Europe – Hard To See When/Whether The Mood Will Turn Positive

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 13th, 2016

Europe – Hard To See When/Whether The Mood Will Turn Positive

  • We believe that “Brexit”, while uncertain on so many levels, will lead to a European recession, a risk which has not yet been reflected in stock performance or EPS revisions
    • Over the last 55 years Europe has had either coincident recessions with the rest of the world or has pre-empted a global recession (1980)
  • An isolated European recession will still likely depress commodity markets and we are yet to see many commodities reflect this risk
    • Another poor 18 months likely for metals, and commodity chemicals could share some of the same pressures – chlor-alkali, PVC and TiO2 are already down – polyethylene to follow
  • Comparing European sales and valuation:
    • At the sector level, for our US universe (Exhibit 1):
      • Paper & Packaging, Capital Goods, and Chemicals have the most revenue exposure to Europe in aggregate; Transports have the least and are the obvious overweight
      • Metals, Capital Goods and Chemicals the sectors most at risk from a global economic slowdown/macro shock
    • At the stock level (Exhibits 9-12):
      • Stocks with high European sales exposure and expensive valuations include IFF and NEU in the Chemicals space and SEE and ATR in Paper & Packaging
        • DOW and LYB are not expensive on normal earnings but given our short term view of the ethylene market, there is scope for each of these stocks to get cheaper – Europe represents ~30% of each company’s sales – yield will likely limit downside for both – see recent research
        • ATR stock has been flat to the market since the Brexit despite deriving 50%+ of company sales in Europe – business has significant high-margin, high-qualification healthcare/pharma exposure and debt levels are low
      • Capital Goods valuations are generally inexpensive and are discounting trouble already – ITW and IEX look most overvalued

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Europe is at another crossroads, and there are plenty of divergent opinions around what happens next. There is a consensus view that “Brexit” is bad, but no consensus on how bad, or for that matter, why! We feel that we are about as qualified to talk about this subject as anyone, given that this is relatively uncharted territory and that everyone is making it up as they go along. Issues that we would focus on are as follows:

  • This could be worse for Europe than for the UK as it may be a catalyst that leads to greater unrest, wider divides between the “haves” and “have nots”, and possibly further fractures.
    1. The EU was never designed to be managed as a single entity. It was constructed to collaborate on the common goals of a group of countries that all maintain their sovereignty, and the EU parliament is relatively powerless.
    2. The collaboration came after centuries of regional conflict in Europe all aimed at getting the three things that EU was supposed to bring peacefully – scale (on the global stage), freedom of movement and a pooling of resources – energy, other natural resources, talent, etc.
    3. There is no consensus in Europe as to how to handle “Brexit” and we do not believe that consensus will be reached quickly, given that each country likely has a different agenda, and several leaders have to balance what is right for Europe with the almost certain knowledge that a similar public vote in their countries would yield the same result.
      1. A UK exit has two major simplifying factors compared to any other exit – there is not a common currency and there are already border controls (except in Ireland).

The visual borrowed from the “Eurasia Group” summarizes the possible current mood – Exhibit 2.

Exhibit 2

  • The UK may be in better shape eventually, particularly if the new Prime Minister can provide the strong leadership to hold it all together and to avoid a possible Scotland exit – which would damage the “go-it-alone” UK strategy greatly.

In short, we do not know how this will unravel and we do not think that anyone has a better crystal ball today. However, what is very evident is that confidence has taken a beating and we think that this is the tangible data to focus on. Consumer and business confidence is down across Europe and we do not expect resolutions which would improve the situation any time soon – there is trade risk, currency risk, and economic growth risk.

For the purpose of this analysis we are assuming a 300 basis point drop in growth in Europe for the next 18-month – this results in a GDP decline of 1% for the second half of 2016 and 1.2% for 2017 (current consensus from the European Commission expects growth of 1.6% in ’16, and 1.8% in ’17. In addition, we are assuming that the pound falls to $1.25 and the Euro is 10% lower in 2017 than in 2016. These assumptions impact all companies and all industries but in this report we are focusing only on the stand-outs.

Exhibit 3

Source: Bloomberg, SSR Analysis

With these assumptions we would:

  • Be long Transports in the US market and short Paper and Packaging.
  • We would avoid metals and other commodities – mostly because of the economic impact on commodity demand and pricing.
  • If oil pricing falls on economic weakness and US natural gas remains flat or rallies we would stay away from anyone benefitting from cheap US energy relative to the rest of the world as margins will likely compress – leading to negative revisions.
  • The following stocks look interesting – in part based on fundamentals and specific regional and product exposure and in part based on valuation – it is a short list:
    • Rails: KSU, CSX, NSC, and UNP (in order from least to most expensive)
  • The following stocks look very vulnerable for the opposite reasons – it is a much longer list:
    • Chemicals: CC, TROX, HUN, OLN, EMN
    • Metals: X
    • Capital Goods: DE, CNHI, CAT – yield could limit downside for DE

Prior Recessions

Looking at the three non-2008 economic slowdowns of the past 25 year, our sectors have tended to begin fading before the peak in output, in keeping with their cyclical status. There is not much to be gleaned from the individual sector results, other than that the Chemicals sector has been the laggard in two of the three cases. We have not included the Packaging results as the business mix for the primary constituent (IP) has changed so significantly that the historical performance is less relevant.

Exhibit 4

Source: Bloomberg, Capital IQ, SSR Analysis

Exhibit 5

Source: Bloomberg, Capital IQ, SSR Analysis

Exhibit 6

Source: Bloomberg, Capital IQ, SSR Analysis

Sector valuations at the time of short term GDP peaks do not show much of a pattern, though the 2000 valuations are notably driven by the tech bubble, which brought relative multiples to multi-decade lows. Numbers in green indicate a sector trading below fair value as measured by return on capital based normal earnings; red indicates a sector trading above normal value.

Exhibit 7

Source: Capital IQ, SSR Analysis

Dollar appreciation in general predictably weighs on stock performance of US companies. Looking at periods of dollar strengthening versus the euro, Industrials and Materials have largely underperformed concurrent with an appreciating dollar. The exhibit below lists periods where the six month trailing EUR/USD rate fell by at least 10%, and the relative sector performance during those six months as the dollar appreciated.

Exhibit 8

Source: Capital IQ, SSR Analysis

Stock Level

Chemicals

For Chemicals and Metals economic slowdowns are more about commodity overhang and lost global margins than they are volume declines in the regions hit by slower or negative growth. We already have many commodity chemicals at or close to cyclical lows: PVC, Caustic Soda, TiO2, potash, urea, polyester. For these products a slowdown in Europe likely means a prolonged trough as all are globally traded. The downside comes in product areas where there is still margin; most notably polyethylene, which we have written about extensively, but also in the styrene chain, where margins had been improving over the last 12 months. We do not believe that any of the commodity chemical companies are cheap enough to buy and “ride it out” yet. One of the better examples of this is CF where we highlighted the attractive value of the stock when it was 1SD below “normal value’ with the benefit of a significant step up in volumes (through expansion) taking place in 2016 – the stock has subsequently dropped to 1.5SD cheap!

  • The most downside is likely in the names that are carrying very high levels of debt and for these companies some sort of radical strategy refresh might be necessary to ride out a period of economic weakness: EMN, CC, OLN, HUN, TROX and possibly even CF.

NEU, IFF and possibly ECL look most concerning at the intersection of high European sales and expensive valuations. High European exposure could also present a further headwind for DOW and LYB, which in our opinion are also likely to be challenged in Q3 by weakening fundamentals in the ethylene/polyethylene market.

We would only own companies in the sector on a relative trade and we would focus on both valuation and margins that are not impacted by global commodity exposure. Industrial gases are the obvious place to hide and PX has the most attractive valuation and is less exposed to Europe than APD. We still believe that MON will sell to Bayer and so we would own MON, recognizing that the stock has reasonable downside if the deal does not happen.

Otherwise we are waiting for better entry points.

Exhibit 9

Source: Capital IQ, SSR Analysis

Capital Goods

The Capital Goods sector in aggregate slants inexpensive, so the most Euro-exposed names (AGCO, FLS) are already discounting some measure of weakness. The major risk for this group is the threat of a general global slowdown if a European recession has knock-on effects.

SWK is a stock we have been positive on, and Europe has been a highlight for the company’s tool business, with share gains driving strong organic growth recently – while share gains could continue and help SWK endure a European slowdown, the Brexit likely poses an incremental headwind.

Exhibit 10

Source: Capital IQ, SSR Analysis

Paper & Packaging

The relatively high percentage of European sales in the sector is driven by a handful of names. ATR has the largest exposure but a defensible business mix and the stock was not overly penalized in the aftermath of the Brexit. There is more risk for OI, which is dependent on volume leverage to capitalize on recent restructuring programs in the region.

The commodity overhang risk is most pronounced here in containerboard and to a lesser extent in free sheet. This will likely keep downward pressure on PKG, IP and UFS, with only PKG showing valuation that looks fully risk adjusted.

Exhibit 11

Source: Capital IQ, SSR Analysis

Metals

Metals stocks mostly show modest European sales exposures, driven by primarily domestic-facing steel producers (WOR, NUE, ATI, RS). NEM is the outlier here, generating roughly 66% of its sales in the UK – the stock rose on the Brexit news perhaps on the thought that an independent UK would boost local manufacturing.

The Metals stock we have been most cautious on, US Steel (X), generates ~20% of its revenues from US Steel Europe, and the stock has room to move significantly cheaper.

Exhibit 12

Source: Capital IQ, SSR Analysis

Trade Balances

US trade balances with Europe in major industrial categories show large trade deficits, due in most instances to Germany’s significant export position. Beyond the direct products, one of the larger US trade deficits is in road vehicles, which include large amounts of embedded metal, plastics, and chemicals. The general threat is a lower value for the euro which would encourage more European exports to the US to the further detriment of US based manufacturers.

Exhibit 13

Source: US Census Bureau, SSR Analysis

Exhibit 14

Source: US Census Bureau, SSR Analysis

Exhibit 15

Source: US Census Bureau, SSR Analysis

Exhibit 16

Source: US Census Bureau, SSR Analysis

Exhibit 17

Source: US Census Bureau, SSR Analysis

Exhibit 18

Source: US Census Bureau, SSR Analysis

Exhibit 19

Source: US Census Bureau, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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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