SSR Industrials & Materials Monthly Review, October 2017: Strong 1H Earnings Trends Continuing in Q3

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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 1st, 2017

SSR Industrials & Materials Monthly Review, October 2017:

Strong 1H Earnings Trends Continuing in Q3

  • Earnings continued the trends seen in Q1 and Q2, with an increasing percentage of positive revenue surprises and the strongest top and bottom line growth since the early part of the decade
    • 85% of Industrials & Materials companies that have reported beat revenue expectations, the highest percentage seen this decade
    • Revenue and earnings growth figures are inflated by some extreme moves in the miners – see commentary on CAT below
    • Results suggest particular strength in autos (PCAR, CMI) and mining (CAT, FCX, NEM), with leverage more significant in the latter
    • GE the extreme negative outlier – stock was the worst performer in our universe on the month as skepticism is increasing quickly ahead of the mid-November business review
  • Research over the past month:
    • Akzo – we see the move to acquire AXTA as another strategic misstep; company would be better served improving internal operations in coatings and chemicals than giving away upside in its high cost specialty businesses and chasing lean companies with potentially significant long term fundamental headwinds
    • European Chemicals – noting the divergence in expectations for US and European chemical companies, we explored which companies are most levered to a convergence
    • Stanley – a classic case study of our normal valuation framework, the stock has further upside in our view as sustained earnings momentum drives return on capital back towards the long term trend
    • DWDP – focused on cash generation and usage ahead of the combined company’s first report
    • CAT – stock has seen strong gains on positive revisions and is only cheap if the mining recovery accelerates, something that does not appear to be currently priced in to the mining stocks
    • Earnings Momentum – comparing valuation and estimates in the Industrials space as we did for Chemicals partially informed our above work on CAT
    • Pricing/Volume – stratifying our Industrials/Materials universe into small, mid and large cap groups, we assessed the outlook for major markets and the impact of a potential hurricane trigger on demand
    • Alcoa – we see potential cyclical and normal valuation upside for the stock
  • 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 the DWDP commentary above
    • In Industrials, with GE off our favorites list, we are most positive specifically on SWK in the large cap space – see research referenced above 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

Q3 earnings have so far continued the trends we have observed in 2017, namely stronger results than expected on the top line and the largest magnitude of year over year growth in several years. Positive revenue surprises have been widespread as suggested by the left chart of Exhibit 5. Standouts at the stock level suggest particular strength in auto (SNA, PCAR, CMI) and mining (CAT, FCX, CLF), with leverage more significant in the latter. On the negative side, GE is in an altogether separate realm – skepticism towards the stock is growing quickly ahead of the mid-November business review.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month of October is shown in Exhibit 7. We show the 25 best and worst performing stocks on this time frame in Appendix 1. Eight of the 25 worst performers were in the Transports group, with UPS most meaningful from a market cap perspective (earnings were not out of line with expectations but renewed concerns about potential disintermediation by Amazon weighed on the stock).

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