SSR Industrials & Materials Monthly Review, March 2017: Q1 Commodity Rally Could Continue; Reactionary Laggards Highlight Need for Proactivity

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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

April 3rd, 2017

SSR Industrials & Materials Monthly Review, March 2017:

Q1 Commodity Rally Could Continue; Reactionary Laggards Highlight Need for Proactivity

  • Commodity exposed stocks are leading the way in Industrials & Materials one quarter into 2017
    • HUN, OLN, WLK, AA among top performers – China production cuts appear to be real and with little commodity capacity being added outside of ethylene, this rally could still have legs
    • Despite the optics of a large near term capacity build, ethylene is also setting up to be a tighter market than many currently anticipate – see research referenced below
  • With the prospect of near term fiscal aid dimming and incremental economic growth unable to move the needle, companies are choosing to remain proactive (PPG) at the risk of becoming reactive to external forces for improvements (Akzo, GE)
    • Eastman appears to be a prime target for activist/acquirer focus – research referenced below – and is one of only five stocks in our coverage to appear in the top 25 on valuation, skepticism, and dividend yield
  • Since our last monthly we have written on:
    • Ethylene – the IHS conference increased our bullish conviction on the ethylene cycle
    • Akzo – we believe PPG could raise its bid to €100 without overpaying, while Akzo’s go it alone strategy of splitting off Chemicals and acquiring in Coatings falls well far short of this value
    • Dow/DuPont – still great value in the stocks as regulatory approvals signal the last stretch of the first step
    • GE – potential changes at the chronically complex, underperforming Conglomerate could unlock significant value
    • Eastman – faced with similar problems of complexity and under-delivering, EMN’s sector leading cash flow and depressed valuation make it an interesting midsized target for an activist
    • Aluminum and Steel – of the two metals we prefer aluminum as prices are being pushed higher more by China shutdowns than tariffs, demand growth is superior and less anticipatory, and the capacity overhang is considerably smaller
  • 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 despite the merger delay – the regulatory driven DD/FMC ag/nutrition swap is an example of the type of horse trading we expect to see in the non-ag portions of the business post-merge
    • Based on our work this year, we are overweight Metals and Paper & Packaging – favorites and concerns within sectors are primarily value motivated
    • Among large cap names we are most positive on LYB, SWK, and GE
    • Industrial Gas remains a prominent concern as we do not see an easy fix for the industry’s stagnation

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 best performing Industrials & Materials stocks in Q1 have been focused in the commodity markets – HUN, OLN, and WLK in Chemicals, and AA in Metals were all among the top 10 performers. We wrote early in the year that commodity rallies rarely falter in Q1, and we could see further moves higher yet.

CSX tellingly leads the way as the top performer in Q1, less as a result of the improving rail traffic picture in the US and more due to management shakeup at the behest of an activist. Much of our research of late has been focused on similar stories as the incremental improvements in the economy remain too sluggish to move the needle and the prospect of any near term fiscal help appears to be fading, spurring companies and activists to push for change.

GE has not responded as well as CSX has to prospective management turnover – the stock is among the worst performers in Q1. We see the value in the stock and the dividend yield pays you to wait for change.

PPG is trending higher as its attempt to acquire Akzo Nobel unfolds. We believe the company could raise its bid as high as €100 per share. Akzo has had its hand forced on a specialty chemical spin that likely should have occurred years ago and appears to be in a weak position with respect to investors.

Eastman seems in obvious need of having its own hand forced – like GE, this is a complexity and expectations story, where significant cash generation and value is obscured by a convoluted, disliked portfolio. Unlike GE, EMN is small enough to see change effected reasonably quickly, and the upside would be significant.

Three months into 2017 and we have seen little progress on tax reform or infrastructure build out, and little indication that the governing party can effectively legislate after a botched attempt at healthcare reform. Consumer confidence, however, is at levels not seen since the early 2000s however – Exhibit 5 – and higher consumption drove a positively revised Q4 GDP figure. Continually improving rail traffic – Exhibit 6 – signals strength in the domestic economy, confirmed by positive readings on manufacturing activity and new orders. There may be sufficient momentum to sustain the economy until fiscal policies around tax/infrastructure initiatives potentially unleash a more robust, 3-4% growth engine not seen in many years – the risk is that the legislative failures of healthcare carry over and the current optimism fades.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance for the month and Q1 is shown in Exhibit 7. Commodity stocks drove the outperformance in the Chemicals space. In Electrical Equipment it was a mix of small caps (IIVI +22%) and large (AME, ROP, ROK all in the top 25 in Q1). We show the 25 best and worst performing stocks for these periods in Appendix 1.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. Conglomerates supplant Transports as the most expensive group after divergent performances over the past month. The ordinal ranking is otherwise unchanged from a month ago, with Paper & Packaging and Metals showing the best values, both more than a standard deviation below mid-cycle.

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). Valuations are insufficiently crediting returns that remain above trend in the Paper & Packaging space and are improving for Metals companies. The opposite is true in Electrical Equipment where valuations are anticipating an above trend returns that have yet to be seen.

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. The Commodity Chemicals space remains inexpensive with returns at trend and likely to improve as HUN and OLN should see continued momentum in their end markets, while the ethylene producers are likely to see less pressure than consensus currently believes. Diversified Chemicals is largely driven by DD, which looks expensive without the benefit of DOW merger synergies.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

2016 was a strong rebound year for our portfolio selection methodology, particularly in the overlap of valuation and skepticism – 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. 25 stocks currently fall in these historically outperforming ranges – Exhibit 12 – including several of the names we are most positive on such as LYB, SWK, 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 13 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.

Consumption boosted US fourth quarter GDP to a revised 2.1%. Consumer confidence remains strong and will need to remain so to push the economy towards more robust growth. Business sentiment is equally strong, with very healthy ISM readings, particularly for new orders. The formal Brexit proceedings began with considerable fanfare but has yet to trip up an incrementally improving European economy. Data out of China continues to be positive if you believe it, but Q1 growth was underpinned by the traditional government spending model which becomes increasingly harder to sustain.

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 ordinal ranking in Exhibit 20 remains unchanged from a month ago. 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. Exhibit 21 is curious in that one would expect the line of best fit to trend in the opposite direction. The skepticism extremes in Paper & Packaging and Metals are on display here as valuations fail to reflect the forward growth expectations which were among the most positively revised on the month – Exhibit 22.

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. Metals revisions were again the most positive in the group, most strongly in AA and NUE (each +20%), though this did not carry over into performance. Excluding the soon to be acquired JOY, Capital Goods would have been roughly flat, in line with other sectors.

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 March

March 29, 2017: “What’s Wrong With Eastman?” – A Common Question

March 27, 2017: More Constructively Bullish On Ethylene – Takeaways from the IHS Conference

March 23, 2017: Akzo – An Opportunity for Active Managers to Manage Actively

March 21, 2017: Dow/DuPont: The Last Stretch Of The First Step

March 19, 2017: Trying to Make Sense of GE: Are the Green Shoots Appearing?

March 16, 2017: Chemicals Monthly, March 2017 – Need for M&A Clouds a Confident US Economy

March 9, 2017: Aluminum and Steel: Costs Pushing Prices, So Are We Investing or Gambling?

March 9, 2017: PPG/Akzo – A Smart Deal Rather Than a “Me Too” Acquisition/Merger

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. CF and UFS join last month’s holdovers, EMN, OLN, and UPS, as the only stocks to appear on all three metrics.

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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