SSR Industrials & Materials Monthly Review, November 2016: Post-Election Optimism Trumps Pre-Election Uncertainty Fears

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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, 2016

SSR Industrials & Materials Monthly Review, November 2016:

Post-Election Optimism Trumps Pre-Election Uncertainty Fears

  • The Trump rally has naturally boosted many of the stocks in the Industrials & Materials space, but our outlook and the valuation landscape is little changed
    • The incoming administration may have an ambitious and pro-business agenda for its first 100 days, but much can happen by inauguration day on January 20th – creating potential for short term noise and the possibility that stocks come back to earth
    • There is little evidence that potential uncertainty is being discounted in valuations – with the existing uncertainty of the Brexit, potential disruptions in Italy, and the demand warnings we saw earlier this summer, it could be argued that a Trump presidency only adds a more significant and less predictable wild card to the global economic outlook
      • Pre-election, this notion was widely accepted; post-election it appears to have been disregarded entirely as the president-elect is seen as pro US business
  • Metals stocks have been most responsive, Chemicals stocks least responsive to the Trump rally
    • Despite the recent rally, the Metals sector at large remains the best value in our space and this speaks to the extent of its previous discount
    • Chemicals as a group have outpaced the market by only ~1% over the past month, but trade risk concerns and continued deal-related holding patterns in the largest cap stocks (DOW, DD, MON) have limited upside
  • In November we published research on:
    • Lyondell (LYB)
      • Buyout by Aramco might make sense
      • On its own, the stock has a wide enough margin umbrella to withstand any fundamental ethylene weakness (see below), and the dividend/buyback policy offers valuation support
    • DOW/DD – prefer DD in the event the deal falls through
    • Ethylene – timing of capacity startups and likelihood of delays suggests a fundamental picture that is less dire than consensus contemplates
    • Fertilizers – Q3 reports indicated low inventories and possible inflections in demand, notably in potash, and supply/foreign cost economics, notably in urea
    • Industrials & Materials landscape post-Trump – assessing which stocks have the most upside remaining after post-election gains, and identifying possible derivative plays
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW/DD and MON remain our favorites as valuations have not over-reacted in the Trump rally and these stocks have significant non-politically inspired upside to their pending deals

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

The demand warnings and negative guidance that pervaded Q3 earnings reports in the wake of the Brexit have given way to a general (domestic) optimism that the Trump presidency will be a positive for US business – competitive tax rates, infrastructure stimulus, and favorable terms for repatriation of foreign cash reserves. This has been reflected in stock performance since the election, with preliminary jitters quickly yielding to strong gains, focused in Metals, E&C, Transports, and Capital Goods. Yet the performance of the Chemicals and Conglomerates sectors (+1-2% versus the S&P but far behind the outsized gains enjoyed by other industries) hints at some of the underlying risks of a Trump administration, most notably the potential for significant trade disruptions. Sector performance on the month relative to the S&P is shown in Exhibit 5. (We show the 25 best and worst performing stocks in Appendix 1.)

Exhibit 5

Source: Capital IQ and SSR Analysis

These stock moves give some pause as many names have reacted immediately and significantly to the mere prospect of benefits likely to accrue in out years. With ongoing uncertainty in Europe (Brexit, Italian referendum) and an uninspiring global macro that led many companies to issue warnings and negative guidance earlier in the year, these moves seem anticipatory and in direct contrast to the widely held pre-election assumption of negative market reactions to the uncertainty generated by a President Trump.

Excluding any global noise, while there is some evidence that the more US focused companies have seen greater post-election upside at the extremes, in general the correlation is weak – Exhibit 6. We would continue to focus on DOW/DD and MON, which have only modestly outperformed post-election day and have the potential for significant deal-related upside regardless of political policy. Elsewhere, from a valuation perspective, CAT and TRN in the Capital Goods space and MOS/CF in Fertilizers have the most upside to historical norms after the recent rally – see research.

Exhibit 6

Source: Capital IQ, Company Filings, and SSR Analysis

Exhibit 7 summarizes discount from normal value by sector. That the Metals group remains the cheapest in our coverage after a month of 16% outperformance highlights the significant discount that existed. The sector also looks cheaper since we have temporarily removed AA from our coverage as we adjust our model post-ARNC spin. On the other end of the spectrum, the premium in the Transports group is driven by Rails and Trucking, both of which look significantly expensive on our models – Logistics shows the best value in this space (FDX more so than UPS). Within Rails, the picture is complicated – KSU has most at risk given its 50% exposure to Mexico and the inflammatory rhetoric from the President-elect. NSC, CSX, and UNP figure to benefit from increased coal shipments, with UNP likely better positioned given the lower cost surface mining operations in Wyoming’s Powder River Basin versus the underground Appalachian coal that NSC and CSX ship. However, like KSU, UNP does have a not insignificant Mexican exposure (10%). If Trump can strike a more pacifying tone regarding NAFTA and Mexico, KSU has significant upside (second cheapest stock in our coverage).

Exhibit 7

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 8 (see our skepticism work for more detail). At the extremes we continue to see Metals and Paper & Packaging discounting earnings declines, while Electrical Equipment and Transports are getting a valuation benefit beyond that which current earnings would imply.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 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. Coatings remains an outlier because of SHW – within the sector we are more positive on RPM and AXTA.

Exhibit 9

Source: Capital IQ and SSR Analysis

Portfolio Performance

The overlap of our traditional valuation and skepticism based portfolios (see Exhibit 2) produced cumulative monthly gains of 15.6% in 2013 and 9.8% in 2014, but was far less successful in 2015. Our return on capital based models that produce the portfolio selections assume cyclicality and fail to capture the secular changes impacting an industry – a major issue for many Metals and Commodity Chemical stocks. FCX, CLF, HUN, and OLN were among the mainstays on the long side throughout the year and condemned our portfolios to a year of underperformance.

To begin 2016 however, and particularly in recent months, commodity stocks rallied and our portfolios have benefitted accordingly. In November, strong gains in Metals and E&C stocks more than offset modest outperformance from the short side stocks.

Exhibit 10

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 month we have a list of 13 stocks that fall in these historically outperforming ranges – Exhibit 11. OLN looks far cheaper than it would if we adjust its capital base for the goodwill associated with the Dow deal and we remain negative on the stock despite its apparent discount – see recent research on the topic.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12 shows the historical forward performance of the stocks meeting the criteria in Exhibit 11 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 12

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 market rally suggests otherwise, but the Trump presidency could represent an additional source of uncertainty in an already uncertain world. US consumer confidence turned sharply higher, however, and Q3 GDP was revised upward on stronger than initial consumer spending. Europe meanwhile faces fresh problems. Italy’s upcoming referendum could have widespread political and financial ramifications – another possible blow for the bloc that is still dealing with the Brexit fallout. Among emerging markets, India notably grew less than expected in the recent GDP data – currency reform is not expected to help the situation.

Exhibit 13

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

Commodity Pricing

Copper and steel pricing rallied significantly on optimism around infrastructure spending under the Trump administration – further pricing gains are possible if higher coal pricing induces lower Chinese output. Aluminum was not nearly as impacted, with pricing roughly flat for the month. Natural gas continued its strong year to date run as forecasts are calling for a colder than anticipated winter. Crude was also higher after OPEC members finally agreed on an output curtailment.

US commodity and energy prices are indexed in Exhibits 14 through 15.

 

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, and in Exhibit 20 we plot the growth figure against each sector’s current skepticism index value. Note that we have excluded the Metals sector from these exhibits as the temporary removal of AA has left the groups’ 2015 net income base below 0.

Exhibit 19                                                                                      Exhibit 20

Source: Capital IQ and SSR Analysis

The negative revision in the Electrical Equipment space are mostly a function of EMR (-10%), which recently divested its Network Power business, but fellow large cap ETN also saw its estimate decline by 4%. The Capital Goods sector was boosted by DE, which raised its outlook and saw its 2017 earnings estimate rise by over 15%.

Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows 2016 EPS revisions over the past month and Exhibit 23 plots these revisions versus performance results on the month. 2017 estimates are coming into focus but 2016 revisions remained significant in certain instances. OLN was the biggest drag on the Chemicals 2016 figure – we remain negative on the stock. CF was also a contributor to the negative revisions for ’16, and was the main driver of the negative Chemicals figure for 2017 – continued weakness in urea pricing has weighed on the stock but we see the potential for a turn in the cycle next year.

Exhibit 22                                                                                     Exhibit 23

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

Mid-Cycle “Normal” Valuation

In Exhibits 24-33 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 24

Source: Capital IQ and SSR Analysis

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

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 34 through 44.

Exhibit 34

Source: Capital IQ and SSR Analysis

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

Research Published in November

November 28, 2016 – Whyondell?

November 21, 2016 – Could or Should Aramco Buy Lyondell?

November 18, 2016 – Dow or DuPont? We Suggest DuPont

November 17, 2016 – Chemicals Monthly: Trumped Up Performance Potentially Temporary

November 17, 2016 – Industrials & Materials: Some Post Election Theories (or Trumped Up Ideas)

November 14, 2016 – Ethylene: Discounting too Much Downside, Despite the Trump Trade Risk

November 8, 2016 – Fertilizers: Fundamentals at or Close to Trough – Attractive Risk/Reward

Dividends

In Exhibit 45 we show a screen of stocks with low value, high skepticism and high dividend yield. EMN rejoins the four holdover companies from last month: CF, HUN, OLN, and PKG.

Exhibit 45

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©2016, 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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