SSR Industrials & Materials Monthly Review, September 2017: Most Outperform as Revisions Yet to Reflect Hurricane Impact

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 1st, 2017

SSR Industrials & Materials Monthly Review, September 2017:

Most Outperform as Revisions Yet to Reflect Hurricane Impact

  • We are expecting the hurricane impacts to put a dent in Q3 earnings – revisions do not currently reflect this as many companies have yet to make statements assessing their exposure, and the September performance results were strongly positive (+4% or higher) for most of our sectors save Metals (the only sector to see material negative revisions over the month) and Conglomerates
    • Q4 likely to make up for some temporary sales weakness with potential for accelerating growth into 2018
  • Research over the past month:
    • DowDuPont – the company’s quick turnaround in altering the composition of the spin companies addressed some concerns of activist investors and did not change our overall bullish thesis; new portfolio alignments could result in higher multiples for the constituent companies and provide upside to our valuation target
    • GE – we see the Power unit as perhaps the biggest issue for the company moving forward as we are concerned about underlying fundamentals; additionally, the new CEO’s willingness/ability to recognize the potential strategic misstep of having doubled down on a poor business could be compromised by his leading role in the Alstom deal
    • Hunstman/Clariant – this is the least exciting pending Chemical merger in our view – not much upside to the deal and go-it-alone strategies that are even less compelling
    • Industrials – our analysis of the large and mid cap Industrials universe mostly showed valuations to be ahead of fundamentals to varying degrees – valuations similarly elevated in the small cap space but with a few clearer opportunities
    • Ethylene – we believe conditions are in place for a robust ethylene cycle to begin immediately, with hurricane recovery demand bridging the 2018 gap to an improved fundamental picture through 2020 – see significant upside for LYB and WLK (more levered than DWDP on a per share basis)
  • Exhibit 1 summarizes our preferences by sector and stock
    • Performance results for our group through the end of Q3 confirmed some of our convictions:
      • AA the top performer in our group, +66% YTD, with X the third worst performer, down 22%
      • Commodity chemicals have continued to perform well – WLK and OLN top performers
      • SWK among the top 25 outperformers, along with OI and KSU
      • Our earlier faith in GE was not rewarded – stock has been second worst performer YTD
    • 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

Earnings revisions do not yet reflect the hurricane-related disruptions that we think are likely to impact this group rather significantly in Q3 results – however, stock performance outside of Metals and Conglomerates during September reflects the expectation of a strong recovery in Q4. Somewhat cynically, the hurricane boost may in fact lead to a step up in growth and/or an improved fundamental picture in 2018. This is perhaps most acutely to be seen in the ethylene market in our view – research this month – but could also drive a broader industrial recovery with an accompanying demand pull on other materials, including aluminum, PVC, lumber, insulation products and steel. In our weekly email on Friday we discussed the steady, geosynchronous ~2% growth environment of the past several years – perhaps compounding to the point of tightening in various industries and markets, but we are still waiting for a push higher to more robust growth rates. US second quarter GDP was recently revised up slightly, but already marked the first quarter of 3% growth since early 2015 – Exhibit 5. It will be interesting to see the IMF’s global growth forecast in the October update. The absence of recent negative revisions stands out in comparison to the persistent lowering of expectations in prior years – Exhibit 6.

Exhibit 5

Source: BEA

Exhibit 6

Source: IMF

Sector performance for the month of September and through Q3 is shown in Exhibit 7. We show the 25 best and worst performing stocks on this time frame in Appendix 1. Transports – both rails and truckers – gained on expectation of tightness related to hurricane clean up and recovery. Machinery, Chemical, and Engineering & Construction stocks likewise saw gains of only slightly smaller magnitude. These sectors, with the exception of E&C have been the winners year to date – right chart of Exhibit 7.

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. GE had yet another bad month, with radio silence from the new CEO leaving a vacuum into which any bad piece of news sees an over-reaction – this month it was the idea that India may go to electric rather than diesel in its new rail projects – jeopardizing a large GE contract (would be bad for GE and likely good for the proposed Siemens/Alstom rail combination). 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 value continues to be in Metals.

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

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. Cumulative monthly results in 2017 to date have been roughly flat (+1.2%) for the SI selections, slightly positive (+2.4%) for the overlap selections, and most robust for the normal value selections (+6.8%).

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 have 27 stocks that currently fall in these historically outperforming ranges, down five from last month – 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.

The macro landscape appears stable, with potential for upside to the steady geosynchronous growth we have discussed in the overview and our weekly email on Friday. Employment indicators are generally improving or holding steady at multi-year lows and modest inflation is beginning to take hold, perhaps most crucially in Europe. Domestically, consumer confidence has rebounded after a few weeks of moderate declines as the Gulf states endured a seemingly continuous battering of hurricanes.

Exhibit 14

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

Commodity Pricing

US commodity and energy prices are indexed in Exhibits 15 through 19. Aluminum is the only major metal to see a price gain over the past month, +2% versus -4-5% for copper and steel. Year to date, aluminum pricing is up 24%, underlying the price gain we noted for AA.

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. With a combined estimate that incorporates some synergy expectations and a dominant cap weight, DWDP has pushed the Chemicals net income growth to the top of the pack. The divergence between the Conglomerates inclusive and exclusive of GE remains notable. Metals and Capital Goods are reflecting a relatively low 2016 base in Exhibit 20. Changes over the past month are shown in Exhibit 22 – Chemicals most positive due to DWDP.

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. Note these revision figures are a simple average versus the cap weighted revisions shown in Exhibit 4. NUE, WOR, STLD, and CMP were all hit with negative revisions in September.

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.

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 September
September 27, 2017: Small Cap Industrials – Elevated Values Again, But Some Ideas

September 26, 2017: What A Real Ethylene Cycle Looks Like – More Upside for LYB and WLK

September 25, 2017: Industrials – Valuation Largely Ahead Of Fundamentals

September 20, 2017: HUN/Clariant – The Art Of The Possible vs The Ideal

September 18, 2017: GE – Power Could Undermine The New Throne

September 17, 2017: Chemicals September – DWDP Comes in Like a Hurricane

September 13, 2017: DowDuPont: A Fast and Large Capitulation, but No Change To The Investment Thesis

September 11, 2017: The Hurricane Boost – Enough To Bridge The Ethylene Gap! Moving To Overweight

September 5, 2017: DowDuPont: The moves the activists are suggesting may be exactly the wrong thing to do at exactly the wrong time

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. EMN reenters the dividend screen this month, and CMP has entered the skepticism screen. These two join holdover OLN as the only stock to appear 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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