Weekly Findings – November 25th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

November 25th, 2018

Weekly Findings – November 25th, 2018

Thought for the week: “Underperforming Capital Good – The same M&A potential as Chemicals”

  • Chart of The Week – The 2019 Disconnects
  • CAT, TKR and OSK – Cheaper and levered to Cycles but TKR/OSK the better bets
  • Weekly Winners & Losers

Chart of the Week – The 2019 Disconnects

  • Chart of the Week – The 2019 Disconnects

As we approach the last month of a year that has seen significant underperformance from the Industrials and Materials group – chart below – the chart of the week shows that there are plenty of companies that have underperformed meaningfully while still enjoying positive earnings revisions for 2019. In many cases the estimates for 2019 were even better at mid-year and have given back some of more bullish projections, but for many the growth and free cash flow expectations remain high.

If we look at the circled group we see three industries well represented, capital goods, chemicals and the paper and containerboard side of paper and packaging. Clearly this is where the skepticism is greatest – i.e. where investors don’t believe the numbers. Some stocks are cheaper than others and we compare and contrast CAT, TKR and OSK in the section below. While there are a couple of chemicals names in the mix, it is very hard to recommend either WLK or LYB today – despite what we wrote about LYB and Braskem last week, as the macro is truly in charge here and as we have seen from past cycles, earnings can swing wildly if the economic growth trajectory changes or energy remans volatile – again see the work published last week. The same is also likely true of the paper and containerboard stocks – and like basic chemicals we also have the risk of new capacity on the horizon such that any slowdown in 2019 will be met with higher available capacity, dropping operating rates for all.

Resolution to the trade impasse with China would help the paper and packaging sector as well as the others, but as the chemicals sector is always looking for something to worry about – falling oil prices alongside a (likely temporary) rise in natural gas prices would take center stage and keep the pressure on.

Capital goods is a more interesting space as the sector could benefit from both a trade resolution and further stimulus to the US economy – which is likely important to the Trump administration over the coming 12 months. We think it is possible that infrastructure spending will move up the agenda quickly.

Elsewhere in the chart:

  • The extreme underperformance of HUN is indicative of the complete lack of faith in the polyurethane markets – note that Covestro is one of the extreme underperformers this week. HUN’s valuation – 5x forward EBITDA – is one of the lowest in the group. M&A would be the only logical near-term catalyst. The same can be said for Covestro.
  • ALB; a very poor year as the shine came off Lithium valuations but despite positive revisions for 2019 not cheap enough for us. Livent – the FMC spin – is currently at its offer price and does not provide much of a valuation boost for ALB – at least not yet. ALB spent a lot of money this week on new lithium capacity ($1.15bn). The stock was down 5% this week – not enough to make the bad performer list. Given the macro backdrop (despite Lithium) ALB is not cheap enough to make our value biased interest list – chart below. The recent move towards more expensive has been resilience in ALB’s share price while the market has gone down – lithium in general may provide some market resilience, but Livent is probably the better play because of its focus.

  • CAT, TKR and OSK – Cheaper and levered to Cycles but TKR/OSK the better bets

In the chart of the week CAT, TKR and OSK stand out, and a we have noted above that the interesting group is dominated by capital good names and paper packaging companies.

Before discussing the investment merits of CAT, the first chart below is interesting and pulls us back to our theme of growing investor disinterest in the old economies. While we can draw similar charts for the larger cap material companies, where we have the history – CAT is a high-quality company making high quality products. It has cyclicality in its trading, as does the market, and the trend line below is a little unfair as it captures the 1980s which were all about the high quality old economy companies. In the second chart we show the data from 1990, and the trend is much better – reflecting the better performance through the cycles – but the trend line is below 1.0 – the company has a discount to the market – despite a much better return on capital direction than most – third chart.

The important question is what to do with the stock today – the company is not expensive, but it is not a “value” buy either – chart below. However, forward earnings are 75% above normal – second chart, and in prior period when earnings have been this strong the stock has seen a higher value.

The opportunity with CAT is the very low PE, if forward E is correct as cash flow generation will be very high in 2019 – more dividends and more buybacks – but also possibly more M&A. With the right moves from the White House, CAT could be a great stock in 2019, but the wrong moves will confirm investor skepticism, estimates will be too high, and the stock still has downside to reach prior valuation lows. OSK and TKR may be the better bets.

OSK has seen not only improving returns on capital but also more stability in earnings than in the past – first chart. It may be more interesting than CAT and others because of this, as well as:

  • Much lower relative value – second and third charts
  • Low absolute value – 6.7x EBITDA
  • A good size for acquisition – EV of $5.2bn

OSK has been on our radar for a while – mostly because of valuation and the underperformance has made the stock even more attractive. If we believe our own thesis that valuations will likely continue to disappoint in the “old economy” sectors, CEO’s are going to need to focus on earnings and cash flow growth, even if that leaves them with cash surpluses. The sensible cash flow options are then either share buyback or M&A – OSK is a potential target in our view.

We have never written about TKR, but the charts are even more compelling than for OSK. Another old industry company with very strong profitability trends – with the usual cyclical overlay. The company is cheap on a relative basis – second and third charts – and similarly valued to OSK on an EV-forward EBITDA basis. This would also be a bite sized acquisition for a larger company looking to deploy cash in a way that generates earnings growth

The right strategy is probably to buy both OSK and TKR and if you want to hedge against further market weakness, short one of the more expensive industrial names, such as HON or MMM. We have added both TKR and OSK to our favored list.

  • Weekly Winners and Losers

©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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