SSR Industrials & Materials Monthly Review, April 2017: Earnings Party Like Its 2011

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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, 2017

SSR Industrials & Materials Monthly Review, April 2017:

Earnings Party Like Its 2011

  • Q1 earnings surprises in Industrials & Materials have come in to the upside on both the top and bottom lines
    • Most significant beats since 2011, driven in many cases by better than expected volume growth
    • The US has featured in the volume growth story despite the very weak Q1 GDP numbers
  • Activists remain active
    • Soroban reported a 6% stake in PX, likely hoping to see the Linde deal through to completion
    • Third Point’s push for HON to separate its aerospace business might make sense from a complexity standpoint, but this is not the typical underperforming target – valuations are elevated with the stock at all time highs
    • Eastman in our view remains a prime target for activist/acquirer focus and is one of only four stocks in our coverage to appear in the top 25 on valuation, skepticism, and dividend yield
  • Since our last monthly we have written on:
    • PPG/Akzo – we think this deal has likely been mostly worked out, which would give PPG a multi-year growth runway – Akzo continues to have upside to the offer price, and would be the more exposed of the two on the downside should the deal fall apart
    • Industrial Gas – Air Liquide remains our only isolated long preference in this stagnating space but we see a relative trade based on multiple convergence both to the PX/Linde merger and to historical norms for APD/PX – short APD, long Linde would be the pairs trade
    • Lyondell – comments on cash available for M&A signal a strategy shift away from buybacks, which may be ill-received depending on the deal – WLK seems a logical target to us – we see the earnings related dip as an entry point and remain more bullish than consensus on the ethylene cycle
    • The SMID space – updating our work from earlier in the year, which proved effective in sorting winners and losers in Q1
  • Exhibit 1 summarizes our preferences by sector and stock
    • We continue to see potential for a strong year in commodity chemicals and remain bullish on DOW/DD despite the merger delay – the regulatory driven DD/FMC ag/nutrition swap is an example of the type of horse trading we expect to see in the non-ag portions of the business post-merge
    • Based on our work this year, we are overweight Metals and Paper & Packaging – favorites and concerns within sectors are primarily value motivated
      • Our concern about X appears warranted – worst performing stock in our group on the month after dismal earnings – outdated blast furnaces increasingly uncompetitive vs. electric arc
    • Among large cap names we are most positive on LYB, SWK, and GE
    • Industrial Gas remains a prominent concern as we do not see an easy fix for the industry’s stagnation

Exhibit 1

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

Deal-making, at the behest of activists or otherwise, is increasingly an integral part of the strategy for many companies in the Industrial & Materials space. This month we have seen Lyondell indicate a shift in its longtime buyback strategy in favor of M&A. While we remain positive on LYB for its leverage to the ethylene cycle, this is a bit of risk in our view, depending on the deal – WLK appears to meet the criteria laid out by LYB, and we think this would be both a logical and well-received move. Elsewhere in the Chemical space, Soroban Capital announced a sizable stake in PX, likely hoping to encourage the consummation of the pending Linde deal. We think the best way to play this space is short APD/long Linde on multiple convergences, or long Air Liquide in isolation. Also this month, Third Point came out to push HON to separate its aerospace business – unusual in that HON has been executing well and the stock has outperformed, and only marginally understandable from a complexity standpoint given HON scores relatively low on our complexity index.

This recent spate of activism comes as we are seeing signs of growing strength in the Industrials & Materials space, perhaps best indicated by the largest average revenue beat among large caps of this decade. Upside surprises in the Industrials & Materials space, on both top and bottom lines, have been indeed been significant for Q1 reporters to date – Exhibit 5 – driven in many cases by volume growth. Accordingly we see a larger and more concentrated cluster than we have been used to in the top right quadrant of Exhibit 6, which plots revenue and EPS results versus consensus by company. DOW and DD have consistently appeared in this quadrant in recent quarters, indicating both underlying business momentum and focused management teams ahead of the merger. HUN and POL also beat estimates robustly, indicating strength in commodity and basic chemicals – POL was the best performer in our coverage on the month. CAT also appears among the top performing stocks in April, and is the clear standout in Exhibit 6, but we think valuation is more than discounting any improvement in underlying business momentum.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month is shown in Exhibit 7. Only the E&C sector trailed the S&P, with the strong earnings noted above boosting most of our sectors. We show the 25 best and worst performing stocks on the month in Appendix 1.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. We see generally less attractive valuations after a month of outperformance, notably in Capital Goods which is approaching fair value. The Paper & Packaging space continues to show value even after a strong month. Metals remains the cheapest sector in Industrials and Materials, but as shown by the 25% plunge in X on earnings, this is a sector with advantaged and disadvantaged companies – the miss for US Steel highlighted its outdated blast furnaces relative to the newer electric arc furnaces of competitors.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 9 (see our skepticism work for more detail). Valuations are insufficiently crediting returns that remain above trend in the Paper & Packaging space and are improving for Metals companies. The opposite is true in Electrical Equipment where valuations are anticipating an above trend returns that have yet to be seen.

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. The Commodity Chemicals space remains inexpensive with returns at trend and likely to improve as HUN and OLN should see continued momentum in their end markets (confirmed for HUN in Q1), while the ethylene producers are likely to see less pressure than consensus currently believes. Diversified Chemicals is largely driven by DD, which looks expensive without the benefit of DOW merger synergies.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

2016 was a strong rebound year for our portfolio selection methodology, particularly in the overlap of valuation and skepticism – Exhibit 11. Results in 2017 to date have been mixed and volatile as Metals stocks in particular are showing extreme sensitivity to indications of success or failure in the Trump administration. See accompanying work from earlier in the year.

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. 28 stocks currently fall in these historically outperforming ranges – Exhibit 12 – including several of the names we are most positive on such as LYB, SWK, WLK, IP and EMN.

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 Q1 GDP figure for the US disappointed, coming in below the 1% estimate to the lowest level seen in the past three years. Auto spending, long a buttress for a mixed domestic economy, is turning into a headwind. Consumer sentiment and economic expectation readings remain strong, however, and the lackluster Q1 result is mostly regarded as a temporary dip rather than evidence of a sustained downturn. European growth remains spotty – UK and France GDP readings similarly disappointed, but Spanish growth offered encouragement that the weakened peripheral nations might be finding their footing. Despite considerable noise around trade – the Trump administration has most recently cast its eye northward to Canadian lumber and dairy, and there was a head-fake on NAFTA withdrawal earlier in the week – the most significant international developments center around rising tensions on the Korean peninsula and in the Middle East. China, with its managed economy seemingly back on track for slower but still significant growth, is ostensibly seeking to avoid further escalation but has yet to display the ability or willingness to control its inflammatory neighbor.

Exhibit 14

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

Commodity Pricing

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 Metals group has a somewhat low base which inflates its growth figure in Exhibit 21 but there is likely also a good deal of stimulus optimism embedded in 2018 estimates – despite the optics of US Steel’s significant decline on earnings, 2018 estimates for the Metals group as a whole actually increased on the month. Capital Goods also saw positive revisions and overtook E&C in the rankings in Exhibit 20. Exhibit 21 is curious in that one would expect the line of best fit to trend in the opposite direction. The skepticism extremes in Paper & Packaging and Metals are on display here as valuations fail to reflect the forward growth expectations which were among the most positively revised on the month – Exhibit 22.

Exhibit 20 Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows average 2017 EPS revision over the past month and Exhibit 24 plots these revisions versus performance results on the month. Positive revisions in the Capital Goods were driven mostly by CAT (+30%) but several of the smaller cap names that posted positive earnings beats in Exhibit 6 (TKR, KMT) also saw significant upward changes to estimates on the order of 15%. In the Metals space, a 50% cut to X’s estimate and a 20% cut to CLF’s offset what were largely positive revisions elsewhere including for AA (+12%) and ATI (+13%).

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

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

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

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

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in April

April 24, 2017: PPG/Akzo – Is the Negotiation Over?

April 18, 2017: Chemicals April – M&A the Mood of the Day, Commodity Rally Loses Steam

April 17, 2017: Nova – Flexing Its (Financial) Muscles – Changing The Shape Of US Ethylene

April 17, 2017: Industrial Gases – “Multiple” Risks – Driving the Attempted M&A

April 7, 2017: Lyondell M&A: Triangulating To The Best Idea – WLK?

April 6, 2017: SMID Cap Industrials & Materials – Hoping To Build On a Good Q1

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. UFS dropped out of the skepticism screen this month, leaving four holdovers from last month – CF, EMN, OLN, and UPS.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©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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