SSR Industrials & Materials Monthly Review, August 2016: M&A Mania Continues as Warning Signs Show

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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

September 2nd, 2016

SSR Industrials & Materials Monthly Review, August 2016:

M&A Mania Continues as Warning Signs Show

  • The M&A market remains hot, particularly in Chemicals
    • PX/Linde and POT/AGU added to the list of potential combinations as stagnant growth and industry overcapacity weigh on outlooks and limits strategic alternatives
    • Speculation continues to surround Monsanto and Bayer – we still believe this will happen
  • US industrial production fell back to contraction levels and new orders saw a similar sharp decline
    • Quick drop mirrors the rapid deterioration in demand that A. Schulman (SHLM) expressed regarding it’s mostly (56%) European end markets
    • If SHLM is a leading indicator we would expect guidance from others with a September quarter to comment ahead of impending conferences
  • Big movers for August were Metals (down) and Paper & Packaging (up), each with a 7% move
    • Both remain cheap but could grow cheaper if the macro outlook worsens further
    • Elsewhere performance was mostly positive with greatest strength outside of Packaging seen in machinery sectors – which looks like a bounce off a possible bottom given weak fundamentals
  • August research included:
    • Extensive look at the Coatings industry and a follow up on AXTA specifically
    • Continued coverage of Eastman – after another earnings disappointment, we offered suggestions for what needs to change
    • Analysis of the fertilizer space for dividend support (before the POT/AGU discussions began) – we found CF best positioned
    • M&A work cited above – the difficulties attendant to the PX/Linde merger suggest the move is driven by a lack of other options while MON is facing a growing hedge fund ownership base that could directly or indirectly pressure the company into securing a deal with Bayer
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW and DD remain our longer-term favorites in the Chemical space and Industrials & Materials generally, though we clearly have a positive view of MON near term
    • If the A. Schulman and industrial production stories prove to be leading indicators, all could get cheaper before year-end

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

Merger discussions in the Industrial Gas and Fertilizer industries continue a recent trend of large scale M&A. Praxair/Linde would create the world’s largest Industrial Gas company, though years of consolidation in the industry may have created regulatory hurdles for a deal of this size. The obstacles to getting this deal done go beyond the regulators, and in our opinion reflect the lack of alternatives in the current environment – more on this below. In the troubled Fertilizer space, stocks reacted positively to news of the POT/AGU talks. The companies already have a relationship as part of the Canadian potash exporting consortium, Canpotex, and while AGU would contribute to POT’s nutrient positions (most significantly in nitrogen, less so in potash and phosphate), the real logic for this deal appears to be diversification – marrying the retail stability of AGU with the upside demand leverage of POT. A US deal between MOS and CF would be equally complimentary, though the size difference hampers a MOE.

The increased appetite for M&A comes as warning signs have emerged for the global economy. A. Schulman’s guide down was notable for the intensity and rapidity with which demand appears to have dried up in its major (largely European) end markets, and seemed to give some credence to the notion of a post-Brexit pause in purchasing decisions. Domestically, weak new orders and industrial production readings also showed a sharp midsummer decline. SHLM’s smaller size may point to a more isolated, company specific set of circumstances and the drop in the ISM readings come after five months of expansion, but neither of these events was expected and both happened quickly and in significant magnitude. We would expect more M&A announcements to come – if a prolonged slowdown occurs, those with acquisition related levers should be able to drive growth and outperform.

Exhibit 5

Source: Capital IQ and SSR Analysis

Sector performance relative to the S&P for the month is shown in Exhibit 6. Strength in Paper & Packaging and weakness in Metals was broad-based. On the Packaging side, BLL and WRK saw momentum after earnings beats. WRK’s peers IP and PKG were also among the top performers on the month – July earnings reports were positive on shipments and pricing outlook. On the other side of the spectrum, 9 of the 10 worst performing stocks in our group were in the Metals sector, as steel prices gave back some of their recent gains – US Steel most affected, down 30%. We show the 25 best and worst performing stocks in our coverage for the month in Appendix 1. We remain quite negative on Steel and do not see recent US tariff moves as the panacea that the stocks reflected for a while. A new US political agenda with a major focus on infrastructure spending is the only think in our view that would give some sustained life to the US steel industry.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes discount from normal value by sector. The Metals sector inched back above two standards deviations cheap with its weak August performance, and Paper & Packaging conversely dipped below one SD expensive after its group leading month. Elsewhere, sectors are fairly dispersed with no real extremes in aggregate – Conglomerates excluding GE a possible exception – driven by the strength of HON.

Exhibit 7

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 8 (see our skepticism work for more detail). Paper & Packaging fell behind Metals in the SI rankings, as valuations rose and brought the index closer to equalization – stocks are still considerably more discounted than returns would indicate.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 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. Coatings remains an outlier because of SHW – within the sector we are more positive on PPG and AXTA.

Exhibit 9

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.

To begin 2016, and particularly in recent months, commodity stocks rallied and our portfolios benefitted accordingly. August saw commodity names retreat, which weighed particularly on the overlap portfolio. The short side stocks were bolstered not by a few outliers but by a number of 4% gains (AME, APD, BRC, ECL, IEX, IFF, and ROP).

Exhibit 10

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. This month we have a list of 21 stocks that fall in these historically outperforming ranges – Exhibit 11. OLN looks cheaper than it would if we adjust its capital base for the goodwill associated with the Dow deal – this will be a subject of future research, and we remain negative on the stock despite its apparent discount.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12 shows the historical forward performance of the stocks meeting the criteria in Exhibit 12 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 12

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 macro picture is somewhat mixed, with the sharp decline in US industrial production figures offset by reasonable strength in similar metrics in other regions of the world. US core capex orders showed a second consecutive month of increase for the first time in over a year. The overall picture has turned bullish enough for Fed Chair Yellen to see a strengthened case for an additional rate hike. Expectations are for Friday’s jobs report to show strong gains.

In Europe, which has been in sharp focus since the Brexit, indicators have yet to crack, but if SHLM’s customer demand drop is representative of a broader reduction in purchasing activity in the inventory chain, there may be a quick correction in store.

Exhibit 13

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

Commodity Pricing

A second consecutive month of 6%+ declines in steel pricing leaves the commodity still up more than 35% year to date. Aluminum has trended higher as well, though far less significantly, while copper prices remain depressed by the lack of Chinese demand. Natural gas pricing was virtually flat in August before falling on Thursday’s greater than expected inventory build. Crude was up 10% on the month, putting its year to date gain on par with that of natural gas (~25%). The North American rig count broke an eight week streak of growth by holding essentially flat in the latest data from Baker Hughes.

US commodity and energy prices are indexed in Exhibits 14 through 18.

Exhibit 14

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

Exhibit 15

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Exhibit 16

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18

Source: Capital IQ, 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. Electrical Equipment now shows negative net income growth comparing 2017 estimates to 2015 actual figures. This is the result of divestitures at Emerson (EMR) but also a guide down by that company as well as peer Ametek (AME). This drove the considerable negative revisions in Exhibit 22. We again note that the Metals result in Exhibit 20 is higher than the chart indicates and reflects a very low 2015 base.

Exhibit 19                                                                                      Exhibit 20

Source: Capital IQ and SSR Analysis

Electrical Equipment aside, revisions were mostly modest after most companies’ July earnings reports, and where we did some changes in estimates in August, they were largely based on earnings adjusted guidance from late reporters. In the Capital Goods space, DE most significantly drove the positive result with a 15% increase to its unweighted 2017 net income estimate. Negative revisions for FCX and CLF outweighed a positive revision in NEM in the Metals space.

Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions over the past month and Exhibit 24 plots these revisions versus performance results on the month. The Metals revision result is skewed by a 100% gain in CLF’s estimate ($0.47 from $0.23) – excluding this, near term EPS revisions in the sector were only modestly positive (+1%). Within Chemicals, continued negative revisions in the Fertilizer space (CF -39%, MOS -37%) offset a positive revision to OLN’s 2016 EPS estimate.

Exhibit 22                                                                                      Exhibit 23

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

Mid-Cycle “Normal” Valuation

In Exhibits 24-33 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

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

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

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 34 through 44.

Exhibit 34

Source: Capital IQ and SSR Analysis

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

Research Published in August

August 18, 2016 – MON: How Patient Are the Shareholders, Especially the New Ones

August 17, 2016 – PX/Linde: Are Desperation and Boredom Bigger Drivers than Anything Else

August 16, 2016 – Chemicals Monthly: End Market Exposure is Key

August 16, 2016 – A. Schulman: A Personal Problem or a Leading Indicator

August 15, 2016 – Coatings: Developed Markets Peaking, China and M&A Can Keep Select Momentum

August 8, 2016 – CF: Analysis Suggests Dividend Can Be Sustained – Attractive Long Term Buy

Dividends

In Exhibit 45 we show a screen of stocks with low value, high Skepticism and high dividend yield. This month was have the same five holdover companies from last month: CF, EMN, HUN, OLN, and PKG.

Exhibit 45

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2


Appendix 3


Appendix 3

©2016, 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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