1st, 2016

SSR Industrials & Materials Monthly Review, May 2016:

Monsanto the Standout as Metals Retreat

  • In a month of largely negative performance across our sectors Monsanto was the standout
    • Stock was the largest positive mover in our coverage in May because of the Bayer bid
  • Our May research had a strong ag focus accordingly
    • Before the terms of Bayer’s bid went public, we explored MON’s options and subsequently followed up with a framework for what a fair bid might be
    • FMC shook out of our MON analysis as a plausible target and we followed up with a stock specific piece – we still think the stock is intriguing, perhaps in BASF’s portfolio or perhaps in pieces
    • In the tangential fertilizer industry, we wrote on the broad market and nitrogen (CF) specifically – we believe CF could work even without the OCI deal
    • Our continued coverage of Dow/DuPont also has an implicit ag angle – in our most recent piece we highlight how DD’s apparent cost proactivity pre-merger contrasts with DOW’s approach
  • After three consecutive months of broadly positive performance versus the S&P, Industrials & Materials stocks posted their weakest month in 2016 to date
    • Transports were the biggest laggard as rail traffic fizzled out after a promising start to the year and does not seem to be in a hurry to recover
    • Metals stocks gave back some of the past few months’ gains – steel stocks were notably weak even as domestic pricing was further buoyed by tariffs – global steel fundamentals remain terrible
  • Somewhat counterintuitively, the revisions picture has generally improved despite the price weakness
    • Our portfolio of stocks with high discounts, high skepticism, and positive three month EPS revisions has been limited by negative revisions in recent months
    • Just 10 stocks made the list last month – that number swelled to 32 in May
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW and DD remain our longer-term favorites in the Chemical space and Industrials & Materials generally, though we clearly have a positive view of MON near term and also AXLL based on the M&A landscape and our expectations that both will be acquired

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SI measures current valuation versus current return on capital and what movement in returns on capital is implied in valuation.

Exhibit 3

Source: Company Reports and SSR Analysis

See Appendix 3 for the data underlying this exhibit.

Exhibit 4

Overview

The past few months have been marked by strong outperformance from our Industrial & Materials stocks. After a weak start to the year in January, monthly performance was robust from February through April but the momentum stalled in May – Exhibit 5. Much of the rally from earlier in the year was driven by commodity stocks which benefitted from rising prices and the sentiment that the economic environment was perhaps not as dire as had been anticipated at the end of 2015. We were and remain skeptical of the bounce in commodity stocks, as there does not appear to have been enough (if any) fundamental improvement to justify it. China’s talk of rationalization seems to be just talk as industrial output has picked up and consumer driven growth there remains elusive. Domestically US manufacturing is hovering around break-even levels, and rail traffic remains weak – Exhibit 6.

In a landscape similar to 2015 (commodities under pressure, general economic stagnation) story stocks or takeout targets come into focus. In May we saw examples of each in two of our best performing stocks – ALB and the lithium narrative, MON and consolidation in agricultural chemicals. ALB was up 19% on positive earnings and the expectation of lithium price increases on the back of strong demand. MON has been in our crosshairs for some time – we wrote positively on the stock in March in the absence of M&A (at the time) and expanded our analysis during the past month as the Bayer bid was whispered and then disclosed. We think it is likely that a deal still gets done, but at a price closer to $135 per MON share than the initial $122 offered.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Commodity (metal) stocks gave back some of their recent gains – in order, X, ATI, FCX, JOY, CLF, and AA were the six worst performers in our coverage in May, all down 17-24%. We are considerably more positive on the fundamental outlook for aluminum versus steel – AA is still being disproportionately penalized for its base aluminum business in our view. Only a handful of stocks managed to even match the S&P. Aside from MON and ALB, the big winners were small caps that posted positive earnings results (BRC +20%, NDSN +13%). Most other gains were modest. We show the 25 best and worst performing stocks in our coverage for the month in Appendix 1.

Sector performance relative to the S&P for the month is shown in Exhibit 7. May was a month of widespread underperformance in Industrials & Materials. E&C barely kept pace with the S&P 500 but our other sectors all trailed the market by at least 1%. Weakness in the Transports was largely a function of the rails as traffic remains weak.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. Stocks moved broadly cheaper with the month of underperformance. We are still wary of the discounts in the Metals space (borne out by the volatility of the past few months), with the possible exception of AA.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 9 (see our skepticism work for more detail). Positive revisions in recent months have brought returns closer to trend for the Metals group, which continues to discount earnings weakness. Paper & Packaging also appears to be discounting negative revisions.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index component – valuation versus ROC. All things being equal, you want to buy sectors in the top right corner and sell those in the bottom left.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

The overlap of our traditional valuation and skepticism based portfolios (see Exhibit 2) produced cumulative monthly gains of 15.6% in 2013 and 9.8% in 2014, but was far less successful in 2015. Our return on capital based models that produce the portfolio selections assume cyclicality and fail to capture the secular changes impacting an industry – a major issue for many Metals and Commodity Chemical stocks. FCX, CLF, HUN, and OLN were among the mainstays on the long side throughout the year and condemned our portfolios to a year of underperformance.

To begin 2016, and particularly in recent months, commodity stocks rallied and our portfolios benefitted accordingly – these stocks gave back some of the recent gains in May, but the short selections also underperformed and the year to date results remain positive.

Exhibit 11

Source: Capital IQ and SSR Analysis

An alternative portfolio approach is based on our expanded skepticism index performance analysis which showed a very attractive risk-reward relationship for stocks with positive SI values, valuation discounts, and positive 3 month EPS revisions. We feel there is both a more defined holding period (our work is based on 6 month forward performance) and a greater likelihood of success in those names. This month we have a list of 32 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 12. Revisions have turned broadly positive, resulting in a much larger group here than we have seen in recent months.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 shows the historical forward performance of the stocks meeting the criteria in Exhibit 13 at various ranges. We note that for all ranges where the SI is above 0.5, the average return is in excess of the variability (average > standard deviation).

Exhibit 13

Source: Capital IQ and SSR Analysis

Macro Environment

At SSR we are not economists, nor do we seek to be. We look at the economic indicators that are publicly available and put them into context relative to the drivers within the industries we cover. We examine trends or fundamental influences and we then look at these relative to valuation with the goal of identifying mismatches between what is implied in valuation and what is expected to happen.

After the weak start to the year with disappointing Q1 GDP, April US consumer spending data bodes well for growth heading into Q2. Spending in April came in significantly above expectations at the most robust level since August 2009. Housing prices are also on the rise with supply constrained, another potential boon for the domestic economy.

International growth engines show a mixed picture. Indian GDP growth has surpassed that of China, and surprised to the upside in Q1. China meanwhile has been stronger than perhaps expected but the strength has ostensibly come from a reversion to the traditional industrial model rather than the desired shift to consumer spending.

Exhibit 14

Source: Capital IQ, Government Publications, Bloomberg, SSR Analysis

Commodity Pricing

Continued gains in steel pricing are partly due to tariffs implemented by the US – the steel index is Exhibit 15 is based on domestic hot rolled coil (NYMEX). Aluminum and copper prices (LME) weakened in May and have generally not seen the same price support as steel. Crude settled around $50 per barrel and natural gas pricing is in the $2.15 range.

US commodity and energy prices are indexed in Exhibits 15 through 19.

Exhibit 15

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 16

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 19

 

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 20 we look at expected net income growth by sector, and in Exhibit 21 we plot the growth figure against each sector’s current skepticism index value. We note that the Metals result reflects a very low 2015 base. Estimates for the machinery sectors (Cap Goods, Electrical Equipment) show the least forward optimism on this basis.

Exhibit 20                                                                                                      Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows the change to these longer-term net income estimates over the month. Revisions for larger cap stocks were generally more negative than smaller cap peers, evidenced by predominantly negative revisions at the sector level when cap weighted, but a mixed to positive picture on an unweighted basis.

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions during April and Exhibit 24 plots these revisions versus performance results on the month. Revisions were mixed on average. Within the Metals sector, FCX saw a 13% increase in ’16 estimates and a metal-exposed Capital Goods stock (KMT) saw the most pronounced move (+31%). Note these figures are simple averages versus the market cap weighted figures shown in Exhibit 4.

Exhibit 23                                                                                                      Exhibit 24

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal” Valuation

In Exhibits 25-34 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 25

Source: Capital IQ and SSR Analysis

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

 

Source: Capital IQ and SSR Analysis

Exhibit 28

Source: Capital IQ and SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 45.

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in May

May 31, 2016 – DuPont Adopting a “Go It Alone” Strategy – Which Raises Interesting Questions Such As: What is Dow Ding/What Could Dow Do?

May 25, 2016 – MON-Bayer: What Price is Right?

May 23, 2016 – FMC: Can it Survive the Consolidation Wave? Should it Try?

May 17, 2016 – Chemicals Monthly: Agricultural Action

May 16, 2016 – Nitrogen Fertilizer: Just Like Ethylene, But Different

May 16, 2016 – Monsanto Multiple Choice: Going it Alone, Merging, Selling, Spoiling?

May 5, 2016 – Fertilizers: Looking for Green Shoots

May 1, 2016 – SSR Industrials & Materials Monthly Review, April 2016

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. The four companies that overlap are the same as for the past two months: HUN, IP, OLN, and PKG.

Exhibit 46

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2



Appendix 3


Appendix 3

©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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