Monthly Review August 2013 – Earnings Reveal Nothing New

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Graham Copley / Nick Lipinski



August 1st, 2013

Monthly Review August 2013 – Earnings Reveal Nothing New

  • The summer earnings season has thus far produced mixed results within Industrials and Materials. GE posted a strong quarter, citing improvement in the domestic economy, stabilization in a weak Europe, and strength in emerging markets. CAT did not share that sentiment of emerging market strength, while UNP was cautious about the second half of 2013 even after an earnings beat.
  • The Paper and Packaging sectors led Industrials and Materials over July, spurred by earnings beats, almost universally for Packaging and specifically IP for Paper. Transports brought up the rear after shares fell following UPS’ warning of slower growth and never recovered. The Metals group more than matched the market’s gains despite continuing negative revisions to both immediate and longer term estimates, suggesting a possible valuation floor has been reached.
  • The valuation landscape remains essentially unchanged. Paper and Metals are outliers on the expensive and cheap ends of the spectrum, respectively. Packaging stocks have had a strong past few months and have gone from being slightly undervalued to showing a slight premium.
  • July research included a review of the second quarter and an outlook to 2H 2013 and our third report this year on DuPont. We expected negative revisions for 2H 2013 and this has already played out in several sectors. Our DuPont piece offered commentary on how the company’s potential portfolio restructuring, a possibility we suggested in January, can best be handled.
  • Our model portfolios were down across the board over the month. Our short picks were up with the market; our long side stocks produced absolute returns but lagged the S&P on the whole.
  • We would maintain our focus on the undervalued large cap group and, as noted, we see further upside in DD. We maintain our interest in CAT and AA and the recently announced possible restructuring at DOW looks interesting.

Exhibit 1

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

Exhibit 2

Source: Company Reports and SSR Analysis

Appendix 3
for the data underlying this exhibit.

Exhibit 3


Earnings season has produced a number of contrary opinions on the health of the economy and the outlook for the remainder of 2013. GE was notably more upbeat regarding the US economy than in previous quarters, yet Union Pacific offered cautionary words about expectations for the second half of the year. UPS also noted middling industrial activity in the US in its preemptive earnings warning.

For the month, the Paper and Metals sectors both held in well despite considerable negative revisions to 2013 EPS estimates. These were the only two sectors in the Industrials to post stagnant (in Paper’s case) or declining (Metals) revenue growth year over year for Q2. While, on the average, revenue growth was positive, large cap bellwethers such as CAT, ITW, DD, DOW, GE, and UPS all reported flat or declining figures.

On the strength of mainly positive earnings and a renewed bullish movement in the market, only nine of our companies produced negative absolute returns in July. Mosaic (MOS) was the biggest decliner, down 23% after Urakali shook the fertilizer market with its exit from a venture that controlled over 40%of the global potash market –
see recent work
. Best and worst performers at the company level in our coverage universe are summarized in
Appendix 1

Sector performance relative to the S&P is shown in Exhibit 4.

Despite significant negative revisions, to both 2013 EPS estimates and 2015 net income estimates, the Metals sector more than matched the S&P’s 5% gain for the month, suggesting that the group may have reached a level of valuation support. All of the Transports subsectors trailed the market but the group was most hindered by Mail stocks, as UPS and FDX fell in tandem. Rail companies UNP, CSX, and KSU beat estimates but were cautious about the second half of the year and were not participants in the general market move upward. Conglomerates GE, MMM, UTX, and HON all had positive earnings reports and led the group to a month of market outperformance. Emerson (EMR) and Rockwell Automation (ROK) both gained more than 10% in July, driving Electrical Equipment’s strong sector performance. Outperformance was more evenly distributed in the Packaging sector, where most companies beat earnings estimates. Paper stocks continued to be in favor, though the results mainly reflect the spike in IP following a robust earnings report. The Capital Goods sector largely shook off a disappointing quarter from CAT and on the whole was essentially flat to the market. CAT’s limited downside move following significant negative guidance supports
our view that we have reached a floor

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5 summarizes end-July sector discounts from normal value.

The ordinal ranking in Exhibit 5 is little changed from a month ago. Packaging switched places with Chemicals as the more expensive of the two; several months of outperformance have moved the Packaging sector from slightly undervalued to slightly expensive. An impressive earnings report from Rockwell Automation contributed to Electrical Equipment’s outperformance in July and helped push the sector firmly beyond the mark of one standard deviation above normal value. Transports, in opposition, retreated slightly from that same line after lagging the market over the month.

Note: part of the reason why almost all of our sectors look expensive on a relative basis is because other sub-sectors of the S&P are undervalued versus history – most extremely and most notably financials.

Exhibit 5

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 6.

Paper was the one of best performing sector in the Industrials for July, outpacing the S&P by over 3%, yet its ROC increase on the month was even more substantial, moving over 3.5 standard deviations above normal and inching the sector’s skepticism index value over 1 as one of the biggest monthly movers in our universe. Paper may look expensive on our historical value framework, but not based on current returns. Conglomerates (exclusive of General Electric) saw the biggest move in its skepticism value in July. The group outperformed considerably but its ROC was essentially unchanged, moving valuation further out of line with current returns.

As a reminder, our Skepticism Index measures how in or out of phase current valuation is with current returns on capital. A positive number suggests that either valuation is discounting a decline in return on capital or the stock has upside. On the flip side, a negative number suggests that returns have to rise to justify valuation, or the stock has downside.

Exhibit 6

Valuations Overestimating Current Returns on Capital

Valuations Underestimating Current Returns on Capital

Source: Capital IQ and SSR Analysis

Exhibit 7 is a very busy chart but shows how each sector and sub-sector breaks down by SSRSI 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.

Most sectors and subsectors are grouped around the trend line in the exhibit, which shows all points where valuation and returns on capital are completely in line with one another, consistent with the results in Exhibit 6 which for the most part shows moderate skepticism index values. Metals is an obvious outlier in both exhibits. The Commodity Chemicals subsector is notable in Exhibit 7 as well; the group’s ROC is well above normal (2 SDs) but valuations do not reflect these above average returns.

Exhibit 7

Source: Capital IQ and SSR Analysis

Portfolio Performance

We again tracked our model portfolios over the month, one based on our normal mid-cycle earnings screen, one based on our Skepticism Index and one based on the stocks that appeared on both metrics. Effectively, we bought the cheapest/most Skeptical and we sold short the most expensive/least Skeptical, as summarized in Exhibit 1 of our July monthly. The results are summarized in Exhibit 8, showing performance relative to the S&P, which gained 5% month over month.

IP, PPG, and EMN were notable contras on the short side, each gaining 10% in July. The long side picks produced absolute returns on all three metrics but were unable to outpace the market.

Exhibit 8

Source: Capital IQ and SSR Analysis

Appendix 2
we show the companies coming into our screens and leaving our screens.

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.

Earnings season commentary painted a muddled picture of the state of the US economy. Home price data out at the end of the month showed the largest year over year gain in property values in over seven years. Our colleague Rob Campagnino has written about the wealth effect of increased property values on consumer spending in a report on
the state of the US consumer
; spending continues to be strong in the face of an increased payroll tax, a notable bright spot in the midst of a still sluggish global economy. The latest reading of the Bloomberg Consumer Comfort Index showed the highest level in five years.

Data through June show factory output in China has dropped to its slowest pace since 2009. There is growing concern that the Asian giant will struggle to meet its growth targets as government officials attempt to address what some believe is a massive overextension of credit. The slowdown has extended to the provinces, which typically have experienced growth in excess of the nation’s average as a whole. General Electric’s classification of Europe as weak but stabilizing is evidenced in employment numbers – Spanish unemployment, in particular, fell for the first time since 2011 yet remains at a striking 26%. The Eurozone recession came to a technical end yet chronically high unemployment continues to plague the continent.

The most recent Macro data changes are summarized in Exhibit 9.

Exhibit 9

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

Commodity Pricing

After June price declines of over 5% for aluminum, copper, and steel, metals pricing was more stable this month. Steel was off 2.4% – the China Iron and Steel Association is expecting steel demand in the country to be weaker in the remainder of the year. Aluminum gained about 1%, while copper was little changed. Earlier this month,
we wrote about the implications and possible holes
in the New York Times expose on financial institutions’ machinations in the aluminum market.

Natural gas pricing dipped below $3.50/MMbtu. Crude oil was up sharply, nearly 5% – the effects of the summer driving season have been compounded by continuing unrest in the Middle East.

US commodity prices and energy prices are indexed in Exhibits 10 through 14.

Exhibit 10 Exhibit 11

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

Exhibit 12

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 13 Exhibit 14

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 15 we look at expected net income growth by sector, comparing 2015 estimates with 2012 actual net income. The Metals sector saw significant revisions to 2015 net income estimates and is now showing only a marginal three year increase from 2012. For the group as a whole, estimates for 2015 net income are down 30% since the end of January. Paper still shows healthy expectations; this optimism is also reflected in the estimate for the Packaging sector.

Exhibit 15 & Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17 shows how these longer term estimates have changed over the month. E&C, Packaging and Electrical Equipment showed modest increases month over month; estimates were mainly down otherwise. Negative revisions in the Metals sector were particularly severe. US Steel actually saw a marked increase in its 2015 net income estimate, but its small cap weighting muted the effect as AA, NEM and FCX were all down over 17% on an unweighted basis. For the year, estimates have dropped 39% for AA, 20% for FCX, 48% for CLF, and 63% for NEM. The cuts in the Capital Goods sector were considerable as well, particularly on a weighted basis. CAT did not offer an outlook for 2014, never mind 2015, but analysts slashed their estimates for the equipment maker by 12% after an uninspiring earnings report and company acknowledgment of global economic headwinds.

Exhibit 17

Source: Capital IQ and SSR Analysis

With earnings reports providing some guidance for the duration of the year, revisions to 2013 EPS estimates in July were considerable in both directions. The Metals sector was crushed yet again, with revisions of more than 18%. Paper was notably down as well – expectations here may have been a little overstretched but could still be conservative in the Packaging sector which was up over 3%.

Note that the numbers in Exhibit 18 differ from those in Exhibit 3 as the data is market cap weighted in Exhibit 18 and is a simple average in Exhibit 3.
Exhibit 18 & Exhibit 19

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

Mid-Cycle “Normal Valuation Analysis

Results of our valuation analysis for the end of November are summarized in Charts 20 through 30.

Exhibit 20

Exhibit 21

Exhibit 22

Exhibit 23

Exhibit 24

Exhibit 25

Exhibit 26

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

Exhibit 29

Exhibit 30

Exhibit 30

Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 31 through 42.

Exhibits 31-33

Exhibit 31

Exhibit 32

Skepticism High

Optimism High

Optimism High

Exhibit 33

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 34-36

Optimism High

Skepticism High

Exhibit 34

Exhibit 35

Skepticism High

Optimism High

Optimism High

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Exhibit 38

Exhibit 39

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Optimism High

Skepticism High

Exhibit 40

Exhibit 41

Skepticism High

Optimism High

Exhibit 42

Source: Capital IQ and SSR Analysis

Research Published in July

July 1, 2013 – July Monthly: Midway Through the Year, Metals Still Searching For a Floor

July 11, 2013 – Q2 2013: Not the Brightest of Outlooks Expected

July 17, 2013 – Chemicals Monthly: Expecting Negative Revisions for 2H 2013

July 25, 2013 – DuPont: Getting Appropriate Value for the Growth Engine


In Exhibit 43 we show a screen of stocks with low value, high Skepticism and high dividend yield. OLN is currently the only stock that appears on all three screens.

Exhibit 43

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©2013, 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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