Weekly Findings – July 22nd, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

July 22nd, 2018

Weekly Findings – July 22nd, 2018

Thought for the week: “GE – Powerful Problems Persist”

  • Chart of the Week – GE’s Powerful Problems
  • PPG – Still Painting Over The Cracks
  • PAH – Creating a Better Platform
  • AA and ARNC – Trading Places
  • Weekly Winners & Losers – CLF a break-out

Chart of the Week – GE’s Powerful Problems

  • Chart of the Week – GE’s Powerful Problems

GE reported earnings that beat expectations this week, but the stock responded negatively and most of the focus has been on the power business, something that we have been concerned about for a while. The industry clearly has significant power generation manufacturing overcapacity, with expected GW hours of new capacity demand for 2018 possibly as low as 20-25% of the global theoretical capacity to supply equipment.

GE is doing the right thing – cutting costs – with significant layoffs in the business expected this year and next, and GE is not alone, with Siemens also struggling. However, right-sizing for GE must require some sort of asset write down in addition to the people moves. At the end of 2017 GE listed $71 billion of assets in its Power business and if we annualize Q1 and Q2 profit, the company will make a return in 2018 of less than 2% of assets – by comparison Siemens will likely make more than a 10% return in its Power and Gas segment.

Our Utilities and Renewables group has done some unique work on expected equipment demand based on a number of possible scenarios for both power demand and alternative supply, and while they project better years than 2018 in their forecasts under most scenarios, they don’t get anywhere close to what the potential capacity to build new capacity might be in any year. In our view the improving trend gives false hope for the Power equipment producers and we remain very concerned for the profits in this segment regardless of how focused GE might be on cost. Our reasoning rests on two arguments – one of which may be built into expectations and the other not:

  1. GE cannot have $70+ billion of useful assets in this space and the level of impairment may be very high – possible more than 50%. This write down has to come – we think that investors expect it but may still be surprised by the size. GE needs to right size this business from both an asset and a people perspective. Given the uncertainty around the demand outlook we would encourage the company to err on the side of doing too much rather than too little, or it will become an annual issue.
  2. Competition: No one wants to close half of their manufacturing base, despite what might be required, and we are concerned that while GE and others may be doing the right thing by lowering costs, it will all be competed away in attempts to retain or gain market share. While GE has plenty of history in the developing world, there are now developing world competitors, especially for the smaller turbines, who might be more hungry than GE and les concerned about margins and returns.
    1. We have seen so many examples of this across many industries over decades, where demand slowdowns trigger cost cutting and attempts to right size businesses but at the same time they trigger more intense competition. Industries commoditize in downturns – this is when buyers experiment with other suppliers to learn the cost/benefit of switching to a cheaper alternative.

Several times we have talked about the risk of the “unknown unknowns” at GE, and the evolution of the competitive base within the Power business is one of the unknowns. Aggressive behavior from one or more players may see GE margins deteriorate further in this business, despite the cost efforts. We appear to be seeing some of the same effects in the renewables (wind energy space), which is an added concern. Meanwhile the black box that is GE Capital remains the greater wildcard. It is becoming increasingly unclear to us whether there is a “good entry point” for GE. We do not believe that it is $13 per share.

  • PPG – Still Painting Over The Cracks

We remain very concerned that PPG is more focused on making the numbers than on running its business properly. Having recently concluded an accounting review that smelled very badly of moving earnings around to make quarterly estimates, we see a second quarter “non-recurring” line item of “customer assortment costs” which is the cost of transitioning from a position at Lowes to one at Home Depot. This adjustment was first noted in Q1 2018, where it had a 1 cent per share impact on earnings. In Q2 it was 3 cents and was the difference between beating and missing numbers.

While it may be an “allowed” charge, we have never seen PPG take these charges in the past when they have lost or gained auto OEM business and it is hard to find other companies taking a non-recurring change for something that seems to have happened in the normal course of business. The loss of the Lowes business appears to be mismanagement rather than planned and we struggle with this being classified as a non-recurring charge

The margin chart below remains our primary concern, and while the company will point to raw materials rising more quickly than pricing we see more of an issue with slow growth and the increased competition that usually accompanies slow growth – see our GE Power comments above. PPG posted a better volume number in Q2 – up more than 3% – but also higher receivables that a year ago – more than would be accounted for by pricing and currency trends alone. It is possible that Q2 was seasonally stronger than usual with a correction in Q3.

Separately – we note the extensive management turnover at PPG – too much to be healthy in our view and another cause for concern. The stock has gone nowhere for 4 years – hitting the current $105 per share for the first time in June of 2014 – second chart – consequently, the stock has underperformed the market materially – third chart.

None of what we are seeing at PPG paints a pretty picture – management cannot be happy – except perhaps the new hires – the board can’t be happy, and shareholders are certainly not happy. We see possible binary outcomes here – a desperate bad deal (sending the stock lower) – maybe an overpriced second attempt at a more expensive Akzo – or a change in leadership, which would likely send the stock higher. On a risk reward basis, we would probably buy the stock here but we don’t see it working without a major change in strategy/leadership.

  • PAH – Creating a Better Platform

In last weeks “findings” we talked about activists driving performance YTD in 2018 and highlighted RPM and PAH as two of the winners for the year. Early Friday, PAH announced the sale of its Ag business to Indian Ag player UPL. The cash deal is for $4.2 billion and will wipe out much of the debt at PAH, which will change its name after the sale to Element Solutions and its ticker to ESI

While this transaction is likely what Pershing was looking for, the shareholders did not like it, sending the stock down 7% on Friday. According to Platform the new company (ESI) will have around $450 of EBITDA and $1bn of net debt. At 10x that would give an equity value of $3.5 billion – suggesting not a lot of upside from here the stock is trading today – clearly where investors are leaning initially. So, the question is what is the right multiple? Growth and operating margin (below) for the residual business are hard to follow and model because of two substantial acquisitions in 2015. The residual businesses are in the oilfield services (hard to find a good comp for but IOSP is trading close to 12x EBITDA), and the electronics space with a low of 12.5x for VSM and a high of more than 16x EBITDA for CCMP.

If you pick the lower end of the electronics range 12.5x EBITDA – you get 36% upside in the share price and a management team that is committing to buyback 22% of the current market cap once the deal is complete – interesting on its own, but the residual may be an interesting acquisition if values do not change, as it would be accretive for any existing electronics player. PAH is in our SMID universe – it is well covered for a SMID stock and reasonably well liked – we would expect a positive take on this deal.

  • AA and ARNC – Trading Places

We have talked a lot about trade in our recent Weekly Findings. Alcoa decided to quantify an expected impact of tariffs on 2H earnings, reducing free cash flow estimates as a result. Despite a very strong quarter, the stock is the worst performer of the week, see final chart of this report. Aluminum pricing is down – off its recent high, but not expensive by historic standards – chart below. We see the current pricing weakness as an emotional “head fake” in a very volatile, mostly sentiment driven market. Demand growth remains very strong and supply growth very limited – as are inventories – we still see the longer-term trend as upwards, with trade behavior likely to have little impact, apart from creating volatility and with it perhaps trading opportunity.

When Alcoa and Arconic split we took a strong position that you wanted to own the Aluminum seller and not the buyer. That had been a very good pairs trade until last week, where you would have lost 24% on the relative trade (you would still be well ahead however) – Alcoa’s stock over-reacting very negatively to trade and some incremental pricing and demand commentary (the stock is now trading at 10x earnings and 4x EBITDA! Arconic jumped on the idea that Private Equity might be interested in the company given low valuation. ARNC reports on the 31st.

We are going to hold the line here and see the movements of the last week as an opportunity to enter the trade if you have not done so already. Aluminum is tight – regardless of trade distractions – and the demand levers that are creating the tightness are largely imbedded in auto/machinery/white goods designs that are not going to change because of possible trade game or because aluminum prices rise 10-20%. The pull back in recent pricing is more emotional than supply/demand driven in our view and we see a reversal of direction quite likely. On the short side, maybe there is a PE risk at ARNC, but it would be a very odd bet for a PE company given the commodity metal risk on the raw material side and the lack of pricing power at ARNC – all the reasons we did not like the story from the beginning. PE firms and activists generally shy away from commodity risk because they can neither predict nor control it. The table shows ARNC’s raw materials by segment and today there is upward pressure and an upward trend (aluminum included on a trend basis) in more areas than where there is a downward trend – polyethylene is probably the only product with a meaningful step down in pricing today.

ARNC is not nearly as expensive as it was when the companies split, and the short is less obvious than it was at that time. The buy case for AA is much clearer.

  • Weekly Winners and Losers – CLF, a break-out.

CLF reacting to a very strong earnings beat and better outlook – iron ore prices are higher globally but not so much in the US. The mood is clearly that US tariffs boost US steel production and consequently US iron ore demand. The stock is extremely cheap on earnings and the equity value is sensitive to gains in EV multiple given high debt levels. Estimates for 2018 will likely rise from the current $1.67, given that Q1 plus Q2 plus the current 2H estimates sum to $2.04 per share – suggesting a current PE of less than 5x. This probably has further upside despite the gain last week.

The caveat is volatility – CLF lost money in 2015 and made only 22 cents per share in 2016. As the price chart below shows – this is not a buy and hold stock.

©2018, 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. Sources: Capital IQ, Bloomberg, Government Publications.

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