SMID Cap Industrials & Materials – What Have We Learned So Far This Year?

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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

May 22, 2017

SMID Cap Industrials & Materials – What Have We Learned So Far This Year?

  • Our group of ~120 SMID cap Industrials & Materials stocks followed the trend of positive revenue growth; also observed for large cap Industrials & Materials sectors in Q1 ’17
    • The majority (75%) of these SMID stocks grew the year/year top line (vs 25% in 2016)
  • Q1 ’17 also saw the most positive revenue surprises since 2011, again similar to large cap I&M, but less pronounced in the SMID space which has a more domestic bias than the internationally exposed large cap group
    • This suggests some of the upside surprises in the large cap space were driven by strength in non-US markets – confirmed by many who broke out regional data
    • Better preforming SMID companies were generally those with greater offshore exposure
  • Combining revenue growth, which we see as a proxy for continued momentum throughout the year, with our valuation work (comparing returns on tangible capital and enterprise value), TSE and VSM show notably strong growth and attractive valuations
    • We have been and remain positive on both of these stocks
      • TSE as part of our broader commodity call from earlier in the year
      • VSM in specific research and as a beneficiary of increased digitization and wireless connectivity with significant operating leverage to an uptick in sales
  • Other stocks that look interesting based on analysis of Q1 results and valuation include:
    • RS, GNRC, HUN, WLK, POL
    • We are positive on the HUN-Clariant merger announcement but the combined company will need to avoid a “complexity” trap ala EMN – see accompanying blog out this morning
  • Exhibit 1 summarizes year over year volume and price growth for the SMID companies that disclose these figures

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We have highlighted the Q1 results for our general large cap Industrials & Materials and Chemicals specific universes as being the best quarter versus consensus expectations since 2011. Our SMID cap group shows a similar pattern but less significantly so – Exhibit 2. The gap is possibly explained by a larger non-US exposure in the large cap group and relative strength in those non-US markets.

Most companies that have broken out regional results for Q1 2017 have highlighted significantly stronger volume growth outside the US than in the US, resulting in better revenues. The reasons seem to fall into a handful of buckets:

  • Strong volume growth in China and other parts of Asia – primarily driven by strong consumer growth. Within China, despite some more stimulus this year, industrial growth is weak.
  • Strong industrial and consumer growth in India.
  • Europe bouncing off a very low bottom – so showing much better year/year comps – note that Q1 2016 was a low point for many industries in many regions, as oil collapsed and drove down pricing and volumes.
  • Penalizing the US in Q1 2017 – very weak GDP.
  • While we have focused on the strength of the dollar since the election – the Q1 year/year difference was not significant.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3 shows the individual company results behind the SMID data in Exhibit 2 above. Commodity stocks are notable outliers in the top right quadrant of the plot, indicating revenue and EPS results that came in above consensus – TSE, WLK, CC, and HUN.

The other major outliers provide some interesting insight into increased economic activity in Q1. BGC (General Cable Corp – copper wires and cables), CMC (Commercial Metals – steel recycling/fabrication) and HY (Hyster-Yale – lift trucks) all signaled strength in infrastructure/construction/manufacturing. ATI (Allegheny Technologies – metal alloys and steel products) would also fit in this category. Operating leverage is high for all of these stocks, evidenced by EPS surprises several multiples above the respective revenue surprises. Operating leverage is very high for most companies on the list, with very few suffering from capacity shortages and with minimal cost associated with increasing sales volumes.

Exhibit 3

Source: Capital IQ and SSR Analysis

Valuation and Revenue Growth – Looking for Cheap Stocks with Momentum

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 4 plots return on tangible capital against an enterprise value multiple of the tangible capital base – stocks below the line suggest relative upside, stocks above the line suggest relative downside. We have applied this valuation work to the SMID space in the past as a guide in the absence of sufficient historical data for many of these companies to utilize our mean-reverting, return on capital trend-based normal valuation models.

If we compare a company’s actual EV/tangible capital ratio to the value implied by the line of best fit, we can get to a rough standardized gauge of attractive/unattractive valuations. In Exhibit 5 we plot this valuation measure against year over year revenue growth in Q1 ’17. We would be focused on the top right quadrant of this plot – attractively valued stocks showing revenue growth. Exhibit 6 zooms in on this quadrant for a closer look at the companies.

There are a number of companies in this quadrant that we have done more detailed work on and for which we have a positive bias, TSE, VSM, GNRC and HUN. Others in this quadrant clearly warrant further work.

There are very few obvious short ideas from this analysis, with FMC trading on the promise of what the deal with DuPont will bring, which is likely substantial, and SMG likely getting some seasonal benefit of the doubt as wall and interest in its new hydroponics business.

There are unattractively valued companies with good revenue growth that may have got ahead of themselves in 2017 and may take a pause. UAN is a space that has a good longer-term outlook but is likely in for a disappointing 2017 – we would expect UAN and competitors like CF to, at best, mark-time in 2017, but possible provide a better entry point later.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

In Exhibit 7 we list all the companies in Exhibit 6 and show their end market exposure at a very high level. We also show their exposure to the US as a proportion of total sales.

Earlier in the year, when there was an expectation that the Trump administration might do something to stimulate US economic growth we suggested a focus on companies with a greater proportion of sales in the US. This stimulus is looking less and less likely every day, given the evident lack of focus in Washington and we see exposure to the US as less of a driver today.

However, while parts of Asia may be growing well, and Europe, post the French election looks marginally more stable, we now have more concerns about South America, with the risk of further political unrest in Brazil. At a high level this would be another blow for the Ag industry, with Deere’s recent celebration of better demand in Brazil possibly short lived if we see a further loss of confidence in the country – in the SMID space this is negative for AGCO and for the fertilizer producers.

The group in Exhibit 7 have a bias towards the consumer economy over the industrial economy – which makes sense given generally depressed Industrial Production and generally better consumer spending globally.

Exhibit 7

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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.

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 22, 2017

SMID Cap Industrials & Materials – What Have We Learned So Far This Year?

  • Our group of ~120 SMID cap Industrials & Materials stocks followed the trend of positive revenue growth; also observed for large cap Industrials & Materials sectors in Q1 ’17
    • The majority (75%) of these SMID stocks grew the year/year top line (vs 25% in 2016)
  • Q1 ’17 also saw the most positive revenue surprises since 2011, again similar to large cap I&M, but less pronounced in the SMID space which has a more domestic bias than the internationally exposed large cap group
    • This suggests some of the upside surprises in the large cap space were driven by strength in non-US markets – confirmed by many who broke out regional data
    • Better preforming SMID companies were generally those with greater offshore exposure
  • Combining revenue growth, which we see as a proxy for continued momentum throughout the year, with our valuation work (comparing returns on tangible capital and enterprise value), TSE and VSM show notably strong growth and attractive valuations
    • We have been and remain positive on both of these stocks
      • TSE as part of our broader commodity call from earlier in the year
      • VSM in specific research and as a beneficiary of increased digitization and wireless connectivity with significant operating leverage to an uptick in sales
  • Other stocks that look interesting based on analysis of Q1 results and valuation include:
    • RS, GNRC, HUN, WLK, POL
  • Exhibit 1 summarizes year over year volume and price growth for the SMID companies that disclose these figures

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We have highlighted the Q1 results for our general large cap Industrials & Materials and Chemicals specific universes as being the best quarter versus consensus expectations since 2011. Our SMID cap group shows a similar pattern but less significantly so – Exhibit 2. The gap is possibly explained by a larger non-US exposure in the large cap group and relative strength in those non-US markets.

Most companies that have broken out regional results for Q1 2017 have highlighted significantly stronger volume growth outside the US than in the US, resulting in better revenues. The reasons seem to fall into a handful of buckets:

  • Strong volume growth in China and other parts of Asia – primarily driven by strong consumer growth. Within China, despite some more stimulus this year, industrial growth is weak.
  • Strong industrial and consumer growth in India.
  • Europe bouncing off a very low bottom – so showing much better year/year comps – note that Q1 2016 was a low point for many industries in many regions, as oil collapsed and drove down pricing and volumes.
  • Penalizing the US in Q1 2017 – very weak GDP.
  • While we have focused on the strength of the dollar since the election – the Q1 year/year difference was not significant.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3 shows the individual company results behind the SMID data in Exhibit 2 above. Commodity stocks are notable outliers in the top right quadrant of the plot, indicating revenue and EPS results that came in above consensus – TSE, WLK, CC, and HUN.

The other major outliers provide some interesting insight into increased economic activity in Q1. BGC (General Cable Corp – copper wires and cables), CMC (Commercial Metals – steel recycling/fabrication) and HY (Hyster-Yale – lift trucks) all signaled strength in infrastructure/construction/manufacturing. ATI (Allegheny Technologies – metal alloys and steel products) would also fit in this category. Operating leverage is high for all of these stocks, evidenced by EPS surprises several multiples above the respective revenue surprises. Operating leverage is very high for most companies on the list, with very few suffering from capacity shortages and with minimal cost associated with increasing sales volumes.

Exhibit 3

Source: Capital IQ and SSR Analysis

Valuation and Revenue Growth – Looking for Cheap Stocks with Momentum

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 4 plots return on tangible capital against an enterprise value multiple of the tangible capital base – stocks below the line suggest relative upside, stocks above the line suggest relative downside. We have applied this valuation work to the SMID space in the past as a guide in the absence of sufficient historical data for many of these companies to utilize our mean-reverting, return on capital trend-based normal valuation models.

If we compare a company’s actual EV/tangible capital ratio to the value implied by the line of best fit, we can get to a rough standardized gauge of attractive/unattractive valuations. In Exhibit 5 we plot this valuation measure against year over year revenue growth in Q1 ’17. We would be focused on the top right quadrant of this plot – attractively valued stocks showing revenue growth. Exhibit 6 zooms in on this quadrant for a closer look at the companies.

There are a number of companies in this quadrant that we have done more detailed work on and for which we have a positive bias, TSE, VSM, GNRC and HUN. Others in this quadrant clearly warrant further work.

There are very few obvious short ideas from this analysis, with FMC trading on the promise of what the deal with DuPont will bring, which is likely substantial, and SMG likely getting some seasonal benefit of the doubt as wall and interest in its new hydroponics business.

There are unattractively valued companies with good revenue growth that may have got ahead of themselves in 2017 and may take a pause. UAN is a space that has a good longer-term outlook but is likely in for a disappointing 2017 – we would expect UAN and competitors like CF to, at best, mark-time in 2017, but possible provide a better entry point later.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

In Exhibit 7 we list all the companies in Exhibit 6 and show their end market exposure at a very high level. We also show their exposure to the US as a proportion of total sales.

Earlier in the year, when there was an expectation that the Trump administration might do something to stimulate US economic growth we suggested a focus on companies with a greater proportion of sales in the US. This stimulus is looking less and less likely every day, given the evident lack of focus in Washington and we see exposure to the US as less of a driver today.

However, while parts of Asia may be growing well, and Europe, post the French election looks marginally more stable, we now have more concerns about South America, with the risk of further political unrest in Brazil. At a high level this would be another blow for the Ag industry, with Deere’s recent celebration of better demand in Brazil possibly short lived if we see a further loss of confidence in the country – in the SMID space this is negative for AGCO and for the fertilizer producers.

The group in Exhibit 7 have a bias towards the consumer economy over the industrial economy – which makes sense given generally depressed Industrial Production and generally better consumer spending globally.

Exhibit 7

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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