Monthly Review October 2014: Industrials Cheaper Across the Board – With Some Singular Exceptions

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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

October 1st, 2014

Monthly Review October 2014:

Industrials Cheaper Across the Board – With Some Singular Exceptions

  • In a very volatile market in September, Industrial and Material sectors widely underperformed the S&P, with the notable exception of Transports (+4.4% relative). Rail stocks continue to reach new highs and early reporter FedEx was up on positive earnings.
  • Despite this broad move lower, divergence within specific sectors and our group as a whole is notable. Overall, our small cap names (market cap below $5 billion) have significantly underperformed larger cap peers year to date in 2014 in a marked shift from historical trends. The Metals space also continues to show great dispersion, with X and NUE among the top 20 performers in our coverage this month (though off recent highs), while weakness continued in the mining names (CLF, NEM, and FCX) and certain steel makers (ATI).
  • This volatile September saw some significant stock movements – SIAL was up 30% after being acquired by Merck; DD was back up strongly on an activist call to action (one we have been sounding for some time); OI warned earnings would be at least 5% lower and the stock subsequently dove 15%; GTI saw its share price roughly halved on further negative revisions; while FDX gained 10% on its positive early earnings report.
  • In September we published our views on ethylene in 2015; wrote a thematic piece on the implications of a rising dollar and falling crude; expanded our Packaging coverage to the major can makers (BLL and CCK), who we see as screening on the expensive side; and made a case for more Chemical investment in the Marcellus region.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. DD remains a focus for us – see our recent blog on the stock and its activist drama.

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

Reports of lower train speeds and railcar and driver shortages have not prevented Transports stocks from making new highs – this was the best performing sector within Industrials and Basics, and only Conglomerates managed to keep pace with a volatile, but down market. The Transport strength was driven by the railroads as KSU, NSC, CSX, and UNP were all among the top 10 performers in our group in September.

FDX meanwhile had the second largest gain on the month (+9%), behind only Sigma Aldrich (SIAL) –shares jumped 30% as Merck paid a premium valuation for the specialty chemical maker. Our longtime favorite, DuPont was third best performer in our coverage in September as the market took favorably to Trian Capital’s goading of management.

The worst performer in our group, GTI lost nearly 50% of its value on the month as the company guided down yet again – the graphite electrode manufacturer is the victim of an increasingly competitive market for its increasingly commoditized product, and, arguably, an inept management team that failed to foresee this. Mining remains weak and shares of these companies continue to see downside pressure – CLF down over 30%, NEM 15%, and FCX 10%. Glass maker Owens-Illinois (OI) fell prey to over-optimism and guided down significantly for the duration of the year – the stock price followed suit, and was off 15%. General Cable Corp (BGC) continues to see negative revisions and has seen its share price trimmed in half over 2014, but the cable maker has a very healthy dividend and figures to benefit from a turn in global construction markets, infrastructure build ups in developing regions, and replacement cycles in mature markets – unless we stop using copper wire. 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 5. Most sectors underperformed the S&P in September, with machinery and construction stocks the worst laggards. Revisions stabilized for KBR but momentum continued to the downside (-14%). The Chemicals group was insulated from the selloff by DuPont’s strong gains on an activist call to action (a call that
we noted in January 2013).

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6 summarizes end-July sector discounts from normal value. The overall group continues to trend slightly less expensive than it has in previous months – as expensive sectors are underperforming in a volatile market.

Exhibit 6

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 7. 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. Overall the chart shows that earnings/returns are doing well, and that it is only in the chemicals and transport space that valuations are ahead of current earnings.

Returns in the Paper and Electrical Equipment space remain strong, but valuation is preceding them to the downside. The Metals sector, meanwhile, continues to discount a further decrease in returns, which are below trend but not by as much as valuation would suggest – revisions have stabilized and turned broadly positive, but valuation has not moved as returns have improved.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 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 8

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 September monthly.

Results for September were largely positive, outside of the pure valuation screen. The overlap continues to be the most robust, but has a bit of ground to cover to match 2013’s cumulative gains. Standouts on the long side included, of course, DuPont, while CYT, POL and GNRC drove performance on the short side.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

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 US dollar has been strengthening steadily in recent months and ended September at $1.26 per Euro, a level last seen in mid-2012 – see our recent piece on the implications of this move for the Commodity Chemicals space. August Consumer spending rose 0.5% sequentially (with a notable 1.8% jump in durable goods) and 4.1% year over year. Wage growth remains modest, coming in at just 0.3%. Inflation continues to be subdued, affording the Fed more time to nurse the economy back to health with ever-low interest rates.

International news continues to be dominated at alternating intervals by the Middle East and the CIS. In September, the stories have turned back to the Middle East, where increasing instability driven by Islamic insurgents has resulted in allied air strikes led by the US. Normally this would have significant implications for crude oil but increased US production and middling demand growth globally have brought prices below $100 per barrel. In the CIS meanwhile, German Chancellor Merkel said she does not “see any change at the moment regarding Russia’s position.”

Our note dated August 12th highlighted the risks to Europe from any escalation of Russian sanctions, not just the obvious energy implications but those in the machinery and chemicals industries as well. Unemployment remains elevated at record levels and prices are stagnant – Europe is far from out of the woods, with headwinds continuing to come from the East.

The most recent Macro data changes are summarized in Exhibit 11.

Exhibit 11

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

Commodity Pricing

Despite continued air strikes in the Middle East, crude oil prices remain under $100 per barrel. Brent was up a notch in September but WTI fell to $93 at month’s end. Natural gas on the other hand ticked up for the second consecutive month even as inventories remain on track to return to normalized levels.

We have been following aluminum closely of late – see
our recent blog on the subject
. AA has lost some of its upward momentum but has not given back its gains.
We wrote in March
that pricing would need to rise to see further upside, and on a per ton basis they are up over 10% from that time, even after a 9% drop over September. Prices for the metal continue to rise, crossing $2000 per metric ton for the first time since January 2013, and are up more than 25% since January. Copper and steel pricing has been more stable, and saw slight declines in the past month.

US commodity and energy prices are indexed in Exhibits 12 through 16.

Exhibit 12

Exhibit 13

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

Exhibit 14

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 rankings are unchanged from last month. Machinery shows the least optimistic outlook while Materials have the healthiest growth expectations (with the notable exception of Chemicals which is towards the back of the pack on this metric). E&C is anticipating reasonable growth as well, though given the recent struggles of several companies to effectively gauge sales, forward estimates should be viewed with a grain of salt. Exhibit 19 shows a reasonable correlation between expected net income growth and our skepticism index – with the notable outliers of Electrical Equipment, Chemicals and, to a lesser extent, Transports. In the first two of those sectors, valuation is discounting an increase in returns that is not currently reflected in 2015 net income estimates, while the Transports sector is receiving more credit than its longer term estimates would imply.

Exhibit 18 & Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. The Metals sector was up in absolute terms and on a cap weighted basis as FCX saw significant positive revisions – the absolute earnings power of the company and its market cap influence both of these results. AA, NEM, NUE, X, and STLD all saw sizable increases as well. Electrical Equipment’s increase on the weighted basis was a function of cap weighting – EMR saw little change to its net income estimate but gained in the cap weighting, driving the sector’s leading position. Capital Goods saw a similar effect in the opposite direction, where CAT lost market cat but the absolute estimate was otherwise little changed. The 13.7% cut to LPX’s net income estimate was masked in the cap weighting, which is dominated by IP (estimates here were stable).

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. Revisions were mixed – the Metals sector saw widespread positive revisions, most concentrated in US Steel. Transports were up mainly on the strength of FedEx’s positive earnings report and guidance. Metals is the clear outlier in Exhibit 22 – excluding this sector there was a reasonable correlation between performance and revisions in September.


Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22

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

Skepticism 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

Source: Capital IQ and SSR Analysis

Research Published in September

September 25, 2014 – HB Fuller: Blaming SAP, But Where Is The Growth? (blog)

September 24, 2014 – More Ethylene From Lyondell: Unlikely To Discourage Others (blog)

September 23, 2014 – Why 2015 Could Be A Short Sharp Storm For US Ethylene

September 17, 2014 – Rising Dollar and Falling Crude: Bad For Commodity Chems

September 17, 2014 – Keeping DuPont Together: Corporate Denial or Corporate Vision? (blog)

September 15, 2014 – Chemicals Monthly: Revisions Down But Stocks Up

September 11, 2014 – Oil: The Big Uncertainty For US Chemicals (blog)

September 10, 2014 – BLL & CCK: Can Makers Not Cheap

September 9, 2014 – Marcellus Opportunity: Why We Should See More Chemical Investment

September 2, 2014 – Strong Manufacturing: Buy Industrial Gases (blog)

Dividends

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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