SSR Industrials & Materials Monthly Review, September 2016: “Black Shoots” – Is Stronger Crude and Coal a Turning Point For Pricing

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 2, 2016

SSR Industrials & Materials Monthly Review, September 2016:

“Black Shoots” – Is Stronger Crude and Coal a Turning Point For Pricing

  • Several recent developments have altered the raw material outlook with implications for our group
    • Newcastle coal pricing has made a strong move higher, potentially raising costs for Asian (China mainly) smelters, power generation and factories – Metals and Chemicals are the likely beneficiaries
    • OPEC output agreement could be positive for natural gas based US chemical producers, supporting a margin umbrella that remains robust despite natural gas prices 20% higher than prior year levels
  • M&A update: Chemicals leading the way but the supporting macro drivers impact most sectors
    • MON and Bayer finally agree on a deal, but the market remains skeptical – the fate of the DOW/DD merger will likely provide insight here – there is an acute regulatory focus on Ag
    • PX/Linde talks break up but the executive shuffle at Linde hints at the prospect of a future deal
    • Another cross-border Chemical acquisition – German Lanxess takeout of American Chemtura – we expect the pace of activity to remain robust as the drivers have not changed and are not expected to
  • Rising coal prices in Asia and a push for renewed trade cases in steel and aluminum have boosted Metals stocks, which produced the best returns in September and 2016 year to date
    • Metal pricing was itself mixed on the month with steel declining and aluminum posting modest gains
    • Chemicals results are essentially flat to the market for the month, Q3 and YTD, largely reflecting the holding pattern seen in stocks with pending deal approvals – DOW, DD and MON
    • Other sectors have enjoyed bounce-back years after a tough 2015 – Capital Goods, Transports, and Paper & Packaging have all seen momentum despite continued global economic malaise
  • In September we published on:
    • Ethylene – generally bullish on the sector once estimates reflect the impact of 2017 capacity additions
    • M&A – another reason to be positive on ethylene, which seems a likely next area of consolidation
    • Aluminum (AA) – inventories are down, demand remains robust, and AA’s base aluminum business could also benefit post-split from industry consolidation
    • Olin – apparent attractiveness dimmed by high debt levels and low return on tangible capital
    • Akzo – continuing our Coatings coverage, Akzo looks ripe for activist interest with a non-core specialty business and apparent cost/M&A opportunities in the core Coatings units – we see potential for an APD-like transformation in which Akzo follows PPG’s path to higher valuation
  • Exhibit 1 summarizes our preferences by sector and stock
    • DOW and DD remain our longer-term favorites in the Chemical space and Industrials & Materials generally, though the ability to get the deal past regulators appears to be coming into question – the outcome has a significant bearing on MON

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

Rising coal prices in Asia have garnered attention recently, and the implications for our group are significant, particularly in Metals and basic Chemicals. The reversal of a multi-year trend that has favored Chinese output costs has seen a sharp recovery in part because of new government rules aimed at reducing coal production and in part because of declines in coastal inventories of coal in China. However, before we all get too excited and probably why we have not seen a snap back in the impacted materials and stocks; overall inventories of coal in China continue to rise – suggesting greater inland surpluses – at the margin this is not good for Urea as the high cost producer today is the inland China coal based producer.

On a more positive note, especially for Eastman, Asia coal prices are rising while US coal prices are not, as shown in the green line in Exhibit 5. Eastman’s filter tow (fibers) margins have remained robust, despite falling global prices because US coal pricing has declined so significantly – if global pricing get support from higher energy prices outside the US – coal and oil – EMN may keep its profitability in this sector or even see it increase, for a while longer. We do not like the longer-term prospects for this sector and a feedstock related boost in profits and especially cash flow might provide a window for EMN to exit the business.

Exhibit 5

Source: Capital IQ and SSR Analysis

The OPEC output agreement should be generally bullish for oil prices, offering margin support for US ethylene producers at a time when considerable capacity additions are on the near (investable) horizon. Estimates likely still need to come down to fully reflect these additions and the pressure that they will start placing on margins in 2017. In the US the crude/gas supply situation is heading in the opposite direction, with the North American rig count breaking above 500 total rigs for the first time since February. Over the past 17 weeks, the total count has declined just once. Recent high priced land deals in the Permian Basin, especially the Delaware portion of the basin suggest that the rig count could rise here quite quickly and that US oil and associated gas production could begin to increase again by the end of 2017. It will be a point of investment controversy for the next 12 months as to whether the Permian developments can add enough NGL supply to meet the needs of an expanding US Chemical industry in time

  • We would expect faster infrastructure growth in the Permian – good for pipe and good for steel at the margin but the US overbuilt steel pipe capacity dramatically in the 2011-2014 period.

On the M&A front, MON and Bayer finally came to agreement but investors fear the regulatory overview and MON’s share price has not responded to the bid. The recent proliferation of deals in the Ag space is creating significant complexity and the changes from a MON/Bayer combination will be considered in light of the pending Syngenta/Chem China and DOW/DD deals. On the topic of deals with noteworthy regulatory hurdles, PX/Linde could be on the table again following the ousting of Linde’s CEO and CFO in the aftermath of failed discussions. PX has publicly stated that it remains interested in a deal. APD is a dark horse here in our view and could spoil Praxair’s plans. In another cross-border acquisition of an American chemical company by a German acquirer, Lanxess bought Chemtura in a mid-sized deal valued at $2.6 billion. We expect the pace of activity to remain robust.

Sector performance relative to the S&P is shown in Exhibit 6 for the month of September, Q3 ’16, and 2016 year to date. We show the 25 best and worst performing stocks in our coverage for these time periods in Appendix 1. 2016 has been a broadly positive year thus far for the majority of the Industrials & Materials sectors. Paper & Packaging posted the best Q3 result but the Metals sector is the standout, both for September and the year to date results. Trade cases, higher coal prices in Asia, and a bounce off the lows after a tough 2015 have all contributed to broad based gains in Metals and Mining stocks. Large cap Capital Goods (CAT, DE, ITW) have also enjoyed bounce-back years thus far, but these results are not mirrored in the Electrical Equipment space where the large cap names have struggled with strategic portfolio adjustments. Chemicals results are broadly in line with the market, consistent with the holding pattern seen in deal-dependent stocks (DOW, DD, MON) – note these results do not reflect the impact of companies that have been acquired.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes discount from normal value by sector. The recent relative strength in the Metals space has been roughly worth a one standard deviation move in normal value, but the sector remains cheap versus the group and relative to its own history. Packaging continues to show the best value outside of Metals but the stocks are showing high volatility – the strong move higher year to date has reduced the sector’s attractiveness versus the lows earlier in the year after a down 2015. GE continues to be left behind in the rally in Conglomerates, while the Transports are trending generally more expensive due to positive momentum in Rails and Logistics (UPS and FDX).

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 PPG 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, and particularly in recent months, commodity stocks rallied and our portfolios benefitted accordingly.

This month’s gains were as much a product of weakness on the short side as strength on the long side.

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 22 stocks that fall in these historically outperforming ranges – Exhibit 11. OLN looks 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 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 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.

US GDP was revised up for Q2, to 1.4%, driven by strength in consumer spending. Jobless claims came in lower than expected, adding to a generally positive employment picture. The Fed declined to raise rates in September, though a 2016 hike remains on the table.

Nominally, we are seeing broadly positive data out of China but the numbers must as usual be taken with a grain of salt and there are growing concerns that the government has fallen back on traditional investment led growth levers as consumer demand fails to pick up the slack. Elsewhere in the region, attacks in Kashmir threaten to destabilize the Indian subcontinent, where growth has surpassed that in China.

Exhibit 13

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

Commodity Pricing

Crude rallied at month’s end on news of the OPEC output agreement. Brent crude’s monthly pricing gain (6%) outpaced the rise in natural gas (2%) – while 2016 year to date price movements are broadly consistent (~30%), natural gas is roughly 20% higher than it was this time last year, while crude is essentially flat year over year. Metal pricing was mixed on the month with gains in aluminum (+3%) and copper (+6%) offset by a 7% decline in steel pricing. Steel is still easily the highest gaining metal in 2016, up nearly 30% since January, while aluminum has posted a more moderate 10% move. If coal prices continue to rise in Asia we would expect reduced output from the region and metal pricing should respond positively.

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, and in Exhibit 20 we plot the growth figure against each sector’s current skepticism index value. The Electrical Equipment figure partly reflects Emerson’s divestiture of its Network Power business, but the overall growth in machinery is modest as demonstrated by the broader Capital Goods figure. Also note that the Metals result in Exhibit 20 is higher than the chart indicates and reflects a very low 2015 base.

Exhibit 19 Exhibit 20

Source: Capital IQ and SSR Analysis

Revisions were most positive in the Paper & Packaging sector, driven by a pair of names – GEF raised guidance in its early month earnings release, and WRK saw a significant positive revision as well following the offloading of $2.5 billion in pension obligations. The dichotomy of the Chemicals results on a weighted versus unweighted basis primarily reflects ASH’s spin off of the Valvoline business, which was masked in the cap weight, but evident in the unweighted figure.

Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions over the past month and Exhibit 24 plots these revisions versus performance results on the month. 2017 estimates are starting to come into focus as we reach the end of Q3, though neither set of revisions was a driver of performance in September.

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

Exhibit 25

Exhibit 30

Exhibit 28

Exhibit 29

Exhibit 27


Exhibit 26


Source: Capital IQ and SSR Analysis

Exhibit 32

Exhibit 31

Exhibit 33

Source: Capital IQ and SSR Analysis

Skepticism

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

Exhibits 34-36

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibits 43-44

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Research Published in September

September 29, 2016 – Akzo: Underachieving – Need the PPG Path to Higher Valuation

September 23, 2016 – Trading Ethylene? Tread Carefully

September 20, 2016 – Chemicals Monthly: Deals, Deals, Deals

September 16, 2016 – Aluminum: As Speculators Throw in the Towel, Investors Might Do Otherwise

September 14, 2016 – Change at Linde Suggests an Acquisition is Possible

September 6, 2016 – M&A in Chemicals: More to Come and Other Sectors to Follow

September 6, 2016 – The Olin Illusion

Dividends

In Exhibit 45 we show a screen of stocks with low value, high Skepticism and high dividend yield. This month we again have the same five holdover companies from last month: CF, EMN, 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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