Price Weakness In A Slow Market – Can It Be Different This Time

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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 25th, 2013

Price Weakness In A Slow Market – Can It Be Different This Time

  • Stagnant economic growth has historically resulted in aggressive price competition in almost all industries and ultimately prices bottoming at levels where the swing producer shuts down or cuts back. In today’s markets for most Industrial and Materials sectors we have the drivers of price weakness, overcapacity and stagnant demand, but not the result – yet.
  • The economic environment is not unlike the late 1970’s and early 1980’s which saw a prolonged period of relatively stagnant demand versus expectations; and capacity increases – but also saw historic lows in gross margins for all sectors. Today, the Cap Goods, Conglomerates, Electrical Equipment and Transport sectors are close to historic high gross margins, and even the more troubled sectors are well off historic lows.
  • Market structure can explain much, but not all. Sectors where the US market structure has improved and where markets are regional have clearly seen benefit and should continue to benefit; transports, coatings and some segments of paper. However, where markets are international, better structure in the developing world is often offset by new competitors elsewhere.
  • Refreshing our work on gross margins, we show that overall industrial and materials gross margins have continue to expand through 2012, and are well off the lows of 2008 and 2009, where we saw significant earnings declines. The good news is that pricing has held up in a slow market; the bad news is that it could fall a long way if competitive juices start flowing. In past economic cycles we have seen as much if not more price weakness post an economic bottom as we saw while the economy was declining.
  • Most vulnerable would be sectors where there is global competition and where margins are high: Capital Goods, Specialty Chemicals, and Conglomerates. A stock screen of expensive names with high gross margin in global markets is shown in Exhibit 1.

Source: Capital IQ and SSR Analysis

Overview

The economy may be bouncing along a bottom, but there are few expecting significant growth quickly and a modest gradual recovery is probably about as bullish as commentators get today. Interestingly, there are plenty of examples of industries and companies where price competition and price decline intensifies after the global economy has bottomed and results actually get worse for a couple of years before they get better. This is certainly true in Capital Goods (and we will have a follow up on this sector shortly) and in Chemicals. Leading companies in both industries saw earnings trough a couple of years after the economy troughed in the mid 80s, the early 90s and the late 90s.

Today we see very high gross margins in many sectors, but most notably in Capital Goods, Conglomerates, Specialty Chemicals and Transports, despite a very weak economic environment that has persisted for a couple of years. This would suggest that companies are doing a good job of holding on to pricing, while they reduce costs, as demand growth is very limited. Most of the companies that have reported Q1 2013 earnings have reported zero or negative revenue growth year on year, supporting the weak economic backdrop claim – Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

We are not sure what causes the price weakness, post the economic low, but it is likely to be a combination of the factors below:

  • Companies begin to feel confident again and instead of taking a protectionist approach to their business, they take an expansive one, trying to capture market share or push into incremental markets.
    • “The market is growing again, we must get our fair share of the growth”
  • Companies learn through periods of austerity how to manufacture for less – hence the higher gross margins – this is then competed away as everyone has followed the same path. There are instances where a cost change in a product allows it to compete in a market it has not been in before, increasing the competitive pressure in that market.
  • Customers have learned to lower costs also and use this leverage to pressure suppliers who want a larger share of their business as volumes recover.

Gross margins in general look inflated, but as always our aggregates are just that, aggregates of the individual companies. In Exhibit 3 we show the 20 companies that have seen the greatest gross margin expansion over the last two years and those with the most compression. In Exhibit 4 we plot this against discount from normal value.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

The interesting names are as always the outliers – companies that are expensive despite declining gross margins or companies that are cheap despite improving gross margins. If we look at Eastman for example, the company has appreciated well despite a slightly weaker gross margin trend – this valuation improvement has much more to do with the restructuring of Eastman’s business and much lower earnings volatility and greater growth. In this case the trade off in gross margins has been worth it. In addition, valuation tends to be forward looking and the steel companies are cheap because there is an expectation that gross margins will weaken going forward. GRNC would be the antithesis of this, given the positive step change in earnings, albeit at slightly lower gross margins.

Gross Margins Looking Good

As we suggested
in our earlier work on the subject
, gross margin trajectories explain much of the positive earnings momentum that we have seen in Basic Materials and Industrials over the last few years despite a weak volume environment. They also provide a basis for both optimism and risk looking through the next couple of years. Optimism where we can be comfortable that the GM trend is not driven by movement in a product price or raw material that has had and is expected to have significant volatility – more likely when in regional rather than global markets. The risk comes where there is little structurally to support pricing as often positive points of inflection in economic growth tend to drive increased rather than decreased price competition. Historically gross margins have continued to fall after an economic low has been reached – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

In Exhibit 6 we show sector relative performance (to the S&P 500) following a peak in gross margins, with most sectors capturing 4 or 5 peaks over the last 30 years. Capital Goods and Packaging are the most consistently positive, which would be counterintuitive.

With Capital Goods the standard deviation is high and there are some significant examples where performance is negative – CAT would be one of those.

For Packaging, we suspect that declining gross margins are perhaps associated with a decline in raw materials pricing and an expectation that profitability will improve. Commodity Chemicals has the same pattern, as the stocks also tend to outperform as raw material prices fall.

Exhibit 6

Source: Capital IQ and SSR Analysis

The sector by sector charts are included in Exhibits 7 through 24 (including break-downs by sub sector for Chemicals and Transports). We would make the following observations:

  • We raised a red flag about paper in our original analysis, given the negative turn that gross margins have taken recently. We would extend this to packaging also, though the valuation premium in paper should make that more of a focus.
  • Conglomerates, Transports and Capital Goods have seen improvements since we first published, 7 months ago, but the rest of the groups have either seen volatility driven by raw materials or have seen some slight declines.
  • Electrical Equipment has seen a flattening, and unless the trend can start to rise again companies are going to find it hard to meet the expectations implied in valuation. There is more of a US bias to this group, which is good from a near-term growth perspective, but at the same time should have resulted in continued upward movement in gross margins over the last year.
  • Rail company margins continue to drive the trend for Transports and, given that this is the cheapest sub-group in Transports, highlights what we see as a relative opportunity within the broader sector – long Rail, short Trucks and Mail.
  • Specialties stand out in the chemical space, and look vulnerable in a prolonged weak demand environment.
  • We would expect Commodity Chemicals to have higher margins given the US natural gas advantage and would expect the line to pick up once we add Q1 2013 data.

Exhibits 7 through 24

Exhibit 7

Exhibit 8

Exhibit 9

Exhibit 10

Exhibit 11

Exhibit 12

Exhibit 13

Exhibit 14

Exhibit 15

Exhibit 16 Exhibit 16 Exhibit 17 Exhibit 18 Exhibit 19Exhibit 20

Exhibit 21 Exhibit 22 Exhibit 23

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