Monthly Review May 2014 –What Weather? Earnings Strong Even With GDP Sluggish

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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

April 30th, 2014

Monthly Review May 2014What Weather? Earnings Strong Even With GDP Sluggish

  • Revenue growth year over year has been predominantly positive within Industrials & Basic Materials despite a generally subdued demand environment in Q1 2014 as evidenced by an underwhelming US GDP figure. Weather was a headwind, but several companies reported signs of recovery and positive year on year results in Europe. There is still plenty of operating improvement coming through with self-help initiatives driving results at DOW, AA and others.
  • There were pockets of weakness where earnings misses and subsequent revisions drove underperformance – JEC in E&C and RKT in Packaging. Paper and Metals saw the worst revisions but recent months of underperformance have left little room to the downside; Paper was down less than 0.5% versus the S&P and Metals actually outpaced the market.
  • Electrical Equipment and Paper are over-earning even more than their valuation premiums might suggest – in the Paper sector this premium has been steadily falling ahead of returns. Electrical Equipment has held its valuation but is influenced by expensive niche companies (GNRC) and large cap names (EMR, AME, ROK).
  • April research featured two sets of possible pair trades – we see relative value in DOW vs. LYB and prefer PX to APD. We also published pieces on the export risk of a Chinese slowdown, and natural gas conditions in the US. Reports on two of our longtime Industrial favorites – AA and SWK – rounded out the month.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. The easy money has likely been made in AA – see recent research referenced above. Another longtime favorite, CAT, has done very well and we see further upside here. Our Chemical concerns reflect our cautious outlook for Commodity companies LYB and WLK, given higher natural gas prices.

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

As we move through the first earnings season of calendar 2014 reports have been varied. The historically cold winter had a severe impact on some (UPS); less of an effect for others (DD and PX), and a third group was able to offset some significant headwinds in the US with gains elsewhere (DOW and LYB). Revenue growth year over year has been positive, by and large, despite a generally subdued demand environment in Q1 2014 – Exhibit 5. 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. The transport numbers are surprisingly strong given the predominantly US nature of the business and the weather difficulties.

Exhibit 5

Source: Capital IQ, SSR Analysis

Though some possible weather related weakness in Q1 might reasonably have been expected to be translated into Q2 demand, revisions have been negative on average. The notable exception thus far is the Capital Goods sector which benefited from upwardly revised estimates for large cap tickers CAT, ITW, and IR. We have consistently highlighted the Capital Goods group as the most unloved (excluding Metals) and what we are seeing is extreme caution going into 2014, by both the companies and by analysts translating into positive results – there is more relative strength to come in this group in our view. All four Paper stocks in our index saw negative EPS revisions on the month, but the group’s decline was most driven by LPX (-20%) and UFS (-13%) – year to date LPX’s 2014 EPS estimate has come down 55%. Conversely, E&C’s negative revisions were almost wholly attributable to JEC, which dropped sharply on a weak earnings report and outlook. Packaging likewise was driven down by a sizable cut at RKT.

We would expect the E&C sector to start positing 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.

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-March sector discounts from normal value. Outside of the cyclically weak Metals space, the Capital Goods sector represents the best value within Industrials & Basics – CAT has performed well, and we see further upside, and SWK was up after earnings and should continue higher in our view. IP has been range bound in the mid $40s for over a year which has lowered the once extreme relative multiple of the sector; Paper is no longer so richly valued. Electrical Equipment is now the most expensive sector, and all of the large cap names (EMR, ROK, AME) indeed screen at a premium. Niche companies like GNRC also show rich valuations. As Exhibit 6 suggests, most of the discount in the Conglomerates sector is attributable to GE; most notably within the group, HON is trading at a high premium based on its historic return profile.

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.

The valuation premium in Electrical Equipment is still understating the group’s current return on capital. A similar scenario is exhibited in the Paper sector, where valuations are declining ahead of returns, which remain strongly above trend – the market has started to discount a decline in earnings from these levels.

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 March monthly.

The results for March were very strong, and this continued in April to a lesser extent. The valuation screen had the best return (+2.5%) while the overlap screen, typically the most robust, gained 1.2% on the month – Exhibit 10. This run of positive performance comes on the heels of lackluster returns in the first two months of 2014. Four months into 2014, the aggregate results exclusive of transactions costs are positive for the overlap screen (+3.3%) and for the valuation screen (+1.9%), but the SI screen continues to lag (-2.4%) – 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.

The S&P 500 has been up and down but has moved more or less sideways since the end of February. A much weaker US GDP reading than expected was shrugged off as weather driven and investors seem assured of continual support from the Federal Reserve even as the taper progresses. Looking internationally, several companies have noticed positive trends out of Europe in Q1 earnings reports. We wrote this month that the biggest threat from a Chinese slowdown,
in our view
, is an export push into the international market.

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 is hovering near 52 week highs, with little sign of an inventory rebuild following a decidedly harsh winter –
see our recent piece on the subject
. Crude’s gains on the month (+1%) could not keep up with the strength in natural gas pricing (+10%)

Steel was the strongest gaining metal on the month, up over 5%, followed by aluminum (2 %+) and Copper (1 %+). We believe aluminum pricing will remain subdued for the next 24 month 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 Metals sector was showing only a small increase over 2012 net income levels, but has an easier comparison with 2013 levels that were subdued as a result of a poor year for large cap gold miner NEM. The Transports sector had been showing a much greater degree of forward optimism but this was partly driven by a very low 2012 figure for UPS. Paper still shows the most long term growth in forecast net income. There is the least optimism for the Capital Goods and Chemicals sectors.

Exhibit 18 & Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. Estimates continue to come down in the Metals sector, which has seen some of the most negative revisions in the group for the second month in a row. Packaging saw the second worst declines on both a weighted and an unweighted basis, concurrent with similar declines in 2014 EPS estimates – see Exhibit 21 on the following page. The Capital Goods sector had a very positive month on both measures.

Exhibit 20

Source: Capital IQ and SSR Analysis

In Exhibit 21 we show the change in 2014 EPS estimates over the past month. Capital Goods was the only sector to see material positive revisions, driven, as in the net income exhibits above, by the large cap constituents: CAT, ITW, IR. Exhibit 22 has shown a much better correlation in past months. In April, revisions continued in two sectors (Metals and Paper) that have seen significant downward pressure on estimates over the past few months, to the point where valuations have largely discounted this. E&C estimates were down as well, again a result of JEC.

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 November are summarized in Charts 23 through 33.

Exhibit 23

Exhibit 24 Exhibit 25

Exhibit 26

Exhibit 27

Exhibit 28 Exhibit 29

Exhibit 30

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

Skepticism High

Exhibit 39

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Exhibit 41

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

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in April

 

©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.vidends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. SWK narrowly dropped out of the dividend screen. OLN is joined this month by BRC and FCX as the only companies to appear on all three screens.

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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