SSR Industrials & Materials Monthly Review, April 2016: Revenue Growth Returns Along With Chinese Demand

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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 1st, 2016

SSR Industrials & Materials Monthly Review, April 2016:

Revenue Growth Returns Along With Chinese Demand

  • The rebound in US manufacturing and better than anticipated Chinese demand have helped to buck the trend of declining revenue growth in the Industrials & Materials space
    • There have been as many companies that have hit or beat on the top line as have missed in Q1, after several quarters of predominantly negative revenue surprises
    • Two thirds of our universe of stocks have reported and the pace of year over year revenue growth improved sequentially for all of our sectors save Metals
  • The Metals sector itself largely shrugged this off, as sharp pricing gains led to a month of group leading performance and positive revisions
    • Part of the price momentum was attributed to unexpectedly strong Chinese demand, but speculative futures trading also played a role
    • Price surges over the past several years have tended to fade quickly and we remain cautious due to China’s ability (given new lows in coal pricing) and willingness (given the country’s employment mandate) to increase output and exploit the short term price gain – we would not chase the rally
  • Performance was generally positive across the entire Industrials & Materials sector and commodity exposed stocks continued to show relative strength in April
    • Beyond the metals and mining stocks that rose with prices, commodity chemicals (OLN, WLK and HUN) and ag related machinery stocks (DE, AGCO, VMI) were among the best performers
  • In April we continued our coverage of Dow and DuPont, suggesting flexibility and creativity for the post-merger, pre-spin company; wrote stock specific pieces on PPG (continuing coverage) and BASF (a new addition for us); and highlighted the often short-lived nature of commodity price rallies over the past several years
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW and DD remain our favorites in the Chemical space and Industrials & Materials generally

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SI 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

Markets remain volatile, evidenced by the continued strong bounce in crude pricing (+18% in April), but the surge in metals pricing stole headlines in the latter stages of the month. Estimates for metals and mining stocks benefited accordingly – the three month revision picture has turned positive for the group and overall there is more optimistic sentiment towards the sector than there has been in some time. We remain wary of the destructive influence of China on supply and demand balances and pricing. Despite its projected message of reform, China’s government is tied to and constrained by a growth and employment platform that underlies its legitimacy. Recent trends in 2016 suggest the government is favoring employment for the moment, but the apparent increase in Chinese industrial output contrasts with the trend of slowing growth over the past few years. The dynamic is reminiscent of the Federal Reserve’s interest rate hike dilemma – dancing around a policy that is perhaps painful and dislocating in the near term, but necessary for the healthy functioning of the economy in the long term.

Domestically, US manufacturing has shown some life recently which, combined with the unexpected strength from China, likely contributed to an improved revenue growth picture, with more than two thirds of our universe of stocks having reported Q1 earnings – Exhibit 5. Top line surprises have been far more prevalent in Q1 so far compared to recent quarters that were marked by only occasional revenue beats – Exhibit 6.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

The list of top performing stocks in April was a who’s who of commodity exposed stocks – from CLF, JOY, FCX, AA and NEM in Metals & Mining to OLN, WLK and HUN in Chemicals, and even extending to ag equipment with DE, AGCO and VMI among the 25 largest gainers for the month. Rail stocks showed relative strength on largely positive earnings reports (KSU, UNP, and NSC the best performers in the group) despite continued weakness in rail traffic. Underperforming stocks were a rarity in our universe in April, as more than 75% of our coverage outpaced the S&P. We show the 25 best and worst performing stocks in our coverage for the month in Appendix 1.

Sector performance relative to the S&P for the month is shown in Exhibit 7. Metals stocks enjoyed strong gains on rising prices and the sector in aggregate was the big winner in April. Strength in Rail stocks more than offset weakness in the Trucking space for the Transports. AME dragged down the Electrical Equipment on weak earnings and guidance.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. Consecutive months of leading performance has the Metals group looking less expensive – but it has been a long and painful trough and plenty of upside remains. We remain cautious of the group however, and would prefer to see a more prolonged price rise supported by sustainable fundamentals before getting more positive. The Conglomerates continue to show the only meaningful premium of our sectors. Paper & Packaging stocks remain cheap in aggregate, but several of these stocks are beginning to see momentum – OI, PKG and UFS were among the 25 best performers on the month. OI in particular is on a nice run, up 37% versus the S&P since the middle of January.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 9 (see our skepticism work for more detail). The trend over the past two months has been one of moderating SI values, driven by rising valuations and stable estimates. Electrical Equipment was the lone underperforming sector on the month, and saw compression in its SI value as well as a result.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index 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. As the trend of late has been towards equalization (the dotted blue line), the Paper & Packaging and Metals sectors have moved out of the favorable quadrant (highlighted in green). The premium and extent of over-earning in Coatings is influenced to a significant degree by SHW, which has largely detached from historical norms – we continue to prefer PPG in this space.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

The overlap of our traditional valuation and skepticism based portfolios (see Exhibit 2) produced cumulative monthly gains of 15.6% in 2013 and 9.8% in 2014, but was far less successful in 2015. Our return on capital based models that produce the portfolio selections assume cyclicality and fail to capture the secular changes impacting an industry – a major issue for many Metals and Commodity Chemical stocks. FCX, CLF, HUN, and OLN were among the mainstays on the long side throughout the year and condemned our portfolios to a year of underperformance. Continued strength in these commodity stocks, all of which remain in the long overlap group, has resulted in another month of strong performance for these portfolios. The short side stocks have not been a major help, but have also not moved materially against us, suggesting some are running out of momentum.

Exhibit 11

Source: Capital IQ and SSR Analysis

An alternative portfolio approach is based on our expanded skepticism index performance analysis which showed a very attractive risk-reward relationship for stocks with positive SI values, valuation discounts, and positive 3 month EPS revisions. We feel there is both a more defined holding period (our work is based on 6 month forward performance) and a greater likelihood of success in those names. This month we have a list of 10 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 12. The negative revisions picture continues to trim this list, which numbered as many as 25 stocks in late 2015.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 shows the historical forward performance of the stocks meeting the criteria in Exhibit 13 at various ranges. We note that for all ranges where the SI is above 0.5, the average return is in excess of the variability (average > standard deviation).

Exhibit 13

Source: Capital IQ and SSR Analysis

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 economy got off to a sluggish start in 2016, posting 0.5% GDP growth in Q1. The employment situation remains positive however – jobless claims hovering near multi-decade lows and wage growth picking up. Stumbling out of the gate may be the new normal, as 2015 and 2014 saw similarly disappointing Q1 figures followed by strong gains in the duration of the year.

All things considered, the domestic economy is still the bright spot in an uncertain world. The Brazilian impeachment saga is progressing with a dim outlook for the incumbent President Rousseff. Prevailing pro-business sentiment appears to favor this outcome. Europe’s continued struggles are unlikely to be positively impacted by Britain’s pending exit from the EU. China is grappling with the employment realities associated with rationalizing loss-making enterprises in oversupplied industries – the shift to consumer growth will not materialize if there is no income to spend.

Exhibit 14

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

Commodity Pricing

April saw a significant rise in metal prices, notably in steel which gained roughly 20% for the second consecutive month on a mix of speculative trading and unexpectedly strong Chinese demand. Aluminum posted a strong 11% gain as well, with copper’s gain a more modest 2%. Steel pricing is now more than 20% above prior year levels but comparable figures for aluminum (-14%) and copper (-20%) show continued pressure. Energy prices also posted solid gains – a 6% rise in natural gas pricing was dwarfed by gains in crude pricing that were nearly three times as large.

US commodity and energy prices are indexed in Exhibits 15 through 19.

Exhibit 15 Exhibit 16

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

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18 Exhibit 19

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 20 we look at expected net income growth by sector, and in Exhibit 21 we plot the growth figure against each sector’s current skepticism index value. The group-leading Metals result reflects a very low 2015 base. Estimates for the machinery sectors (Cap Goods, Electrical Equipment) do not appear to be embedding any optimistic assumptions about demand growth over the next two years. The mostly domestic Transports and Paper & Packaging sectors only show modestly better prospects. Estimates for the Conglomerates befit the group’s premium valuations.

Exhibit 20 Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows the change to these longer-term net income estimates over the month. It was another month of positive revisions for the Metals sector, but the major gains were mostly confined to the gold miners (NEM, FCX), with modest strength in AA (+6%) and select steel stocks (NUE +5%, STLD +6%).

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions during April and Exhibit 24 plots these revisions versus performance results on the month. The revisions in the Metals space were even more positive than these figures suggest as they do not include the improvements to negative estimates for CLF and X. Note these figures are simple averages versus the market cap weighted figures shown in Exhibit 4.

Exhibit 23 Exhibit 24

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

Mid-Cycle “Normal” Valuation

In Exhibits 25-34 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.


Exhibit 25

Exhibit 26

Exhibit 31

Exhibit 29

Exhibit 30

Exhibit 28


Exhibit 27


Source: Capital IQ and SSR Analysis

Exhibit 33

Exhibit 32

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 45.

Exhibits 35-37

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibits 38-40

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibits 41-43

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibits 44-45

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in April

April 26, 2016 – Dow DuPont: So Many Scenarios, Few Companies Unaffected

April 19, 2106 – BASF: Trapped from the Inside and the Outside?

April 18, 2016 – SSR Chemicals Monthly: Deals Continue as Energy Advances, Manufacturing Rebounds

April 11, 2016 – PPG: Historical Anchors Away

April 10, 2016 – Commodity Rally Not a Function of Costs or Demand

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. The four companies that overlap are holdovers from last month: HUN, IP, OLN, and PKG.

Exhibit 46

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2



Appendix 3


Appendix 3

©2016, 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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