Monthly Review June 2014 – Valuation Dispersion Elevated as Markets Stretch Higher

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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

June 1st, 2014

Monthly Review June 2014 – Valuation Dispersion Elevated as Markets Stretch Higher

  • As the S&P hits record highs almost daily, valuation dispersion in Industrials and Basics as a whole and within certain constituent sectors is at historically elevated levels. This trend was underscored in May as the worst and best performing stocks (GNRC and PPO, respectively) came from the same sector – Electrical Equipment.
  • Our sectors largely failed to follow the market move upward – only Chemicals and Transports outpaced the S&P (each by 2%) and Packaging was little better than flat. Chemical stocks (WLK, MON, ROC and LYB) comprised four of the best nine performers on the month (see our recent commentary on WLK) and Transports proved resilient in the face of weather related impediments (+5.5% revenue growth in Q1).
  • We continue to see broad based negative revisions. After the weak first quarter in the US we would expect to see a more positive turn to revisions from here – already evident for Capital Goods
  • E&C was the worst performing sector in May, down nearly 5% relative to the S&P. This move lower has pushed the group past Capital Goods as the second cheapest sector in Industrials & Basics (behind only the cyclically depressed Metals space). Within E&C, FLR, URS, KBR and ACM are all one standard deviation below normal value on our framework, with KBR (2.3 SDs) the most extreme (within the sector and within our coverage overall).
  • In May we analyzed revisions and valuation dispersion in Capital Goods and Chemicals, made the case for DD at $85, and published blogs on WLK, DOW’s MLP alternatives, natural gas, and the DD-Tronox speculation.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. The easy quick money has likely been made in AAsee recent research but we think the story is far from over. Another longtime favorite, CAT, has done very well and we see further upside here. WLK is no longer one of our Chemical concerns, following the MLP and Vinnolit acquisition announcements.

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

See
Appendix 3
for the data underlying this exhibit.

Exhibit 4

Overview

The worst winter in some time may have put a dent in first quarter GDP but it did not prevent the majority of Industrials and Basics from growing revenues. With earnings reports from 127 of our 130 companies on the books, sales growth year over year was firmly positive, outside of Paper and E&C – Exhibit 5. The Transport numbers were surprisingly strong given the predominantly US nature of the business and the first quarter weather difficulties – NSC was the only Transport stock to see a revenue decline. Paper would have been marginally positive excluding LPX’s 16% year over year sales decline. E&C results were mixed but declines for FLR (-25%), URS (-9%) and ACM (-6%) more than offset strength in JEC (12%) and PWR (11%). We would expect the E&C sector to start posting increasingly better backlog numbers going forward as projects in the US Gulf move from the drawing board to detailed design and construction. JEC could be a disproportionate beneficiary here. Packaging companies grew revenues by over 2% excluding PKG, which nearly doubled sales due to the accretive impact of Boise Inc., a $2 billion acquisition completed last year.

Paper and E&C’s earnings misses were accompanied by negative revisions, and all together contributed to underperformance for these groups for the month. The Metals sector saw the most extreme cuts to 2014 EPS estimates in May, but was little worse than flat with valuations already at extreme lows. Electrical Equipment was a notable underperformer over the past month – GNRC was off its highs on a weak earnings report and continued lower throughout the month, down 17% as the worst performer in our coverage – it was highlighted by us as one of the most overvalued stocks in the group at the beginning of the year. BWC and GTI were among the 10 weakest stocks as well. Highlighting the divergence in the sector, PPO was the biggest gainer in May – the stock gapped up on news of a long term supply agreement with Panasonic and the positive momentum was sustained through the month.

Exhibit 5

Source: Capital IQ, SSR Analysis

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.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes end-May sector discounts from normal value. E&C stocks took a tumble in May and are now the second cheapest sector, behind only Metals where revisions remain negative and valuations depressed. Within E&C, FLR, URS, KBR and ACM are all one standard deviation below normal value on our framework, with KBR (2.33 SDs) the most extreme. CAT and SWK remain the large cap value plays in the Capital Goods sector. DE looks cheap on valuation alone but lacks a near-term catalyst –
see past Ag related research
. Electrical Equipment is expensive in the aggregate, driven by premiums for the major large cap players (EMR, ROK, AME) but valuations are quite dispersed within the sector. GTI is dealing with cyclical disruptions in the steel market for its graphite electrodes and an activist led boardroom drama, and is but one of a handful of inexpensive small cap names in the sector.

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.

Paper and Electrical Equipment have similarly high skepticism index values. Forward estimates are strong for these sectors, driving above trend earnings on our model, but valuations, while elevated in some instances, do not fully reflect these returns. Most of these groups have seen two to three years of consistent negative revisions as estimates have reflected a global economic recovery (led by the US) that has been slow to materialize – it is hardly surprising that for many groups valuation discounts an expectation that earnings estimates will decline.

Exhibit 8

Valuations Overestimating Current Returns on Capital

Valuations Underestimating Current Returns on Capital

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 April monthly.

The results have been strong for the past three months. The overlap portfolio led the way in typical fashion – Exhibit 10. Five months into 2014, the aggregate results exclusive of transactions costs are positive for the overlap screen (+6.5%) and for the valuation screen (+3.4%), but the SI screen continues to lag (-2.0%) – Exhibit 11.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

In
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.

Q1 marked the first contraction in the US economy since 2011 but the market was undaunted; the S&P rallied 2% in May, hitting new highs almost daily as the month drew to a close. The Fed appears vigilant in its staunch support for further accommodative measures. The reported decline in consumer spending toward month’s end underscored the Fed’s lingering concerns. One data point is just that, one data point, but our colleague Rob Campagnino has for some time highlighted stagnant wage growth and a declining labor force as reasons to be cautious about the US consumer. Declining treasury yields hint at still strong demand for the safety of US paper even as the ongoing taper puts upward pressure on rates – fewer treasury issuances year to date have limited the supply and contributed to the decline as well. The FDIC reported a 23% rise in treasury holdings by US banks in Q1, marking the greatest increase since the crisis.

Europe finally appears to be emerging as a bright spot. Q1 earnings reports within Capital Goods, Chemicals, Conglomerates and Electrical Equipment overwhelmingly confirmed an improving outlook for the long-beleaguered continent. Employment has largely stabilized. Cyber salvos aside, China looks like it has stabilized in the 7-8% growth range, lower than in previous years to be sure but far from the hard landing many feared.

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 came off a bit with the warming weather to finish the month hovering around $4.50 per mm BTU, while crude oil ticked up. Nat gas inventories are in a steady state of replenishment after the depleting winter, but remain well outside of the five year range –
see our recent blog on the topic
.

Steel gave back its gains of a month earlier and was the only metal to decline; copper gained 2.3% We believe aluminum pricing will remain subdued for the next 24 months due to oversupply – mostly from China – in our view
rising prices are needed
for any further significant appreciation in AA, where
the easy money
has largely been made.

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 sector rankings are unchanged from a month ago.

Exhibit 18 Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. The cap weightings altered the results significantly in May. Capital Goods showed the biggest gain on an unweighted basis but a decline with the cap weight – CAT’s net income estimate actually increased but its falling cap weighting dragged on the group overall. Paper’s result was a function of IP – its large absolute figure relative to its sector peers was moderated somewhat in the cap weighting.

Exhibit 20

Source: Capital IQ and SSR Analysis

In Exhibit 21 we show the change in 2014 EPS estimates over the past month. E&C and Paper (two significant laggards in May) were off more than 1% for the second consecutive month. Packaging was the lone sector to see meaningful positive revisions. BLL was most responsible for this increase – the stock has done very well over the past year and consensus sees this strength continuing.

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.


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

Skepticism

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

Exhibits 34-36

Exhibit 34

Optimism High

Skepticism High

Exhibit 35

Exhibit 36

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Optimism High

Skepticism High

Exhibit 38

Optimism High

Exhibit 39

Skepticism High

Optimism High

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Exhibit 41

Skepticism High

Optimism High

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibits 43-45

Exhibit 43

Optimism High

Skepticism High

Exhibit 44

Exhibit 45

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in May

May 28, 2014 – Westlake: Another Interesting Move – Vinnolit (Blog)

May 26, 2014 – DuPont/Tronox: The Math Says Yes – The Rest Says No (Blog)

May 23, 2014 – Dow: Lots of Talk – But Good Topics (Blog)

May 16, 2014 – Chemicals Monthly: Weathering the Strom Well

May 16, 2014 – Natural Gas: Chance of a Price Spike? (Blog)

May 15, 2014 – Chemicals Revisions: Not Positive Enough and Not Supportive of Values for Many

May 13, 2014 – DuPont: The Case for $85: But Why We May Need to be Patient

May 12, 2014 – Large Cap Capital Goods: Turning a Revisions Corner – Time for the Laggards to Win

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. DE rejoins OLN as the only companies to appear on all three screens. BRC and FCX dropped out of the valuation and skepticism screens, respectively.

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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