SSR Industrials & Materials Monthly Review, January 2016: January Weakness Presents Only Select Opportunities

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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

January 31st, 2016

SSR Industrials & Materials Monthly Review, January 2016:

January Weakness Presents Only Select Opportunities

  • Top line growth continues to decline against easier comparable figures in Q4, with about half of our companies having reported earnings
    • Most companies are still managing to beat on the bottom line however – good but not sustainable!
    • The concern is that there will be few levers left to pull if the expectation of weak demand in ’16 materializes, and guidance has for the most part been quite conservative across the board
  • Miners (NEM and CLF, less so FCX) and Ag machinery, far out of favor in 2015, saw relative strength in the first month of ’16
    • Fundamentals remain challenging here however and we do not see an easy fix for the miners
  • Weakness elsewhere could provide an opportunity for attractive entry points
    • DOW and DD were among the worst performers in January, a result which belies the massive consolidation opportunities in front of the companies – we continue to believe synergy and other cost reduction estimates are likely considerably understated
    • AA continues to win large long-term contracts in its downstream business but the stock is weighed down by the upstream operations even as aluminum pricing has stabilized and rebounded from the October lows – we think the stock could easily double from here during 2016
  • The worst performing sector on the month was Paper & Packaging as price cuts to several key paper grades stoked recession fears
    • Discounts in the sector are starting to look significant as several stocks appear to be preemptively pricing in a recession though returns remain strongwe highlighted a few ideas in this sector in a piece published in January
    • The Metals group was the surprise winner in January, up 2% versus the S&P on strength in selected miners – outside of this sector only the Conglomerates outperformed the market
  • January research included our outlook for 2016, a pair of favorable pieces on the Coatings sector (and PPG specifically), and a reiteration of our preference for DowPont in light of the early weakness in the stocks
    • Our preferences at the sector and stock level are shown in Exhibit 1

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

A little less than half of our stocks have reported calendar Q4 earnings but the trend of declining revenue growth appears well intact – Exhibit 5. As we saw in Q3, pressure on the top line has not stopped companies from cutting their way to a beat on the bottom line – Exhibit 6. Our concern (echoed by and large by the market) is that these cost-out opportunities dry up and leave companies with limited levers to offset what is likely to be continued weak demand in 2016.

We will wait for the full group to report before making any definitive judgments but so far the deterioration of the top line has accelerated versus Q3 despite largely easier year over year comparisons in Q4. Interestingly, of the few companies that actually beat consensus revenue estimates, many were machinery stocks that presumably should have been challenged in the current environment. OSK beat revenue expectations by 5% and received a few upgrades, but nevertheless guided 2016 numbers down. ROK, GGG, and DOV were other revenue surprises (+3%) in the Electrical Equipment/Capital Goods sectors and ITW also managed a slight beat of topline estimates.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

If January performance results are any indication, 2016 may see relief for some of the most pressured groups in recent years. Ag-exposed machinery stocks (DE, AGCO, VMI to a lesser extent) were strong relative outperformers as were select miners – NEM was the beneficiary of an upgrade and CLF outperformed a well. FCX remained under pressure however, the second worst performer in our universe for the month. Fundamentals in these sectors remain uninspiring. Conversely, we see early weakness in several of January’s worst performers as an opportunity. DOW and DD were prominent among the laggards, which only makes the stocks more compelling ahead of the unrivaled cost and synergy opportunities, which we think will surprise to the upside – see research out this month. AA was also a major underperformer for the month, even as the company continues to secure large long term contracts on the valued added side of the business. We show the 25 best and worst performing stocks in our coverage on the month in Appendix 1.

Sector performance relative to the S&P for the month is shown in Exhibit 7. Paper & Packaging stocks were punished, even though revisions were significantly worse in several other sectors – price declines in several key paper grades stoked recession fears and drove widespread selloffs in IP, PKG, WRK, and UFS. The Metals result was perhaps most surprising. Negative revisions were significant (-13%) but for several stocks (CLF and FCX) downside is getting limited with shares trading in the low single digits.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. The realization of the apparent values in the Metals and Capital Goods sectors is largely dependent on improved fundamentals in emerging markets where the wave of investment over the past 10 years has created glaring overcapacities in many industries. The discount in the Paper & Packaging sector is starting to look significant as many stocks appear to be already pricing in a recession.

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). Valuation and returns are mostly in line across our sectors. Metals is again an outlier here, along with Paper & Packaging where valuations have fallen ahead of returns which remain strong.

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. The Paper & Packaging sector continues to show the best combination of valuation support and earnings power – if you believe we are entering a recession then valuations are already pricing in a significant decline in earnings (what would be a two standard deviation turn for the sector). Alternatively, even if returns come in a bit, the upside to equate valuations with above trend earnings is close to a two SD turn as well (~36% upside).

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.

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 12 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 12. The negative revisions picture has significantly cut this group, which last month totaled 25 stocks.

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.

It did not take long for the second-guessing of the Fed’s tightening decision to being. The US PMI ended 2015 with two consecutive months in contraction territory and similar indices across the globe have similarly slowed, notably in the former growth engines of Brazil and China – the Industrial Production column in Exhibit 14 contains a lot of red arrows. Cautious tones from US companies during earnings season have not inspired much confidence. Europe appears to be improving incrementally. The ECB’s commitment to further easing should aid the positive news flow but is concerning simply by virtue of its apparent necessity.

Exhibit 14

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

Commodity Pricing

Fresh lows in crude continue, though pricing rebounded from a mid-month dip below $30 per barrel. Natural gas closed the month at its lowest pricing level since March 2012, barely above $2.00 per mmbtu. Metal pricing is showing signs of stabilizing sequentially, but at current price levels the year over year comparable figures will remain challenging until the summer. Aluminum has been slowly but steadily rising off the October lows, Copper is bouncing around its low mark of ’15, and steel pricing is also off the lows, up 5% in January.

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. Estimates in the Metals space were down nearly across the board and significantly on the month – consensus sees 2016 net income for the group at roughly a third of the 2014 base level. At the high end, even the sectors with the most optimism are considerably less so than in recent months. In Exhibit 21 Paper & Packaging is the visual outlier – valuations are pricing in recession but estimates have yet to fully reflect this.

Exhibit 20 Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows the change to 2016 net income estimates over the month. Companies have taken earnings season as an opportunity to reset expectations, across all our sectors generally, and in dramatic fashion in the Metals sector in particular – this on the heels of a 15% aggregate cut to the sector’s estimates last month. Negative revisions in Paper & Packaging and Transports speak to domestic recession concerns. The well-diversified Conglomerates group has been best insulated to this trend.

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions during January and Exhibit 24 plots these revisions versus performance results on the month. Metals stocks appear to be stabilizing, posting positive performance for the second straight month despite continued negative revisions far in excess of any of our other sectors. Outside of Metals, performance in January was reasonably correlated to 2016 EPS revisions.

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 January

January 27, 2016 – Coatings (PPG) A Safer Bet than Industrial Gas

January 19, 2016 – Paper & Packaging: A Few Ideas for 2016

January 18, 2016 – Chemicals Monthly: DowPont and PPG and Not Much Else

January 13, 2016 – Dow/DuPont: So Far Not So Good – But Now More Compelling

January 6, 2016 – PPG: The Best of the Bunch (McGarry) for 2016

January 4, 2016 – Only Select Opportunities in Industrials & Materials in 2016

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. This month IP joins three holdovers from the past four months: HUN, 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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