SMID Cap Industrials & Materials – Hoping To Build On a Good Q1

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 6th, 2017

SMID Cap Industrials & Materials – Hoping To Build On a Good Q1

  • We refresh our earlier SMID cap analysis, which proved effective in sorting winners and losers in Q1
    • Replacing trailing 12-month data with full year 2016 data has repositioned some of the lists, with Trucking companies screening well in particular
  • Updating the analysis of multiple currently relevant factors, alongside valuation and our 2017 fundamental framework, we derive these higher conviction ideas
    • On the positive side: GNRC, WLK, WOR, TRN, WNC, ARII
    • On the negative side: AGCO, ATR, NEU, CBT
    • In general we are avoiding any company with less than 50% of sales in the US and we do not see Trump policies (as suggested so far) helping the Ag industry in any way
  • With typically less history and/or less stable business mixes, the SMID cap space does not fit our standard valuation models, which are based on a “mid-cycle” return on capital – short bursts of rapid growth or decline caused by portfolios changes complicate things further
    • There is a subset of SMID companies with sufficient history that we have valuation models for – these are shown in Exhibits 5 and 6
  • We are analyzing a universe of ~100 SMID cap stocks along six dimensions, overlaid in each instance with valuation and growth metrics for reference (click to jump to a section):
  1. US sales focus – potential benefits from America First stimulus
  2. High current effective tax rates – upside to lower corporate rates
  3. High sales/employees(relative to the group) – less impact from potential wage inflation – more operating leverage
  4. Offshore cash–favorable repatriation terms could result in large buyback/dividend programs
  5. Performance since Election Day – those that have been missed, are down on earnings, or have the most potential upside remaining
  6. Optimism–tendency of corporate optimism to manifest itself in poor capital allocation decisions and underperformance is amplified in the SMID space
  • We show the top 20 stocks on each of these dimensions – changes from Q1 and the full coverage list with quintile rankings by factor are shown in the Appendix
    • Exhibit 1 summarizes the stocks that appear on the most top 20 lists

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

The stocks that emerged from our SMID cap analysis of the Industrials & Materials space earlier in 2017 have outperformed the Russell 2000 index on the long side and underperformed on the short – Exhibit 2. We selected these stocks by combining several ranked lists of currently relevant factors (US sales, tax rates, offshore cash, sales per employee, performance since election) with our corporate optimism framework, a qualitative assessment of end market exposures, and the return on tangible capital vs. valuation plot in Exhibit 3. While we like some of the fundamentals behind a few of the cheaper companies here, such as VSM and TSE, they do not make the cut on this analysis because they have too much of their sales base outside of the US and are vulnerable both to trade policies and a strengthening dollar. Fundamentals and strategic actions may overcome the headwinds for both, but they do not tick enough boxes to make the cut in this piece.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

We include a very basic fundamental overlay which is as much subjective as it objective. On the positive side we have looked for companies with more than 50% US sales and likely to benefit from one or more of three things:

  • US infrastructure spending
  • US manufacturing growth
  • More limited imports of competing goods from China – the electrical equipment space may be a major beneficiary here as well as some capital goods names.

On the opposite side of the fence we list companies with more limited US sales and that have little in their business mix which would benefit from the three factors above – Exhibit 4.

Exhibit 4

There is a subset of companies in Exhibit 4 for which we have sufficient history to use our standard, normal valuation models, which give us greater conviction for this analysis. Those companies are summarized by valuation and skepticism in Exhibits 5 and 6.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

US Sales Focus

With 2016 data, there are only marginal changes to this list and Trucking names continue to dominate at the top. Clearly any “protectionist” policies will see those with predominantly more US centric portfolios much more levered and less concerned about the possible strength of the dollar.

Exhibit 7

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Tax Rates

The assumption here is that Trump will try to cut US corporate taxes and that those with the highest effective rates – often those with the highest concentration of US sales will see the greatest benefit.

Tax rate concessions as well as repatriation of offshore cash (less relevant in the SMID space), will likely come with strings attached in terms of the proportion of new free cash that companies have to reinvest, but as we have seen in past attempts to stimulate growth in this way, companies find ways to funnel the cash to buybacks, dividends and M&A, where the M&A generally results in fewer jobs and lower new investment than the opposite.

There is somewhat less noise around tax rates using 2016 rather than LTM figures, though clearly some of the higher tax rates shown in in Exhibit 8 are still the result of special circumstances – either reflecting a translation – or lower reported income but taxes based on a GAAP income. This is certainly true for any company paying more than 40% tax in the last 12 months. Those with the higher US sales in Exhibit 7 are likely the companies with the most to gain long-term from sustained lower US tax rates.

Exhibit 8

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available

Sales/Employee

We are using this measure as a sign of leverage – companies with high sales per employee often have the highest incremental operating leverage, benefitting the most from incremental sales. In addition, should Trump policies lead to inflation and wage rises, these companies are less exposed. LSTR’s sales per employee figure is likely inflated – its business model relies on what it terms “business capacity operators”, essentially independent agents that arrange transportation for clients, that are not included in the company’s technical employee count. This list is otherwise dominated by chemical producers, as you would expect.

Exhibit 9

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Offshore Cash

The potential repatriation of offshore cash holdings has received attention and there are a number of SMID caps with significant cash in foreign jurisdictions. In Exhibit 10 we have expressed the amount of offshore cash as a percentage of the company’s current market cap – equivalent to a special dividend or the potential reduction in share count if the repatriated funds were used to buy back stock. We assume a 15% repatriation tax.

Exhibit 10

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available

Performance since Election Day

This is a contra-momentum indicator, showing what stocks have lagged post-election. It is important to note here that there are likely no companies on any lists here likely to see direct earnings gains from anything the new Administration does before at the very best Q4 2017. Consequently, there is a risk that expectations get ahead of what is practical and we see some earnings misses before we see the gains.

AYI and WOR are down on recent earnings – both have a significant US sales base (top 20 in the US sales rankings in Exhibit 7) and appear well positioned from a business mix perspective (commercial lighting for AYI; steel for WOR) to benefit from domestic infrastructure stimulus. CCK has a large non-US sales profile and additional Mexico risk from recent acquisitions.

Exhibit 11

Source: Capital IQ and SSR Analysis

 

Optimism

We often reference our work on corporate optimism as a complement in our process of identifying investment opportunities – simply put, those companies that habitually guide to realistic earnings expectations and subsequently over deliver not only predictably outperform, but have been shown to exhibit expanding returns on capital relative to their more overly-optimistic peers – they make better capital allocation decisions. In the SMID space the results are exaggerated compared to the large cap group, where underperformers are more readily identified and held (sometimes forcefully) accountable. In Exhibit 12 we show the most conservative companies in the group – those that have consistently over-delivered and the measure is by how much annual earnings have beaten expectations. The measure is called “Optimism” but we are actually looking for the least optimistic companies and the indicator can be confusing in it labeling if you have not followed our work here – in Exhibit 12 GNRC has most consistently over-delivered and by the most significant level.

Notably, GNRC’s measure was improved by its 2016 figure – many of the others at the top of this list, including WLK and TRN, struggled in 2016 after several years of conservative self-awareness.

Exhibit 12

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available

Appendix – Full List and Changes from Q1

©2017, 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.

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