Significant Downside Risk From An Inventory Correction – The Stars Are Aligned

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Graham Copley

203.901.1629

graham@sector-sovereign.com

June 1, 2012

Significant Downside Risk From An Inventory Correction – The Stars Are Aligned

  • The inventory to sales ratio for our covered sectors is at a 25 year high, having jumped since 2008. There is risk that this corrects, lowering apparent demand and putting pressure on pricing and margins – valuations only discount this possibility in Metals and Mining.
  • Perceived lower costs, as oil prices fall, are compounded with concerns about forward demand, as emerging market growth slows and Europe takes a step down. Without these triggers we would be less concerned about the higher level of inventory, but the combination is likely to encourage de-stocking, driving a cycle of demand and pricing weakness.
  • We would avoid sectors and stocks that are at well above mid-cycle valuations – Paper, Electrical Equipment and Chemicals. Metals and Mining is at a more significant valuation discount than it was in 1991 (the last inventory peak) and appears to be pricing in the risk.
  • Product prices are already declining for plastics, some metals and paper products. Commodity producers could see margins decline more than anticipated from exaggerated price swings and others could see a similar negative surprise from lower volumes. Packaging could be a beneficiary of lower raw materials and has no inventory issue – it is also attractively valued both versus other sectors and versus its value in 1991.

Exhibit 1

Source: Capital IQ and SSR Analysis

  • It is likely that fear has driven above normal levels of raw material and product inventories through the chain for the last the couple of years – fear mainly of raw material costs as crude has risen against a demand backdrop of relatively strong global growth. These signals have clearly reversed recently.
  • Inventories further downstream of our universe are not significantly above normal (based on a sample review of year-end balance sheets) and so we do not expect the kind of overall demand impact for Basic Materials that we saw in the early 1990s. At that time the inventory swing had a 400-500 basis point impact on apparent demand growth, and consequently operating rates. This time we could see 200-300 basis point impact.
  • A quick positive correction in oil prices could turn things around, but without that there is risk that fundamentals deteriorate, exposing the cyclically high valuations in some sectors, most notably, Paper, Electrical Equipment and Chemicals (ex-commodities).

Overview

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. Today we see a potential de-stocking trend, based on the way oil prices are moving and economic forecasts are declining and we do not think that is appropriately discounted in valuation for many sectors.

We are seeing pricing falling and demand slowing across most of the basic materials sectors and there is a real risk that this is prolonged (several months) and more severe than anticipated, not necessarily because of a major negative swing in consumption, but because of a swing in inventories. Inventories throughout the supply chain are difficult to measure accurately and consequently major inventory swings have generally caught suppliers and investors off-guard. An increase in inventories throughout any supply chain tend to be driven by an expectation that costs (raw materials) will be higher tomorrow than they are today and that demand tomorrow will be higher than it is today.

With the run up in oil prices over the last couple of years and with stronger demand, first in Asia and more recently in the US, it is not unreasonable to assume that inventories have increased – aggregate company data suggests that this is the case in the Industrials and Basic Material sectors, but it is likely that it is also the case (though more muted) downstream.

The same dynamic that drives an inventory increase, drives a decline in reverse and we have that reverse dynamic today – oil prices (perceived costs) falling, and much more concern about demand, with Europe grabbing the headlines and overwhelming the US and China from a fundamental as well as an emotional perspective. China’s growth is very important to this group and a slowdown in growth in absolute terms is concerning, even if growth remains positive. While most of the companies in our coverage group have more revenues in Europe than they have in China, given the size of the trading partnership between Europe and China the two are linked.

The problem with an inventory swing is that it is self sustaining for a while, regardless of the underlying consumption fundamentals. Reducing inventory results in buying fewer finished products or less raw materials (depending on where you are in the chain), thereby reducing apparent demand and putting downward pressure on pricing. Lower pricing reaffirms the idea that you can rebuild inventories later at a lower cost and encourages companies to cut inventories further.

Demand may be picking up again in China, the US may be stable and Europe may not be as bad as many fear, but the inventory swing could feed on itself for a while squeezing margins on commodities as pricing falls and cutting profits severely in product areas where incremental margins are high. In other words it could be bad for most of our sectors.

We could see as much as a 200-300 basis point hit to production (operating rates) on an annual basis, which if concentrated in a few months could severely dent Q2 and Q3 results across the group. This is not expected to be as severe as the inventory swing that we saw in the early 1990s, as downstream we have much better inventory management than we did in the early 1990s and we are not expecting much of a swing from the customers of the Industrials and Basic Materials group. However, at the same time an inventory move is not priced in to valuation in most sectors and valuations were more reflective of possible weakness in 1991.

Our valuation work today suggests that the greatest risk is in the following sectors: Paper, Electrical Equipment and Chemicals (ex-commodities), but there are highly valued stocks in every sector and we would be wary of any name that is close to a peak multiple.

On the positive side, Metals and Mining has been pricing in this sort of correction for a while and does not appear to have too much relative downside. The Packaging sector is trading well below mid-cycle value and could be a beneficiary of these events. While there is a risk of lower sales, lower plastic, glass and metal prices would be a positive for Packaging, and the sector has not seen the upward inventory swing in recent years.

Inventories Have Stepped Up To 20+ Year Highs

We have measured inventory to sales ratios for every company in our coverage from 1989 to 2011. The data is summarized in Exhibit 1. We have very robust data from 1992 through 2011 and have made some estimates for the three prior years based on a smaller sample set. The risk is that the 1989

through 1991 estimates are too low, but by no more than 40-50 basis points. Regardless, the ratio at the end of 2011 is the highest we have seen. Furthermore, when we look at Q1 2012, the ratio had increased by 70 basis points over Q1 2011.

The increase in the inventory ratio over the last three years is most pronounced in Chemicals and Capital Goods, but Paper and Metals and Mining are higher. Packaging is essentially flat, as is Electrical Equipment. Conglomerates ex-GE is up marginally. The analysis does not apply to E&C.

The significant positive swings, Q1 2012 versus Q1 2011, are Capital Goods, Conglomerates, Paper and Metals and Mining. Electrical Equipment is up marginally, Chemicals flat and Packaging down. The quarterly data is summarized in Exhibit 2. Note that the ratios are higher because we are using quarterly sales as a denominator. We have chosen to use quarterly sales as we get the most meaningful quarter to quarter comparison by doing so. There are issues with trying to create annualized numbers from Q1 because of seasonality in some sub-industries. Also, because of deals that completed in 2011 we might not be comparing apples with apples if we annualized sales or used trailing 12 months.

Exhibit 2

Source: Capital IQ and SSR Analysis

Concern Stems Not from the Level of Inventories but a Reversal of the Factors that Likely Caused the Increase

Companies build inventories under two scenarios: when they expect costs to increase and when they see demand growing. Increasing inventories may not be a conscious action in the latter case, but it is generally a conscious move in the former. The latter is often used a reason not to be concerned about rising inventories.

The most visible global cost driver has been the price of oil and until recently we have seen a prolonged period of strength in prices following the sharp fall coincident with the global recession in 2008/2009 – Exhibit 3. We did see a pullback in oil prices in the middle of 2011 and this did not drive a meaningful inventory reduction. However, at that time we were still expecting strong global demand growth and it is our opinion that the combination of lower oil and weaker expected demand will be the trigger for an inventory pull back; one factor alone might not have been enough.

The decline in 2008 did not drive a meaningful inventory/sales correction, although in an environment where sales were falling quickly, it is surprising that the ratio did not rise and suggest that inventories were controlled quite well and quite aggressively.

Exhibit 3

Source: IHS and SSR Analysis

Demand growth expectations are far less robust than they were only few months ago. We have been covering stocks, reading quarterly reports and listening to company conference calls for more than 20 years, and we have never seen a period where the US was highlighted as the growth opportunity in the way that it was in Q1 2012. This is clearly a reflection on the weakness elsewhere as it is any strength in the US.

Expectations have come down for China and now also for India, while the situation in Europe continues to deteriorate. All is not well in the US either and we were struck by a comment in IHS’s most recent basic chemicals report where they suggested that according to the American Chemistry Council (ACC) domestic demand for polyethylene in April 2012 was the lowest level since March 2009. This is most likely an indication that the inventory swing is already in motion as we have not seen a significant enough move in consumer confidence or retail sales to have driven this outcome; in fact retail trends remain broadly positive in the US.

While we do not have macro data for May 2012 yet, a summary of the data for April shows more red than green – Exhibit 4.

Exhibit 4

Source: Capital IQ,

Pricing is Turning Lower

In Exhibit 5 we show pricing indices for base metals and plastics and it is the most recent – May 2012 – data point that is most interesting as it shows a negative turn. Some of the May 2012 data is estimated, and if anything final prices for the month may be a little lower than suggested in the charts as spot pricing is weakening quickly, particularly for plastics. We have seen swings in pricing before, and some recently, but as indicated above we think it is the confluence of events that is concerning.

Exhibit 5

Source: Bloomberg, Capital IQ, IHS and SSR Analysis

Valuation Suggests Considerable Downside Risk Everywhere Except Packaging

In Exhibit 6 we look at where the sectors were trading relative to mid-cycle “normal” value at the end of December 1991 and where they are trading today. In 1991 the group was much cheaper than it is today and was discounting expected declines in earnings. Only the Packaging and Paper sectors were trading above normal value, if we exclude GE from the Conglomerates analysis. Metals and Mining is at a significant discount today and while it was also at a discount at the end of 1991, today’s position is much more extreme. If fundamentals play out as we expect, and as they did in 1992 and 1993, only the Metals and Mining sector looks like it is adequately discounting the scenario.

Exhibit 6

Source: Capital IQ and SSR Analysis

In 1992 every sector underperformed the S&P500 (except Chemicals and Metals and Mining), despite their relative cheapness. Within Chemicals, commodities underperformed. Exhibit 7 shows the data in Exhibit 6 in tabular form and includes the data for the end of 1992. Where a discount is increasing, the sector is underperforming. The biggest underperforming moves in 1992 were in Capital Goods, Electrical Equipment and Conglomerates and all of these sectors are much more expensive today than they were in 1992.

Exhibit 7

Source Capital IQ and SSR Analysis

The Packaging space looks to be the most interesting on the upside. This group has been trading well below mid-cycle value, though not at a statistical extreme. This is partly because we have seen significant restructuring activity, that has yet had time to play out, but mainly because, as buyers of plastic, glass and metals, they have been squeezed on raw material costs. As energy prices fall and basic material prices follow, packaging will be a beneficiary. In addition, most processes in packaging allow the companies to operate “just in time” inventory practices, much like their primary customers. Consequently, this group has not seen a meaningful change in inventory over the last few years. We could see as much as a 30% positive move in this group if raw materials move in its direction and this results in positive earnings surprises. A 30% relative move would take the group as far above normal value as it is currently below normal value – Exhibit 8.

Exhibit 8

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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