Sector & Sovereign Industrials & Basic Materials: Monthly Review June 2012

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley

203.901.1629

graham@sector-sovereign.com

June 7, 2012

Sector & Sovereign Industrials & Basic Materials: Monthly Review June 2012

  • Despite a month of broad absolute and relative underperformance valuation changes in May did not do enough to alter our view. The Paper sector underperformed but remains very richly valued in our view, though commodity pricing in the sector is stable. Electrical Equipment is now as expensive as Paper after a month of outperformance.
  • Outside Paper, commodity pricing trends turned negative in May, most significantly in plastics, where surplus supply combined with declining input costs, causing US pricing to fall more than 10%. Base metal pricing has also moved lower.
  • With the exception of Paper and Metals and Mining, each sector saw small positive revisions for 2012 in May, mostly an extension of activity post Q1 earnings. Though still small, the most positive revisions were for Capital Goods. We would expect this more positive trend to reverse in June given more negative expectation for demand and the weaker Euro.
  • The broader Chemical group is looking more expensive and given that the commodity subset has underperformed, it leaves the rest of the group looking very richly valued. There is considerable Euro exposure in this group. Ten of the 25 companies in our “overvalued” screen are in the chemical group.
  • The Packaging sector underperformed in May and while not cheap enough to make a recommendation on valuation alone, should be a beneficiary of falling commodity prices. There are no packaging companies in our “overvalued” screen and a couple in the “undervalued” screen.

Exhibit 1

Source: SSR Analysis

  • Given the risk that we see weaker demand exaggerated by an inventory correction in the near-term we would stay away from any stocks trading at an all time high multiple. This group generally does not outperform in a period of demand weakness, regardless of valuation.

Exhibit 2

Overview

May 2012 was a bad month for the market and a bad month in general for the Industrials and Basic Materials. Macro indicators turned more negative and confidence in Europe’s abilities to fix its own problems without major disruption fell further. At the same time, while expectations for China did not get worse, they did not get better and expectations for India and Brazil did get worse. US manufacturing, jobs and housing starts numbers disappointed. All of this, in our opinion is happening against a backdrop of sector valuations that do not for the most part discount the sort of relative weakness that now looks more likely. Several sectors began to reflect the concerns in May; Capital Goods, Packaging, Paper and Engineering and Construction, all of which underperformed a weaker broader market quite meaningfully – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis

While these sectors underperformed, we are not at valuation levels anywhere except Metals and Mining where we could be confident that things are priced in. There is still significant risk if fundamentals continue to weaken and if they are accompanied by an inventory correction (however small) as
suggested in recent research
. Exhibit 4 shows end-May sector discount from normal value and while E&C’s underperformance in May has made the group look more attractive, these are volatile sectors and we would not be too interested in anything that is not at least 1 standard deviation below normal value. The Paper sector underperformed in May, but it remains one of the most expensive of the sectors, though Electrical Equipment is perhaps being seen as a relative safe haven, and its outperformance in May now puts it at a valuation premium similar to Paper.

History would suggest that it is still only Metals and Mining that is showing an adequate discount today to reflect the risks, but it looked pretty attractive at the end of April and still managed another 6.6% relative downside in May – while we are close to a bottom in Metals and Mining we cannot rule out further incremental downside. The apparent attractiveness of conglomerates is all GE (given our reversion to mean framework), and ex-GE the rest of the group is close to fair value. Chemicals outperformed a little in May, some of this driven by a couple of larger cap names that did well in the month, SHW and MON. Commodity Chemicals underperformed despite relatively attractive valuation.

Exhibit 4

Source: Capital IQ and SSR Analysis

Our Skepticism Index continues to show significant valuation discount relative to current profitability, Exhibit 5, but the expectation that current profitability may not be sustainable is probably appropriate in many sectors and subsectors. Our ROC driver in the SI analysis is driven by forward earnings and we have yet to see SI reductions as a result of estimates coming down.

Exhibit 5

Source: Capital IQ and SSR Analysis

In Exhibit 1 we showed the companies in the upper and lower quartiles of both our valuation analysis and our Skepticism Index work. The left hand side of the exhibit shows the attractively/under-valued companies within each framework and the right hand side shows the unattractive/over-valued companies. We have highlighted the companies that appear in both 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.

There has clearly been deterioration in the macro environment over the last month. The primary focus has been on Europe because it is clearly the region that is making the most noise today. However, out of the limelight, we have seen no real improvement from China, with some more negative recent data, and we have seen deterioration in India and Brazil.

The US has seen disappointments in job numbers and manufacturing. The expected improvement in the housing market in the US is taking its time and we continue to bump along a prolonged bottom.

The most recent Macro data changes are summarized in Exhibit 6.

Exhibit 6

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

Commodity Pricing

Commodity pricing has turned negative again over the last several weeks, most pronounced in basic plastics, where the declines in May are well over 10% in the US. This is in part driven by a fall in costs as all feedstocks for basic chemicals have declined – US ethane pricing has moved dramatically lower – despite a rise in natural gas prices – and propane pricing has effectively collapsed because of significant inventory build in the US as production rises. Within the US, but also elsewhere, the fall in oil prices has impacted costs also.

US plastics price are indexed in Exhibit 7 and energy prices are summarized in Exhibits 8 & 9.

Exhibit 7

Source: IHS

Exhibit 8 Exhibit 9

Source: IHS

Metals pricing is also weakening, with the recovery in March and April short lived. Gold has been volatile, but appears range bound; however, it would not be unusual for gold to appreciate if the macro environment gets worse. Base metal pricing declines are driven much more by supply/demand or perceived supply/demand than they are by costs, and reflect the weaker view of the global economy – Exhibit 10.

Exhibit 10

Source: Capital IQ, Bloomberg and SSR Analysis

Pulp, paper and lumber prices have remained fairly stable and lumber pricing remains quite strong – however, there are early signs of weakness in the pulp market, not yet reflected in pricing but framing discussions for future pricing.

Exhibit 11

Source: Capital IQ and SSR Analysis

Expectation Analysis

We have expanded the longer-term estimate analysis that we introduced in May, and if we look at expectations for 2014 by sector we see that they are now highest for Capital Goods, which has seen the most significant underperformance in May and lowest for Electrical Equipment, which saw the greatest outperformance in May. Clearly there is far more confidence around the estimates for Electrical Equipment than there is for Capital Goods. In Exhibit 12, we show growth versus our Skepticism Index. Intuitively the points should line up from top left to bottom right and the outliers today are Metals and E&C.

Exhibit 12

Source: Capital IQ and SSR Analysis

In Exhibit 13 we show how 2014 estimates have changed over the month. This is mostly because of revisions, but is likely also impacted by the addition of new estimates as analysts that have not provided 2014 estimates previously are included. We show data on a market cap weighted and a simple average basis. The difference shows that negative revisions have clearly been focused in the large cap companies and nothing is positive month on month. The Electrical Equipment data is very biased by a significant negative swing in estimates for EMR and a smaller one for ROK.

Exhibit 13

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 14 through 21.

Exhibit 14

Exhibit 15

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Exhibit 16

Exhibit 17

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Exhibit 18

Exhibit 19

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Exhibit 20

Exhibit 21

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 22 through 29

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23

Source: Capital IQ and SSR Analysis

Exhibit 24

Source: Capital IQ and SSR Analysis

Exhibit 25

Source: Capital IQ and SSR Analysis

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

Source: Capital IQ and SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

©2012, 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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