Monthly Review July 2014 – Commodity Chemicals Stretching the Limits

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

July 1st, 2014

Monthly Review July 2014 – Commodity Chemicals Stretching the Limits

  • Halfway through 2014, results within Industrials & Basic Materials year to date have reflected the strength seen in FDX’s recent earnings report (Transports & Packaging each +1% versus the S&P) as well as the favorable economics of US based Chemicals producers (the best performing sector within our coverage on the year).
  • The strength in the Chemicals space has been driven to a large extent by commodity companies that have steadily marched higher (DOW, LYB, WLK), and the sector in aggregate is not cheap. DD has been one of our favorites for some time and despite the negative pre-announcement, we continue to see value in the name given the company’s expected transformation and the cost initiative we had anticipated.
  • Revisions remain negative on the whole. E&C stocks saw the worst cuts to 2014 EPS estimates in June, influenced by KBR’s bad earnings miss, and the sector was the biggest underperformer on the month (a title it holds in the year to date results as well). Chemicals, Paper, and (of course) Metals & Mining also saw revisions pressure.
  • The negative revisions for the Paper sector did not prevent its component stocks from outperforming a continually strong S&P in June – the group was up over 5% relative to the market. It stands just behind Electrical Equipment which retains the highest valuation premium within our broader coverage, though dispersion here, and for the group at large, remains elevated.
  • June research featured a follow up on our aluminum coverage, a review of the competitive dynamics in the European Basic Chemicals industry, and a preemptive analysis of DuPont’s prospective gains from a cost initiative, which proved prescient.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. Given the strength in aluminum pricing (+11.2% since January) we think the momentum in AA can continue.

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

Packaging and Transports were strong in June, reflecting the strength seen in FDX’s calendar Q2 earnings. Chemicals were also strong despite a drop in DD following a guide lower – within the announcement came definitive news of a cost initiative as we had anticipated. This has been a good call for us despite the recent dip and we still see value in the name moving forward.

Weakness was spread throughout the E&C sector – KBR was having a decent month (+6%) until its earnings report sent the stock lower. It is far and away the cheapest stock in our coverage (+2 SDs below normal) and has had trouble finding non-government sources of revenue – government contracts represented 32% of sales in 2010 but have dwindled to just 9% amidst a broader drop in earnings. JEC was the worst performer among its E&C peers for the month – it is one of several companies with large backlogs in the Chemicals, Oil & Gas and Refining markets which could result in considerable project delays due to a shortage of the necessary skilled workers.

IP broke above $50 on a Barron’s report that highlighted the company’s cash flow generation. The stock has not traded at such a level since the late 1990s. Our return on capital model does not support the claim that the stock is inexpensive. Within the Paper sector, MWV also was up sharply, gapping higher after activist investment group Starboard LP revealed a 5% stake in the company.

Best and worst performers at the company level in our coverage universe are summarized in Appendix 1 .

Sector performance relative to the S&P is shown in Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6 summarizes end-May sector discounts from normal value. E&C stocks tumbled further in June and are the second cheapest sector, behind only Metals where revisions remain negative and valuations depressed. CAT was up 5.6% on the month, and along with SWK, sticks out as a large cap value play with leverage to a broader global economic recovery. Within Capital Goods, DE also looks cheap on valuation alone but equipment spending is weak given flat farm incomes – see past Ag related research . Electrical Equipment is expensive in the aggregate, driven by premiums for the major large cap players (EMR, ROK, AME) but valuations are quite dispersed within the sector. GTI is dealing with cyclical disruptions in the steel market for its graphite electrodes and an activist led boardroom drama, and is but one of a handful of inexpensive small cap names in the sector.

Exhibit 6

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 7. 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.

Paper and Electrical Equipment have similarly high skepticism index values. Forward estimates are strong for these sectors, driving above trend earnings on our model, but valuations, while elevated in some instances, do not fully reflect these returns. Most of these groups have seen two to three years of consistent negative revisions as estimates have reflected a global economic recovery (led by the US) that has been slow to materialize – it is hardly surprising that for many groups valuation discounts an expectation that earnings estimates will decline.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 is a very busy chart but shows how each sector and sub-sector breaks down by SSRSI 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 8

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 June monthly.

The results have been strong in recent months. The overlap portfolio led the way in typical fashion – Exhibit 9. Halfway through 2014, the aggregate results exclusive of transactions costs are positive for the overlap screen (+9.1%), marginally so also for the valuation screen (+0.7%), but the SI screen continues to lag (-1.8%) – Exhibit 10.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

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.

Pending home sales rose the most in 4 years in May, a good sign for the US economy in the second half of 2014 and a positive signal for a housing market that looked like it was beginning to lose some steam. Q1 US GDP came in worse than anticipated and was revised down but is expected to snap back sharply in Q2. FDX indicated an expectation of steady improvement in the domestic and global economies in its recent earnings call.

The ECB made a bold move to jump-start the seeming recovery that has been gaining traction in Europe, dropping deposit rates below zero in an effort to induce lending. This approach has been employed in several Scandinavian countries to mixed results and highlights a fundamental limitation of monetary policy – you cannot force anyone to borrow or lend. News out of China remains broadly similar to the trend of steady growth that we have seen over the past six months.

The most recent Macro data changes are summarized in Exhibit 11.

Exhibit 11

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

Commodity Pricing

Natural gas pricing ended June under $4.50 per mmBTU – the summer has been temperate thus far. Inventories are in a steady state of replenishment after the depleting winter, but remain well outside of the five year range – see our recent blog on the topic . Brent and WTI were each up about $3 per barrel in June, but moderated on the last day of the month as it appears the Iraqi situation will not disrupt supplies.

We have been following aluminum closely of late – AA has been a good call and we wrote in March that pricing would need to rise to see further upside. Aluminum is up 11.2% since January and has been much stronger than Copper (-0.8%) and Steel (+1.9%) over that time.

US commodity and energy prices are indexed in Exhibits 12 through 16.

Exhibit 12

Exhibit 13

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

Exhibit 14

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 15

Exhibit 16

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 17 we look at expected net income growth by sector, comparing 2015 estimates with 2013 actual net income. The sector rankings are unchanged from a month ago.

 

Exhibit 17 & Exhibit 18

Source: Capital IQ and SSR Analysis

Exhibit 19 shows how these longer term estimates have changed over the month. E&C was heavily influenced by KBR’s estimate which was off 29% and is down over 60% on the year. On the other side, Capital Goods was up mainly due to CAT – the company’s 2015 net income estimate was up 4% in June, but is still down over 20% from where the estimate was last year at this time (in large part explaining Capital Goods lagging position in Exhibit 17 above). EMR’s modest estimate brought down Electrical Equipment’s cap average but on an equal weighted basis the sector was flat on the month.

Exhibit 19

Source: Capital IQ and SSR Analysis

In Exhibit 20 we show the change in 2014 EPS estimates over the past month. KBR’s estimate was more than halved following its very poor earnings report – the rest of the E&C sector was stable. This month’s Metal culprits were NUE and CMC. Both steel makers saw their full year EPS estimate cut by more than 15%. Paper’s drop was mostly a function of LPX.

Note that the numbers in Exhibit 20 differ from those in Exhibit 4 as the data is cap weighted at each index point in Exhibit 20 and a current cap weighted average of percentage changes in Exhibit 4.

Exhibit 20

Exhibit 21

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 22 through 32.

Exhibit 22

Exhibit 23Exhibit 24

Exhibit 25

Exhibit 26

Exhibit 27Exhibit 28

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Exhibit 31

Exhibit 32

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 33 through 44.

Exhibits 33-35

Exhibit 33

Optimism High

Skepticism High

Exhibit 34

Exhibit 35

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 36-38

Exhibit 36

Optimism High

Skepticism High

Exhibit 37

Optimism High

Exhibit 38

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 39-41

Exhibit 39

Exhibit 40

Skepticism High

Optimism High

Exhibit 41

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibits 42-44

Optimism High

Skepticism High

Exhibit 42

Exhibit 43

Skepticism High

Optimism High

Exhibit 44

Source: Capital IQ and SSR Analysis

Research Published in June

June 27, 2014 – DuPont: Lower Guidance But Big Savings Ahead (Blog)

June 22, 2014 – Aluminum: Perhaps Too Cautious Too Soon!

June 20, 2014 – Chemicals Monthly: All Eyes on Iraq

June 18, 2014 – APD: A Wise, But Not Long-Term, Compromise (Blog)

June 16, 2014 – European Basic Chemicals: There is Life In The Old Dog Yet!

June 2, 2014 – DuPont: A Cost Initiative Could Be Substantial

June 1, 2014 – Monthly Review June 2014: Valuation Dispersion Elevated as Markets Stretch Higher

Dividends

In Exhibit 45 we show a screen of stocks with low value, high Skepticism and high dividend yield. DD joins holdovers DE and OLN as the only stocks to appear on all three screens.

Exhibit 45

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

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