SSR Industrials & Materials Monthly Review, November 2017: Tax Relief, Macro Momentum, but Mixed Performance

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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

November 30th, 2017

SSR Industrials & Materials Monthly Review, November 2017:

Tax Relief, Macro Momentum, but Mixed Performance

  • A late month tax relief rally boosted US focused stocks but performance at the sector level was mixed in November
    • US focused Transports saw particular strength at month’s end on optimism about favorable tax legislation
    • Conglomerates overcame another poor month for GE (see research referenced below) to lead the group –
    • Weakness in Metals was more widespread (AA, ATI, WOR among top four worst performers for the month) than in Paper & Packaging where poorly received earnings drove BLL down 7% to weigh on the group
  • Over the past month we have published on:
    • Paint – we explored the M&A options for the Coatings industry in light of Akzo walking away from a potential acquisition of AXTA and the subsequent news of talks between Nippon Paints and AXTA; which have since quickly evaporated
    • Complexity – updating our prior work in light of the ongoing story at GE; high-level analysis confirms our original conclusions that the most complex companies underperform and are afforded lower multiples relative to their less complex peers
    • GE – like the market, we were underwhelmed by the scope and tone of CEO John Flannery’s business review and remain concerned about long term problems in the Power business
    • What Makes a “Good” Company – analyzing the historical record of 123 Industrials & Materials companies on EBITDA growth and stock performance, we attempt to drill down to the characteristics of successful companies
    • Lyondell – speculation about a possible acquisition of Braskem echoed our prior musings; in our view, such a deal would consolidate several basic chemical markets without triggering regulatory problems
  • Exhibit 1 summarizes our preferences by sector and stock
    • Mega mergers offer the most potential upside in Materials – see our prior work on PX/LIN and DWDP
    • In Industrials, with GE off our favorites list, we are most positive specifically on SWK in the large cap space – see prior research for further ideas in the Industrials space

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

In our last monthly we discussed the increasing percentage of Industrials and Materials companies showing positive earnings surprises (83% of our universe beat revenue estimates, highest of the decade) and year over year growth (largest percentage of companies showing growth since the easy post-crisis comps around 2010-11) in Q3 – continuing trends that have strengthened throughout the year. These figures have held as the late reporters announced results over the past month, and if we look at the absolute level of earnings growth – Exhibit 5 – the magnitude is as impressive as the trend. Some of the growth has been aided by M&A, but the significant operating leverage seen suggests an improving macroeconomic landscape and demonstrates the upside potential for companies that have grown increasingly lean since the financial crisis and in the weak global growth environment that has persisted since.

2017 has not quite felt like a breakout year for economic growth, but as we have consistently monitored in our Friday Findings emails, the pace of growth in major Western economies has been quietly improving – a notion confirmed in Q3 by some of the larger multi-nationals we cover (notably DowDuPont). Exhibit 6 updates an exhibit from a prior monthly report, showing the positive trends for several US economic indicators. Consumers have tellingly expressed growing confidence, on both sides of the Atlantic, which may be the most important leading indicator given the roughly two-thirds weight of consumer spending on GDP in the developed economics of US and Europe.

We are still seeing attempted or ongoing M&A in select markets that are struggling despite the generally improving macro (seen in the Coatings industry this week) and valuations remain broadly elevated versus historical norms, but if the momentum we are seeing in earnings can be sustained in 2018 there are still pockets of value. At the sector level, our Metals and Paper/Packaging indices are both nearly a full standard deviation below mid-cycle value. AA (the worst performer in our coverage in November) could be most interesting within Metals as the stock has tended to see moves higher happen very quickly when they come. Paper & Packaging stocks were also among the worst performers on the month until positive news on tax reform legislation boosted these largely US-focused companies – anyone increasingly relying on Amazon for their holiday shopping can appreciate the potential for long term value in the containerboard names.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month of November is shown in Exhibit 7 – with the monthly gain in the value of bitcoin/dollar included as a somewhat farcical point of reference. We show the 25 best and worst performing stocks on this time frame in Appendix 1.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. GE’s underperformance continues to drive the valuation divergence between the Conglomerates inclusive and exclusive of the mega cap. Within Transports, both Rail and Trucking are more than one standard deviation expensive, offset by a less extreme premium in Logistics.

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 and returns are in-line for several sectors (SI close to 0) and the only relative extreme values continue to be in Metals and Paper & Packaging.

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 continue to 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