SSR Industrials & Materials Monthly Review, May 2017: Consistently Slow Economy Makes M&A More Compelling

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 1st, 2017

SSR Industrials & Materials Monthly Review, May 2017:

Consistently Slow Economy Makes M&A More Compelling

  • M&A remains an attractive option when faced with limited opportunities for organic growth; with continued tepid growth in Europe and a US acceleration looking increasingly distant if plausible at all
    • HuntsmanClariant the latest in a wave of cross-border deals, notably in the Chemicals sector
  • Despite the political headlines, domestic indicators remain healthy (mostly)
    • Rail traffic showing steady improvement, manufacturing indices near multi-year highs, consumer and business confidence readings off the highs of a few months ago but still indicating robust spending plans
    • The auto market, long a source of strength, is now a possible risk at peak levels, highlighted by growth of incentives and loans, as well as increasing loan defaults
  • Research since our last monthly:
    • GE – first updating our earlier work considering Q1 results and word cloud analysis of the earnings call transcript, then, reaffirming our positive view of the stock after recent comments from CEO Jeff Immelt – we think change is likely coming, spurred by Trian, and the potential value ($40 a share within 18 months) is hard to ignore
    • HuntsmanClariant – we are negative on the deal – the major risk, in our view, is the significant increase in business complexity from combining two distinctly hard-to-model portfolios with little overlap
    • Ethylene historical IRR analysis demonstrates the difficulties of profitably installing new basic chemical capacity and suggests delays/cancellations for newly announced and maybe uncompleted builds
    • Lyondell (LYB), which has benefitted from the far superior returns of capacity expansions at existing facilities, is best served in our view by a committed buyback strategy – increasing investor leverage to the ethylene cycle – we think capital deployed to M&A would be most logically directed to WLK
    • Air Products (APD) – we see this as a cost-cutting story that has run out of legs – without an obvious bull case and with somewhat alarming comments around capital spending, we would be short the stock – prefer to play Industrial Gas via Air Liquide but would be long Linde against a short APD position
    • Akzo/PPG – PPG’s decision not to pursue a hostile bid for Akzo is likely the right one given all the signals from the Dutch courts over the last week that they are unlikely to be helpful; today Akzo has more questions to answer than PPG in our view, given its overly confident management team
    • SMID cap Industrials & Materials – lessons from the year to date
  • Exhibit 1 summarizes our preferences by sector and stock
    • We continue to see potential for a strong year in commodity chemicals and remain bullish on DOW/DD
    • Based on our work this year, we are overweight Metals and Paper & Packaging – favorites and concerns within sectors are primarily value motivated
    • Among other large cap names we are most positive on LYB, SWK, and GE

Exhibit 1

Exhibit 2

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

Despite the optics of President Trump’s first international foray, US economic indicators are showing little cause for concern – but also little sign of breaking out of the 2% level expansion that has frustrated many companies since the financial crisis and driven many to M&A – more on this below. Domestic rail traffic is accelerating against easy comparable figures from 2016, but renewed strength in coal shipments may be short-lived – CSX, NSC and KSU nevertheless among the top eight performing stocks in our group in May. Confidence indices are off their recent highs – Exhibit 5 – but are still supportive of expectations for continued business investment and consumer spend. The auto market, once the bright spot in a middling economy, now looks like a risk, with the proliferation of auto related debt and loosening lending standards garnering headlines.

Exhibit 5

Source: Capital IQ and SSR Analysis

Another month, another major Chemicals deal. HuntsmanClariant is the latest addition to the summary of pending deals in Exhibit 6, and notably represents yet another cross-border move. Top line growth is increasingly hard to come by and the prospect of new markets and a multi-year synergy/growth platform has proved compelling. In the case of HUN, we had anticipated the company might be either the hunter or the hunted following its spin of the TiO2 business – similar to what occurred with Rockwood (former ROC). Elsewhere, outside of the smaller Nova/Williams deal, there has been little consolidation in the commodity space, particularly ethylene, which could be a logical next area of focus.

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month is shown in Exhibit 7. E&C brought up the rear in the performance results for the second consecutive month – PWR and FLR both among the five worst performing stocks in our group in May, each down more than 13%. We show the 25 best and worst performing stocks for the month in Appendix 1.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. The Conglomerates (both including and excluding GE) look expensive in absolute nears and relative to their respective ranges since 2010. On the inexpensive side, the Metals and Packaging sectors are off their extremes – E&C back approaching its peak discount after a significant down month.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 9 (see our skepticism work for more detail). Only the Metals group is at a relative skepticism extreme – valuations not crediting the group in aggregate for improving returns which have moved above trend since earlier in the year – Exhibit 10.

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. We see a broad range of valuations despite returns that are mostly within half a standard deviation of trend. Coatings remains the prominent outlier – SHW’s runaway return on capital is influencing the group but PPG’s returns are also near an all-time peak above trend.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

Every month we take the top and bottom 25 stocks on our normal valuation and skepticism index frameworks (summarized in Exhibit 2) and track the results, which have typically been robust, particularly for the overlap of the two. 2016 was a strong rebound year for this portfolio selection methodology after 2015 failed to live up to the record established in 2013 and 2014 – Exhibit 11. Results in 2017 to date have been mixed and volatile as Metals stocks in particular are showing extreme sensitivity to indications of success or failure in the Trump administration. See accompanying work from earlier in the year.

Exhibit 11

Source: Capital IQ and SSR Analysis

An alternative portfolio approach is based on our expanded skepticism index performance analysis which showed a very attractive risk-reward relationship for stocks with positive SI values, valuation discounts, and positive 3 month EPS revisions. This group grew by four stocks over the past month, giving us 32 stocks that currently fall in these historically outperforming ranges – Exhibit 12 – including several of the names we are most positive on such as SWK, WLK, IP and EMN.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 shows the historical forward performance of the stocks meeting the criteria in Exhibit 12 at various ranges. We note that for all ranges where the SI is above 0.5, the average return is in excess of the variability (average > standard deviation).

Exhibit 13

Source: Capital IQ and SSR Analysis

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 global employment picture improved broadly over the past month. US headline unemployment was down to its lowest levels in a decade, though the participation rate remains discouragingly low. European economies continued on a path of gradual recovery, with unemployment rates down nearly across the board. Trade talk ruffled some feathers during President Trump’s recent international rounds, but there has been sufficiently little progress on other major initiatives that this was largely shrugged off as bluster. In Asia, Indian economic growth disappointed versus expectations, falling to the slowest rate in two years, with the nation’s cash ban named as a weight.

Exhibit 14

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

Commodity Pricing

US commodity and energy prices are indexed in Exhibits 15 through 19.

Exhibit 15                                                                          Exhibit 16

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

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18                                                                                      Exhibit 19

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 20 we look at expected net income growth by sector, and in Exhibit 21 we plot the growth figure against each sector’s current skepticism index value. The Metals group has a somewhat low base which inflates its growth figure in Exhibit 21 but there is likely also a good deal of stimulus optimism embedded in 2018 estimates – despite some of the most significant negative revisions in our group on the month – Exhibit 22. Exhibit 21 is curious in that one would expect the line of best fit to trend in the opposite direction – the Metals outlier is influencing this and the trend ex. Metals is more sensible.

Exhibit 20                                                                                    Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows average 2017 EPS revision over the past month and Exhibit 24 plots these revisions versus performance results on the month – revisions were a reasonable driver of performance in May. The correlation would be tighter still if we excluded the 30% decline in SEE’s estimate, likely associated with the pending sale of its industrial cleaning business to Bain. Electrical Equipment revisions were most pronounced for small caps IIVI (+9%) and BGC (+29%).

Exhibit 23                                                                                    Exhibit 24

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

Mid-Cycle “Normal” Valuation

In Exhibits 25-34 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 25

Source: Capital IQ and SSR Analysis

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

Source: Capital IQ and SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 45.

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in May

May 30, 2017: GE – Does Jeff Immelt’s Earnings Statement Imply Too Much To Manage

May 24, 2017: The Cheapest Pound of Ethylene – Why LYB Should Buy LYB – Or WLK!!

May 23, 2017: HuntsmanClariant – Could Two Poorly Understood Businesses Combine To Make Matters Worse

May 22, 2017: Huntsman – Another Cross-Border Deal – Another Reaction to Slow Growth, but a Good Idea

May 22, 2017: SMID Cap Industrials & Materials – What Have We Learned So Far This Year?

May 16, 2017: Chemicals May – Surprise! An Unexpectedly Good Q1

May 11, 2017: GE – Follow the (New) Words – Buy!

May 9, 2017: Akzo – Arrogance and Optimism – Likely To Hurt EVERY Stakeholder

May 5, 2017: Lyondell – Dip = Opportunity? – Harder to Do a Deal – Bring Back the Buy Back

May 2, 2017: Air Products – Back Down the Rabbit Hole?

May 1, 2017: Making Money in Ethylene – Much Harder Than It Looks

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. The four companies appearing on each list are holdovers from last month – CF, EMN, OLN, and UPS.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Appendix 1

Appendix 2


Appendix 3


Appendix 3

©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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