Monthly Review December 2014 – Falling Crude Leads to Further Weakness in Chemicals, E&C

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 1st, 2014

Monthly Review December 2014 – Falling Crude Leads to Further Weakness in Chemicals, E&C

  • The broad performance themes seen in October were repeated in November – E&C and Chemicals were the lagging sectors, hit by the effects of a steady downward drift in oil pricing and compounded by the OPEC production news on the last trading day of the month. Several Chemical companies continue to deal with the fallout of lower crude pricing, and the implications for the projected US investment projects spread to the construction firms.
  • Paper & Packaging stocks were the best performers in November. Falling crude helps many companies in these sectors, which are highly levered to spending on non-durable goods. Several wood based paper products producers also continue to benefit from a growing expectation that the IRS will rule favorably on their prospective MLP conversions – RKT announced it has filed a private letter ruling on its November 4th earnings call and the stock was up sharply, with peers trading higher in tandem.
  • In November we published company specific pieces on Eastman and Praxair, endorsing the valuation and the story for both. We also looked at capital allocation as an explanatory factor for activist involvement, highlighted some Capital Goods plays for the China/Europe themes in the face of further stimulus, and also addressed the China question from a containerboard perspective, specifically with regards to OCC demand.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. After reporting lower revenue and a softer outlook, DE fell but not by much, which was not a surprise to us. PKG stands to benefit from lower crude from a demand perspective – additionally, the stock appears to have less of an MLP expectancy premium despite its disproportional leverage to that structure, giving it less risk in the case the IRS denies conversion and more upside in the event they allow it.

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SSRSI 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

From a performance perspective, November as a whole broadly resembled October, with Chemicals, E&C and Metals the lagging sectors. The overall results were shaken up a bit on the last trading day of the month, as the OPEC production news led to some significant moves. The stocks that took the biggest hits are some of the most levered to the planned US chemical investments – LYB and WLK obviously on the Chemicals side, but also KBR and PWR within E&C, and UNP, KSU, and TRN on the transportation front.

Exhibit 5

Source: Capital IQ and SSR Analysis

For the full month, smaller cap PPO (Electrical Equipment) was the biggest winner, up 17% on a strong earnings report and the announcement of a significant contract with Panasonic. RKT was the latest stock to jump higher on an MLP mention – management mentioned on its Q3 earnings call that the company has filed a private letter ruling with the IRS, and the stock ripped higher, ending the month up 11%. IP moved higher in tandem. At this point several of the wood based paper products producers seem to be pricing in the expectation that the IRS will rule favorably. CAT was down sharply on the OPEC news but had previously been a solid performer on the month and ended November about flat. On the downside, two Metals names (CLF and X) were hit hardest, but end of month OPEC-influenced slides for LYB and KBR put those stocks in the bottom five for November. Best and worst performers for the month at the company level in our coverage universe are summarized in
Appendix 1
.

Q3 earnings results are all but fully in the books and the theme of strong revenue growth remains intact. Transports (Rail and Trucking in particular) continue to benefit from the backlog in the US system – the Packaging group is a corollary story here. Within Chemicals, the number were surprisingly positive for the Ag players, with MOS and MON showing strong growth. Revenue was down 16% at CF, but this has been the best insulated Ag Chem stock, partly due to an activist presence. The Diversified Chemicals group is influenced by a 20% quarter over quarter decline for ASH, but was up 2.4% excluding this outlier. Mining stocks were a weight on the Metals group – NEM, FCX and CLF were the only companies to report negative sales growth but the group as a whole was still a standout. Exhibit 6 summarizes revenue growth by sector and subsector, with the number of companies having reported in parentheses. Note the Capital Goods subsectors sum to more than the group overall, as some stocks are included in multiple subgroups.

Exhibit 6

Source: Capital IQ, SSR Analysis

Sector performance relative to the S&P across the month is shown in Exhibit 7. E&C stocks underperformed significantly, with KBR, ACM, and FLR all down over 6% in an up market. Paper and Packaging were aided in their moves higher by continued MLP speculation. The Capital Goods space had outpaced the S&P until several large cap names took a dive on the OPEC announcement. Strength in the Transports group was notable in the Trucking companies – ODFL, LSTR, HTZ, and R were all up over 8% in November and among the top eight performers in our coverage over this time. A fifth Transport stock, EXPD, cracked the top eight as well. The railroads countered this strength, and were hit hard on the last day of the month.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes end-November sector discounts from normal value. Chemicals stocks are shading cheaper in the wake of the crude-related shakeup, notably Commodity names. Revenue growth was stolid for the Metals sector, but it will be a long way up on the valuation front – stocks continue to trend lower even as revisions turn positive (albeit off a very low, revised down base).

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 9. As a reminder, our Skepticism Index measures how in or out of phase current valuation is with current returns on capital. A positive number suggests that either valuation is discounting a decline in return on capital or the stock has upside. On the flip side, a negative number suggests that returns have to rise to justify valuation, or the stock has downside.

On the whole, Industrials and Materials sectors are not fully being given valuation credit for what are by and large above average returns – overall our skepticism index is the highest it has been since we began publishing. Part of the story here could be a possible inflection point in several company ROC trends, which underlie the analysis. Several large cap Electrical Equipment companies and IP within the Paper space for instance, are all markedly over-earning relative to their long term, downward sloping 20+ year histories, suggesting that the story has changed in some cases.

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. All things being equal, you want to buy sectors in the top right corner and sell those in the bottom left.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

We again tracked our model portfolios over the month, one based on our normal mid-cycle earnings screen, one based on our Skepticism Index and one based on the stocks that appeared on both metrics. Effectively, we bought the cheapest/most Skeptical and we sold short the most expensive/least Skeptical, as summarized in Exhibit 2 of our November monthly.

Metals stocks, notably FCX, weighed on the long side stocks in November, while the shorts were bolstered by double digit performances from a number of expensive stocks that continue to see upward momentum (BDC, GNRC, EME, SNA). The overlap continues to be the most robust. 2014 has clearly not been a year for value investors as the market has continually made new highs – if the bull run starts to lose some steam, the value plays should catch up.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

In
Appendix 2
we show the companies coming into our screens and leaving our screens.

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 US enters the last leg of 2014 as the main positive story amongst global economies. The impacts of lower crude on corporates are mixed but an implicit tax cut for the American consumer that has been starved for wage growth should lead to
a robust holiday season
, and could potentially kick-start a more meaningful second act to the recovery in 2015.

Comments from ECB President Draghi indicated further stimulus could be in store for the still struggling Eurozone economy. Reports here had been markedly positive earlier in the year but that optimistic sentiment has faded fast. China cut rates for the first time since 2012 – Chinese manufacturing activity continues to slow.

The most recent Macro data changes are summarized in Exhibit 13.

Exhibit 13

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

Commodity Pricing

The fall in crude remains the headline within commodities. Natural gas and metal pricing has been stable.

US commodity and energy prices are indexed in Exhibits 14 through 18.

Exhibit 14

Exhibit 15

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 16

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 17

Exhibit 18

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 19 we look at expected net income growth by sector, comparing 2015 estimates with 2013 actual net income. Relative strength in the domestic industrial and manufacturing sectors is not enough to drive meaningful growth in the machinery and diversified Industrial conglomerate sectors – or it is being inadequately reflected in consensus growth estimates. The result in the Paper space is heavily influenced by IP, which accounts for roughly 50% of the sector weighting. Estimates for the E&C space continue to be robust, though recent earnings misses make us skeptical here. Exhibit 20 shows a reasonable correlation between expected net income growth and our skepticism index, with Electrical Equipment the notable outlier (the R-squared is closer to 30% absent the sector).

Exhibit 19 Exhibit 20

Source: Capital IQ and SSR Analysis

Exhibit 21 shows how these longer term estimates have changed over the month. Where revisions came in, they came in negative. Metals, Capital Goods and Electrical Equipment lost ground on both a weighted and cap-neutral basis.

Exhibit 21

Source: Capital IQ and SSR Analysis

In Exhibit 22 we show the change in 2014 EPS estimates over the past month.

Note that the numbers in Exhibit 22 differ from those in Exhibit 4 as the data is cap weighted at each index point in Exhibit 22 and a current cap weighted average of percentage changes in Exhibit 4. We expected revisions to moderate heading into the end of the year, but there continue to be significant moves, partly influenced by some later earnings reports (RKT to the upside in the Packaging space for instance). In the Metals space, the weakness was in the miners, FCX and CLF in particular. E&C actual saw positive revisions in spite of the underperformance in the sector.
Exhibit 22

Exhibit 23

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal Valuation Analysis

Results of our valuation analysis for the end of May are summarized in Charts 24 through 34.

Exhibit 24

Exhibit 25

 

Exhibit 26

Exhibit 27

Exhibit 28

Exhibit 29 Exhibit 30

Exhibit 31

 

Source: Capital IQ and SSR Analysis

Exhibit 32

Exhibit 33

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 46.

Exhibits 35-37

Exhibit 35

Optimism High

Exhibit 36

Skepticism High

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibit 37

Exhibits 38-40

Exhibit 38

Optimism High

Skepticism High

Exhibit 39

Optimism High

Exhibit 40

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 41-43

Exhibit 41

Exhibit 42

Skepticism High

Optimism High

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibits 44-46

Optimism High

Skepticism High

Exhibit 44

Exhibit 45

Exhibit 46

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in November

November 24, 2014 – Praxair: An Unusual GARPY Opportunity

November 21, 2014 – A Capital Goods View: Europe & China

November 18, 2014 – Chemicals Monthly: Spoiled for Choice

November 11, 2014 – Eastman: A Good Story, But At Risk of a Complexity “Own Goal”

November 10, 2014 – The China OCC Question

November 6, 2014 – Capital Allocation: Why the Activists Are Where They Are

November 3, 2014 – Monthly Review November 2014: Metals, Chemicals, E&C Left Behind in Market Rebound

Dividends

In Exhibit 47 we show a screen of stocks with low value, high Skepticism and high dividend yield.

Exhibit 47

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2


Appendix 3

Appendix 3

©2014, 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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