Weekly Findings – July 29th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

July 29th, 2018

Weekly Findings – July 29th, 2018

Thought for the week: “The strong economy and (tax assisted) strong corporate earnings give the US President some room to maneuver on trade – but for how long?”

  • Chart of the Week – Trade Window Closing?
  • SWK – Cheap Again
  • SHW – More Pressure For PPG
  • APD – Good Numbers But Growth Is Getting More Expensive vs PX
  • Weekly Winners & Losers – Still do not see the ARNC take private logic

Chart of the Week – Industrials and Materials Quarter-To-Date 54 Companies

  • Chart of the Week – Trading Window Closing?

The effect of the tax act on confidence and corporate profitability has given the US economy a meaningful tailwind and has provided the Trump Administration with a cushion as its attempts (in an unorthodox manner) to address trade policy imbalances around the world. The tailwind is shown in the chart of the week, with the majority of companies reporting thus far beating revenue and earnings estimates for Q2 2018. However, there has begun to be a reaction in terms of earnings expectations. The many cautionary comments have not dropped down to estimates in aggregate yet meaningfully as the average reporting company in our group has seen a 4% increase in estimates for this year since July 1st, this is in line with the level that the average Q2 beat would suggest alone. The caution is greatest among companies likely to be directly impacted by tariff changes: SWK, for example, having blown away Q2 estimates guided for a flat year, effectively taking down 2H estimates.

We think the President is increasingly on borrowed time with trade as he needs to start signing some agreements to ensure certain good things happen and to avoid the bad things:

  • The biggest negative would be to put the brakes on global growth – this is a major risk to the US even if US growth remains strong, as its negative impact on commodity pricing would have negative implications for the US – especially in energy.
  • Encouraging some manufacturers to move production back to the US would be a good thing, but only where the US has a competitive advantage which is sustainable without tariffs or government intervention
    • Chemical and plastic consumers would be an obvious group, but some machinery manufacture might also make sense
    • The complex balancing act is not to encourage too much, as the US does not have the workforce to accommodate significant investment and wage inflation is already a problem.
  • Push too hard and he could cause some US manufacturers (with meaningful exports) to move production offshore – some has already been threatened.

With the positives of the tax cuts, in part driving the better US economy and low unemployment, Mr. Trump can afford to shake things up in trade. However, it would not be a stretch to see the chart of the week look quite different next quarter – with a migration of data points from the top right to the bottom left – and worse again in Q4 if the uncertainty persists.

In conclusion, as long as the trade debate goes on, the Industrials and Materials sectors are unlikely to do well. The longer it drags on the greater the risk to the global economy – justifying the underperformance of the group YTD. On the flip side, a fair and quick fix could present an interesting entry point for the group, even if this does not look likely today

  • SWK – Cheap Again

SWK has done all that we asked of the company when we wrote an initiation-like piece in 2013: driven the integration benefits of its prior acquisitions hard, while fixing issues with its security business, and returned its return on capital to normal levels – first chart. The company has managed this while adding to the capital base through two sizeable acquisitions in 2016. The Craftsman deal has yet to show any returns (in line with the strategy and the expected timing of the startup of new manufacturing capacity) and yet the company is back at its return on capital trend line without any benefit from Craftsman.

Initially the stock responded to the improving trends but has lost some support since the beginning of the year in line with other companies likely to be impacted by higher tariffs on imports from China (SWK still makes much of what its sells in the US in Asia, though the proportion has declined in recent years with more domestic production and will decline again when Craftsman gets going. We see the dip in the stock and the low valuation – second chart – as another opportunity to get in to a very good story. Our normal model shows the stock cheap on a relative basis, by more than 17%, and also cheap on an absolute basis, taking out the high broader market valuation. The risk is a slowdown in US housing related spending, and while some of the home sales data may be disappointing, it is likely not appropriate to corelate this with housing related spending – consumer confidence and household income is the bigger driver.

The real upside is the potential for SWK to blow through its return on capital trend (in part because of Craftsman and in part because of a less onerous trade outcome) and show a series of upside surprises – the second chart shows the historic volatility in SWK – for the company to move from where it is today to be 1SD above normal value, there is almost 40% upside. This is an interesting absolute opportunity, but it is equally interesting as a defensive relative play, banking on US centric growth. SWK is not as good a “US centric strong economy” idea as SMG, but it is not far behind.

  • SHW – More Problems For PPG?

SHW took a couple of quarters to get its act together with respect to the Valspar merger and drove concerns that perhaps the business was too far outside its “wheelhouse”. This quarter would suggest that the company is getting its act together and we see the all-important turn in return on capital in the first chart below. Our reversion to mean valuation-based recommendations on well executed M&A have driven some very effective research conclusions, with SWK and PX probably our best examples over the last few years and FUL our current project. This story could be just as good if SHW can push down costs and gain revenue synergies that drive returns back to trend. Recent peaks have come from the strength (and low capital base) of the store-based strategy in North America – this opportunity does not exist with the Valspar business and it would be unreasonable to expect that 30+% returns can be achieved again. However, in a best case, the historic trend might be achievable and that would suggest a “normal value” for SHW well above $700 per share – the harder to answer question is how many years it might take to get there.

In the meantime, the negative for PPG – as reflected in the title – is that PPG’s period of operating while its competitor only has “10 men on the field” is likely going to come to a close sooner rather than later. In the second chart we show SHW net debt and while it is high there are two points to note:

  • Prior to the VAL acquisition SHW was paying down debt at a healthy rate
  • The company has paid down $1bn of debt since the deal closed and looks like it could probably pay down twice as much in the coming 12 months

While shareholders might frown on another significant deal tomorrow, by year-end they may feel differently. Further, the debt level is not that high versus what the cash flows and the balance sheet could handle. The store model could be looked at as a stable annuity and could support higher leverage for the right opportunity.

PPG has had 2 plus years effectively playing with an extra man relative to SHW and maybe that analogy is not generous enough to illustrate PPG’s opportunity. PPG has done nothing with that competitive edge – how will the company fare as the competitive edge goes away;

  • Do prices rise for potential acquisition targets as the number of interested parties increases
  • Does SHW really swing for the fences now and approach Akzo – it would be a bold move today, but SHW has cash flows, and valuation multiples on its side.

We remain convinced that change is needed at PPG and these SHW numbers suggest that change is needed urgently.

  • APD – Good Numbers But Growth Is Getting More Expensive vs PX

We have been the (lone) voice of concern on APD for a while, and with the latest numbers we see the green shoots of one of our primary concerns. To be clear, we have no issue with the leadership of APD, and the great strides that the company has made over the last few years. Furthermore, we don’t really have an issue with the strategy, as any alternative that we can come up with is likely too far off-piste to pique any interest.

Our concerns are two-fold – simple return on capital math, which we address below, and likely increased earnings volatility, stemming from the increasing portion of earnings coming from large projects. The math is straight forward; APD is not competitive in most situations when it comes to traditional industrial gas markets and consequently is looking to deploy capital more peripherally, part of which involves an oversized focus on China, where the opportunities are significant, but the risks are higher. We expect APD’s incremental investment dollar for the next several years to have a lower return on capital than it has in the past, consequently dragging down the overall. The turn this year is clearly shown in the chart below and the comparison with PX is stark in that respect. APD has been investing at below its trend returns for many years in our view, with the 2016/2017 upward trend in returns more driven by aggressive cost cutting, post the change in leadership, than more disciplined investment – as well as some capital write-downs.

In the second chart we show incremental returns on capital (with data missing in years where capital has fallen). PX has shown much greater discipline than APD, in part because of the risk averse culture with respect to some of the emerging market and otherwise emerging technologies, but also because PX is competitive in the traditional Industrial Gas market. Furthermore, the company is not afraid to buy back stock when it cannot find investment opportunities that meet its hurdle goal. Our strong preference for PX today is driven by the expectation that the Linde deal will give the combined company plenty of opportunity to deploy high return capital and maintain a positive bias towards its return on capital trajectory.

Our fear for APD is not that the company cannot grow earnings – all evidence would suggest otherwise; it is how expensive that earnings growth may become if incremental returns on capital continue to decline. When you combine that possibility with the risk of greater volatility of earnings, when large projects take turnarounds or if there is any trade/currency issue with China, the issue becomes what multiple you should pay for the earnings. We do not believe that APD has material earnings risk, we think it has multiple risk.

PX has regained the relative multiple high-ground over the last few months and APD is not nearly as expensive relative to the broader market as it was – third chart – but we would still rather own PX.

  • Weekly Winners and Losers – PE rumors again for ARNC

In last week’s findings we talked about AA and ARNC. We struggle with the PE business case for ARNC as we see the company sandwiched between customers with very strong purchasing power and raw materials that are both volatile and potentially inflationary. PE firms historically shy away from taking commodity risk. On the flip side, the PE community has lots of money to put to work today and all the easy ideas are gone, so perhaps rising risk appetite is inevitable

©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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