SSR Industrials & Materials Monthly Review, June 2017: Change is Good in 1H

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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

July 3rd, 2017

SSR Industrials & Materials Monthly Review, June 2017:

Change is Good in 1H

  • Midway through 2017 the worst performing stocks have been commodity focused Trump-trade regression candidates (X, MOS, CLF, BGC, CF), perpetual disappointers in the E&C space (FLR, ACM), and…GE
    • The top performing stock in our space (CSX, +52% YTD, S&P 500 +8%) demonstrates the impact that activist-inspired change can create – new CEO, fresh approach, significant outperformance
      • Most of the top 25 performers in 1H ’17 have had a recent CEO change (in some cases at the behest of an activist) or recently completed/pending M&A
    • Aluminum has been a bright spot in the underperforming Metals space – AA +16% in 2017 through June
    • Another favorite of ours, SWK, has been the top performer among large cap Capital Goods (+23%)
    • Certain commodity chemical stocks have held on to early year gains – WLK and OLN each +18%
    • Paper & Packaging has also been a good place to be – PKG and OI, two of our valuation favorites in the sector, are both up more than 30% – PKG now looks fairly valued on our models
  • Over the past month we have published work on:
    • GE – in several pieces we highlighted the negative effects of having energy in the portfolio; just another reason why we think the new CEO should work to streamline the company by separating businesses
    • Akzo – we are more positive on PPG than Akzo now that the deal has fallen through, but Elliot’s increased Akzo stake makes us less aggressively negative on the stock, even if the activist’s end game remains unclear
    • Nitrogen Fertilizers – one of the only true “value” opportunities in the I&M space currently, CF looks best positioned of the nitrogen stocks to withstand a more prolonged downturn than is expected; LXU and UAN could be bankruptcy candidates if current pricing levels persist or worsen over the next year
    • PX/Linde – with deal terms finalized earlier in the month, we are bullish on both names for what are likely to be above target synergies and the potential for longer-term share gain
    • FUL and SHLM – both early reporters missed estimates but the stocks moved in different directions, perhaps reflecting the apparent divergence in the companies’ respective optimism paths
    • Eastman – we noted that the share price spike, in tandem with CE following its deal to combine filter tow businesses with Blackstone, was misplaced and highlighted the broader lack of creativity and proactivity that has weighed on the stock for the past several years; EMN has given back these gains at month’s end
  • 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
    • Based on our work this year, we are overweight Metals and Paper & Packaging – favorites and concerns within sectors are primarily value motivated – as noted above PKG has been a favorite in Paper & Packaging but we have removed it after a strong run has it looking fairly valued on our models
    • Among other large cap names we are most positive on LYB, SWK, and GE

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

Nearly a decade into an inching recovery, we are seeing stocks with M&A/synergy upside and stocks with fresh leadership or potential for a shakeup getting bid up relative to the market and peers. Exhibit 5 lists the top 25 performing stocks in the Industrials & Materials space year to date – many of them have either recently completed or currently pending M&A transactions, and many others have seen a recent leadership change (at the behest of an activist or otherwise).

Exhibit 5

Source: Capital IQ and SSR Analysis

Company cash levels are rising – Exhibit 6 – and we would expect the trend of deal-making to continue. Over the past year buybacks have seen a reduced share of cash spend in Industrials & Materials relative to M&A, but we would also expect a resumption of repurchasing activity from companies hesitant to pay up for acquisitions or looking for a lever to boost earnings.

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month of June and 1H 2017 is shown in Exhibit 7. We show the 25 best and worst performing stocks for these time periods in Appendix 1. Though not notable in June, the divergence between GE and the rest of its industrial conglomerate peers is evident in the first half performance results. Electrical Equipment has led the way six months into 2017 and results were broad based – ROP, AME, ROK, and ETN together account for roughly 2/3 of the index weight and were all up at least 15%. Similarly, in Capital Goods, the largest cap names (CAT, DE, CMI, SWK, ITW, IR) all saw gains of 15% plus.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. After a strong start to the year, Capital Goods is now close to fair value after showing one of the larger sector discounts earlier in 2017. Conversely, E&C weakness year to date has that sector nearing its valuation low since 2010. With our Metals group still cheap but off the recent trough, the only other sector screening at an extreme is Conglomerates, where premium valuations are prevalent with the notable exception of GE.

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). Only the Metals group is at a relative skepticism extreme – valuations not crediting the group in aggregate for improving returns which have moved above trend since earlier in the year – Exhibit 10.

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. We see a broad range of valuations despite returns that are mostly within half a standard deviation of trend. Coatings remains the prominent outlier – SHW’s runaway return on capital is influencing the group but PPG’s returns are also near an all-time peak above trend.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

Every month we take the top and bottom 25 stocks on our normal valuation and skepticism index frameworks (summarized in Exhibit 2) and track the results, which have typically been robust, particularly for the overlap of the two. 2016 was a strong rebound year for this portfolio selection methodology after 2015 failed to live up to the record established in 2013 and 2014 – Exhibit 11. Results in 2017 to date have been volatile and are roughly flat halfway through the year, as cheap-screening 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. This month we are down to 27 (from 32) stocks that currently fall in these historically outperforming ranges – Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 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 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.

US first quarter GDP was revised higher on the back of consumer spending, which proved more robust than initially estimated but still showed the slowest year over year growth rate to start a year since 2013. The domestic economy appeared stable enough for the Fed to continue its incremental rate hike program; the labor market appears to be healthy and improving but a recent push by the Trump administration to increase apprenticeship participation highlights the ongoing structural disconnect between job openings and current workforce skillsets.

In Europe, the ECB’s loose monetary policy has yet to raise inflation close enough to the target rate of 2% to be pared back. However, growth in the region, while still underwhelming, has been steadily improving and deflationary concerns have largely been subdued.

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. Aside from a reshuffling of Electrical Equipment, Transports, and Chemicals in the middle of the pack, we see the same ranking as last month. The healthiest forward estimates are in the Metals and Paper & Packaging sectors – interesting in that valuations display an embedded skepticism about the sustainability of returns in these sectors. We also see another discrepancy between GE and its peer group. Revisions to 2018 estimates – Exhibit 22 – were mostly modest. WRK drove the Paper & Packaging result on the positive side, and E&C’s decline was mainly a function of FLR.

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 – revisions were a mixed driver of performance in June. Negative revisions in the Metals space were concentrated in steel stocks (X, NUE, ATI, STLD all cut 6% or more). Elsewhere revisions were modest ahead of the Q2 earnings season.

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 June

June 30, 2017: FUL and SHLM – Potential Divergent Optimism Paths

June 28, 2017: GE – What A (Problematic) Difference A Deal Makes

June 27, 2017: Nitrogen Fertilizers – A Game Of Thrones Winter!

June 20, 2017: Eastman – Misplaced Rally on the Blackstone-Celanese News

June 19, 2017: Chemicals June – Not All Mergers Are Created Equal

June 16, 2017: GE – Crying out for Revolution as Opposed to Evolution

June 13, 2017: Akzo – Time for a New Game! – Problem or Opportunity for PPG?

June 12, 2017: GE – A Quick Review of Our Thoughts

June 7, 2017: LYB, WLK: A Risk To The Upside – Albeit Remote – Qatar

June 5, 2017: Akzo/PPG– Maybe the DEVIL is in the details – Did PPG dodge a bullet?

June 2, 2017: PX/LIN – Buy Both – Now We Have the Deal Terms Out of the Way

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. UPS drops out of the valuation screen this month, leaving holdovers CF, EMN, and OLN as the only three stocks to appear in the top 25 on all three metrics.

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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