Monthly Review August 2014 – Earnings Season Unkind to Industrials & Basics

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Graham Copley / Nick Lipinski



August 1st, 2014

Monthly Review August 2014 – Earnings Season Unkind to Industrials & Basics

  • The Q2 earnings season has not been kind to the Industrial & Basic Material sectors – Conglomerates, Capital Goods, Paper, Packaging and Electrical Equipment all underperformed the S&P by over 3% in July, with earnings related weakness the primary driver.
  • The Metals space on the whole saw the most negative revisions in our coverage outside of the Paper sector but emerged as the only sector to meaningfully outpace the market on the strength of a very positive earnings report for US Steel (X) and continuing momentum in one of our favorites, Alcoa (AA).
  • Driving Alcoa’s move higher has been Aluminum pricing, which continued to see strong gains in July, up 7% on the month and 19% since January. Natural gas fell below $4.00 per MMBTU for the first time since last November.
  • In July we wrote about possibilities for DuPont’s agriculture business and further expounded on our preference of PX relative to APD. We see the combination of DD and DOW’s Ag businesses as a sensible option, while APD in our view has some work to do to justify its multiple premium to PX.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. AA has been a solid call for us – the stock has come a long way in a short time but could continue to rise along with aluminum pricing. We continue to see value in DD, even after the recent dip on the Ag-related negative earnings pre-announcement (see research referenced above).
  • Otherwise we like the renewed momentum at SWK and see perhaps some improving broader indications in mining, which in our view is probably best played through CAT.

Exhibit 1

Source: SSR Analysis

Exhibit 2

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 3

Source: Company Reports and SSR Analysis

Appendix 3
for the data underlying this exhibit.

Exhibit 4


Earnings season has seen the continuation of recent thematic trends within the Industrial & Basic Material sectors. Ag revenues remain weak, both machinery and chemicals. The Commodity Chemicals group’s year over year revenue growth is influenced by a poor number from OLN but LYB posted a very strong beat, and DOW had a solid quarter as well. The Coatings sector continues to produce healthy returns and year over year growth. Transports saw very strong sales gains (though in the case of UPS this did not fall through to the bottom line) and Conglomerates universally grew revenue, both indicating positive industrial production. Strength in the Diversified and Transport exposed Capital Goods subsectors confirmed that trend. Mining reflects only CAT at the moment – revenue was down but volume trends were encouraging (
see recent research
). The Packaging sector is influenced by PKG’s large bump in sales from the $2 billion Boise acquisition and would have shown a more modest 1.8% growth absent this gain. Exhibit 5 summarizes year over year revenue growth for our sectors and subsectors – note that for Capital Goods the sum of companies reporting by subsector does not equal the sector total, as some stocks are included in multiple subsectors.

Exhibit 5

Source: Capital IQ and SSR Analysis

Despite seeing revenue growth, most sectors were dragged down from a performance perspective by several companies that saw sharp drops after earnings disappointments. The big movers over July were a mix of earnings winners (APD, LYB, X), earnings losers (GTI, AGCO, OSK, ROK) M&A targets and acquirers (ACM, URS), and continuing momentum plays (AA). 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 6. The Metals sector was aided by a 20% jump in US Steel after earnings and further upside in Alcoa, which was the fifth best performer in our coverage in July. E&C was up marginally as the URS-ACM deal countered softness in KBR and JEC. Electrical Equipment was hindered by ROK’s 5% drop after earnings. UFS missed earnings by a mile (-29% on the bottom line), citing higher unit costs from lack-of-order downtime for the company’s paper operations. Underperformance was widespread in the Paper space. The Capital Goods sector was impacted by CAT and ETN, which both plunged after earnings, more than offsetting a nice pop from SWK on a solid report. There were no major misses in the Packaging sector, which was soft even despite a brief spike on a report that suggested certain containerboard producers could qualify their mills as MLPs.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes end-July sector discounts from normal value.

Exhibit 7

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 8. 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 8

Source: Capital IQ and SSR Analysis

Exhibit 9 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.

Exhibit 9

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 2 of our July monthly.

The results had been strong in recent months, but poor earnings reports doomed several of our long side picks (AGCO and UFS most notably). The overlap portfolio has still produced solid relative results year to date in 2014 year to date following a similarly strong performance in 2013, though the other two screens have been less successful (Exhibit 11).

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

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.

US second quarter GDP blew away the estimate by a full point. For the quarter, durable goods purchase rose at the fastest rate since the start of the recovery in 2009. Consumer spending in Q2 exceeded expectations, rising 2.5%. Auto sales remain strong, with June’s pace not seen since July of 2006. Business spending appears to be contributing as well, with new orders and shipments for non-defense capital goods excluding aircraft ticking up in the latest data through June.

As the domestic economy hums along, rhetorical salvos and the threat of further sanctions continue to fly back and forth between Russia and the US and EU. The latest conflict in the Middle East has seen the resumption of hostilities between Israel and Palestine; in general the situation in the broader region is tenuous. Chinese construction appeared to slow in Q2, at least through the lens of CAT, which noted construction equipment demand “weakened a bit” in the country. In Europe, employment conditions appear broadly to be gradually strengthening. Amidst a global market sell off on the last day of the month, the US dollar gained against all major currencies.

The most recent Macro data changes are summarized in Exhibit 12.

Exhibit 12

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

Commodity Pricing

Natural gas pricing dropped below $4.00 per MMBTU for the first time since November, while Brent and WTI were each off about $5 per barrel in July as the distress in the Middle East has failed to materially impact the market.

We have been following aluminum closely of late – see
our recent blog on the subject
. AA has been a good call for us and
we wrote in March
that pricing would need to rise to see further upside. Aluminum is up 19.2% since January and has been much stronger than Copper (1.4%) and Steel (+3.3%) over that time.

US commodity and energy prices are indexed in Exhibits 13 through 17.

Exhibit 13 Exhibit 14

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

Exhibit 15

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 16

Exhibit 17

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 18 we look at expected net income growth by sector, comparing 2015 estimates with 2013 actual net income. The Paper sector still anticipates the healthiest net income growth and Capital Goods the weakest – there have been some monthly fluctuations (see Exhibit 19 below) but these have on the whole averaged out and the ordinal ranking and absolute figures are scarcely changed from March when we updated the exhibit to reflect 2013 net income. Exhibit 19 shows a reasonable correlation between expected net income growth and our skepticism index – except for Electrical Equipment (and, to a lesser extent, Chemicals). In these sectors, valuation is discounting an increase in returns that is not currently reflected in 2015 net income estimates.

Exhibit 18 & Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. The Paper sector was hit hard – MWV was unchanged, but IP estimate was trimmed 3.3% after reporting earnings, while LPX and UFS saw more substantial cuts of 13% and 17% respectively. Our other sectors saw fluctuations on a cap weighted basis but these more or less evened out using a simple average (unweighted).

Exhibit 20

Source: Capital IQ and SSR Analysis

In Exhibit 21 we show the change in 2014 EPS estimates over the past month.

Note that the numbers in Exhibit 21 differ from those in Exhibit 4 as the data is cap weighted at each index point in Exhibit 21 and a current cap weighted average of percentage changes in Exhibit 4. The cuts to the Paper sector were again driven by UFS ($4.10 EPS revised to $3.22) and LPX ($0.35 to $0.19). The increase in the Chemicals sector was a function of LYB which saw more than $0.50 added to its full year EPS estimate after reporting earnings. The Metals sector is the outlier in Exhibit 22 as the performance of AA and X overcame the negative revisions and underperformance of most of the rest of the group.
Exhibit 21

Exhibit 22

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 May are summarized in Charts 23 through 33.

Exhibit 23

Exhibit 24

Exhibit 25

Exhibit 26

Exhibit 27

Exhibit 28

Exhibit 29

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Exhibit 32

Exhibit 33

Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 34 through 45.

Exhibits 34-36

Optimism High

Skepticism High

Exhibit 34

Exhibit 35

Optimism High

Exhibit 36

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Optimism High

Skepticism High

Exhibit 37

Optimism High

Exhibit 38

Skepticism High

Optimism High

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Skepticism High

Optimism High

Exhibit 41

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibits 43-45

Optimism High

Skepticism High

Exhibit 43

Exhibit 44 & 45


Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in July

July 28, 2014 – Industrial Gases: APD Must Focus on Costs, But PX the Better Investment

July 28, 2014 – SWK: Business Momentum to Continue (Blog)

July 25, 2014 – Lyondell Numbers and Very Weak NGLs Bode Well for Westlake (Blog)

July 23, 2014 – DuPont: Ag-rivating, But Unlikely to Change Without Action

July 23, 2014 – Dow: Good Quarter Understates Potential – Particularly If Dow Can Stick To the Path (Blog)

July 15, 2014 – Chemicals Monthly: Albemarle Active, Gases Gain

July 11, 2014 – Aluminum: A Short Term Bubble or the Real Thing (Blog)

July 1, 2014 – Monthly Review July 2014: Commodity Chemicals Stretching the Limits


In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield.

Exhibit 46

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©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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