Archive for April, 2012

• 80 of the 132 companies that comprise our industry group indices have reported earnings for the first calendar quarter of 2012.  On average we have seen positive surprises (67 companies), but at the same time we have seen negative near-term revisions (34 companies).  Caution around demand outside the US is broadly evident – the group that has reported has underperformed – though only slightly – since reporting.
• However, results are very mixed with negative surprises as well as positive in every sector except Packaging – which has underperformed anyway.  Conglomerates, Capital Goods and Electrical Equipment have had the biggest upside surprises; Paper the smallest.
• Performance has for the most part tracked either the surprise or the guidance, with very few incidences of investors looking through the numbers and ignoring the near-term noise.  Relative performance has for the most part been directional but not volatile and as a consequence we do not see any moves that would cause us to change our overall stance of caution towards the Paper space and interest in Metals and Mining.
• We have had only one report in the commodity chemicals space.  This confirmed our view that March was a disproportionally large part of the first quarter and that the outlook for Q2 mirrors March, but surprised negatively on how very poor Europe was relative to the US.

Exhibit 1

Source: Capital IQ and SSR Analysis – Performance is Since Reporting

• The metals sector remains attractive in our valuation framework, and at the larger cap company level the appeal is broad, with the best only fairly valued, and most well below fair value. This suggests that a basket approach owning the group is appropriate.
• Return on capital analysis when compared with valuation analysis shows the group to be outside the historic range meaningfully; suggesting that either relative valuation will improve or returns will fall.  In other words, skepticism is very high.
• As indicated in our initial report, we think that this valuation discount is driven by near-term price movements and cyclical concern about demand as it relates to China.  Industry specific metrics are good – returns are high, though declining from a cyclical peak, cash flow is good and balance sheets are conservative.
• While cheap stocks and sectors can always get a bit cheaper, we see as much as 35% upside as the sector normalizes in value.  Within the group there are individual companies that offer as much as 45-50% upside. For the sector to move to extreme historical cyclical lows there is around 16% further relative downside (which is not insignificant), but we do not see industry fundamentals that would support that.
• In the chart below we introduce a skepticism measure.  Reflecting ROC deviations and premium/discount from normal value based on our valuation framework, this skepticism measure confirms our overall conclusion of undervaluation in the Metals and Mining sector.

Source: Capital IQ and SSR Analysis

As production of natural gas in the US has risen it has increased not just the volume of methane available, but also the amount of associated gases; ethane, propane, butane and natural gasoline.  With the exception of ethane, these products have values that are derived from crude oil and as a consequence greatly enhance the value of the gas being developed – this type of gas (wet gas) is being preferentially developed today as a result.  There is a limit to how much ethane can be left in the methane gas stream that we burn every day, and when that limit is reached it has one valuable alternative use – as a feedstock for the production of ethylene, one of the major building blocks of the plastics and chemicals industry.  Without this use, the ethane would need to be injected into storage or, more likely, flared.

We are at a tipping point in North America, as we have reached the limit of consumption by the chemical industry and ethane is about to slip into a surplus that could last for many years.  Ethane prices have been by far the most attractive feedstock for the North American chemical industry since the price of oil increased materially, despite the fact that ethane prices have also risen, generating a very good margin for those extracting the ethane from natural gas.  With oil prices expected to stay high and natural gas prices in North America expected to stay low, the very strong margin that US ethylene producers have already seen will expand as ethane prices fall to break-even extraction values – a territory they occupied for most of the period from 1980 to 2005.  Ethane availability in the US Gulf is rising steadily today because of developments in the Eagle Ford shale basin in West Texas, but will step change in 2013 when pipelines are completed to bring supplies to the Gulf Coast from the Western Marcellus.  By end 2013, ethane supply in the US Gulf could be 20-25% higher than it is today.

Our analysis shows that there is a real risk that in the near-term we are flooded with ethane – possibly through 2016/2017 (and perhaps beyond).  Today we have a surplus, but it could get much larger.  Ethylene expansions are underway, but the big projects all seem to be “just around the corner” in terms of putting a shovel in the ground or ordering long lead time equipment, almost as if there is a big game of chicken going on.  Hardly surprising given that there is no domestic outlet for this new capacity and to drop $1bn for a new plant that takes 4-5 years to build and that could have no market as soon as it starts-up is understandably something you want to think long and hard about.

In the near to medium term, cash flows will be very high and returns on existing and new capital could sit at or above 35% for a prolonged period – as many a 5 or 6 years.

The stocks do not reflect this earnings tailwind – the commodity chemical companies in the US are in aggregate fairly valued on an historic normalized basis, whereas, at the beginning of a significant profit super-cycle we would expect the sector to trade well above mid-cycle values.  This suggests as much as 30-40% relative upside as the earnings momentum becomes more obvious.

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Today we have initiated coverage of the Industrials and Basic Industries Sectors.

Outperformance over the past 6 months despite negative revisions has sadly led the group as a whole to be, in aggregate, fairly valued – limiting our initial conclusions.  There are some outliers and we have introduced a robust, return on capital valuation framework, which shows that the US metals sector looks pretty attractive, while both paper and electrical equipment appear to be meaningfully overvalued relative to history.

Returns on capital have negative long-term trends for most sub-industries and it appears that only extreme, prolonged, financial pain drives enough change to reverse these trends.  Paper may have been through such a reversal but current values discount returns (7-8%) that even assuming structural improvements are well above the 20 year average of 4.5%.

Valuation matters in cyclical industries and we have seen sub-industries bounce off cyclical relative lows, in the last year, despite broad negative revisions.  Economic conditions, which ultimately drive profitability in this group, are still under pressure in Asia and Europe and in the US are floating around mid-cycle.  The outlook does not suggest a demand tailwind for stock performance absent a strong valuation base.  If fact we see demand as a possible mild but broad negative risk, particularly where capacity is not constrained (almost everywhere except some precious metals and construction/mining equipment).

As the broader space is in a territory that it has only been in a few times in that last 40 years; high margins, high returns on incremental sales and, for many companies, record returns on capital, some corporate and analyst rhetoric suggests that “it is different this time”.  This is as much an unreasonable a conclusion as it was in the late 70s, in 1988, in 1996 and 2006.  To assume that a set of industries that have shown volatile cyclicality over a 40+ year period have suddenly changed this time around is ill-advised and very likely to lead to meaningful disappointment. All of the sub-industries except Metals and Mining have a declining slope to their 40 year return on capital trend lines, though there is some improvement when you look at a 30 years trend in all cases.  While these trends should not decline to “zero” they are compelling, persistent and in most cases have not reached levels low enough to drive the kind of industry wide remedial action required to turn things around.

There is evidence to suggest that industries show little signs of structural change until long-term returns are consistently lower than the cost of debt.  Operating with consistent returns below the cost of capital, but above the cost of debt seems to be commonplace, which would suggest that cyclical trends will continue in those industries until the cost of debt threshold is breached.  Paper and Metals have spent long period below this threshold – paper more recently than metals.  The two sectors that have operated most consistently in this returns “no man’s land” between the cost of debt and the cost of capital are chemicals and capital goods.

Accordingly, you have to be disciplined about valuation and view other short term factors, such as revisions, momentum, and product pricing in the context of both absolute and relative valuation indicators. Metals appears to be a classic case in point where short term negative pricing trends are driving emotion and the sector looks very interesting on a relative and absolute basis.