Our Outlook for Basic Materials Stocks
Weak demand abounds, with some pockets of strength and a few surprises.
Quarter-End Insights
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The beginning of 2009 has been a period of great uncertainty for basic materials companies. The weak global economy continues to weigh on demand for commodities such as steel, aluminum, chemicals, coal, and fertilizers. During their earnings conference calls, many companies' management teams commented that activity in the first quarter was so far mirroring the weakness seen during the end of 2008. The drop in revenues, combined with fixed cost deleveraging, is hurting many firms' earnings and cash flows. Companies are continuing to respond with layoffs, reduced capital expenditure budgets, curtailed production, and now dividend cuts. Some outfits haven't made it, though, and we saw two bankruptcies from our coverage list during the first quarter: containerboard and corrugated box producer Smurfit Stone and Chemtura , a chemicals company.
Steel and aluminum producers have been hit by low demand, thanks to ailing auto and construction end markets. In the U.S., steel mills continue to hold back production to prevent an inventory glut, operating with 40% to 45% capacity utilization rates during January and February, making fixed-cost absorption a challenge. Even ArcelorMittal (MT), the world's largest steel producer, needs to work hard to fix its balance sheet, and the firm recently cut its dividend. The situation is even more dire in aluminum markets. At current aluminum prices, the industry's best assets are barely breaking even. Alcoa recently cut its dividend and announced plans to raise equity capital.
Chemicals markets are facing weak demand, too, although demand for agricultural chemicals has held up relatively well. Amid this precariousness in the first quarter, Dow Chemical (DOW) and Rohm and Haas finally reached an agreement to close Dow's acquisition of Rohm by April 1. Dow's plans had been undermined when Kuwait Petroleum and Petrochemical Industries walked away from the joint venture that would have provided Dow with roughly $7 billion in cash proceeds. Now that the Dow-Rohm deal is proceeding, Dow must work quickly to pay down the balance of its bridge loan.
There are many storm clouds on the horizon for coal companies. The immediate concern for producers of metallurgical coal (a raw material for steelmaking) is significant demand weakness. However, producers of thermal coal (used to generate electricity) aren't immune from economic weakness. Peabody Energy , the nation's largest coal producer, expects demand for coal to fall 60 million to 70 million tons this year--caused by a combination of weak export demand, inventory drawdowns, weak gross domestic product, and cheaper natural gas replacing coal. We haven't witness a fall of this magnitude for decades.
In the fertilizer space, the effects of the global economic slowdown have manifested in a virtual standstill in global fertilizer markets that has persisted for months. As a result, despite significant capacity curtailments, inventories have piled up all the way to the producer level. In early March the Belarusian Potash Company (BPC) reduced the price it will charge for potash for delivery to large Brazilian importers to $750 per metric ton from a prior level of $1,000 per metric ton. We believe this has set the stage for Canpotex (which represents Agrium , Potash Corp. (POT), and Mosaic (MOS)) to accept lower prices in the coming year.
While most drivers were negative during the first quarter, some forces have been pointing up, which has contributed to uncertainty and created a wide range of possible outcomes for basic materials companies in 2009. Copper prices have bounced from $1.30 at year-end 2008 to over $1.80 today, although they're still a far cry from the peak of over $4.00 reached in July 2008. The partial recovery in copper prices has given producers such as Freeport-McMoRan (FCX) some much-needed breathing room. In addition, while most basic materials industries suffered from end-market weakness, there were some pockets of strength. For example, Monsanto's seed business has continued to perform well. Further, although we saw some companies with precarious financial health go bankrupt, other companies with similarly weak balance sheets were rescued by suitors or favorable refinancing. For example, Nova Chemicals , a struggling chemicals producer with a crushing debt load, received a takeout offer from Abu Dhabi's International Petroleum Investment Company at a hefty premium.
As we progress through 2009, we'll be looking for signs that demand for commodities is stabilizing. The upcoming price negotiations between major producers and consumers of iron ore, metallurgical coal, and potash will be important signposts. Against the backdrop of this weak demand for many commodities, we're choosing to highlight three companies whose business models include the provision of value-added services in "Our Top Basic Materials Picks" section below.
Valuations by Industry
Presently all of the industries in the basic materials sector appear undervalued. Coal companies are trading at the steepest discounts to their fair value estimates, followed by building materials companies and miners (nonferrous/nonmetals). However, because coal companies have higher uncertainty ratings, the building materials and mining (nonferrous/nonmetals) industries have higher average star ratings. Five-star stocks in these categories include Vulcan Materials (VMC) and Compass Minerals (CMP), a company we highlighted in our last Quarter-End Insights piece. The engineering and construction industry seems to be the most fairly valued, and it also carries the lowest average star rating. We even have a couple of 2-star companies--i.e., slightly overvalued based on our fair value estimates--in this industry, including Headwaters, Inc. and Layne Christensen Company .
| Basic Materials Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty | |
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| Building Materials | 3.90 | 0.57 | 0.62 | 9 | 65.4 |
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| Chemicals | 3.80 | 0.81 | 0.66 | -19 | 55.9 |
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| Coal | 3.70 | 0.56 | 0.55 | -2 | 74.8 |
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| Engineering & Construction | 3.20 | 0.80 | 0.91 | 14 | 57.5 |
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| Forestry/Wood | 3.80 | 0.64 | 0.76 | 19 | 39.4 |
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| Gold & Silver | 3.40 | 0.63 | 0.60 | -5 | 71.7 |
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| Metal Products | 3.90 | 0.62 | 0.62 | 0 | 72.4 |
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| Mining (Nonferrous/Nonmetals) | 3.90 | 0.59 | 0.52 | -12 | 46.5 |
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| Paper | 3.70 | 0.62 | 0.67 | 8 | 69.3 |
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| Steel/Iron | 3.60 | 0.64 | 0.62 | 3 | 75.6 |
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| Data as of 03-13-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage. |
Our Top Basic Materials Picks
We've picked five stocks from our 4- and 5-star lists to keep on your radar screen. Three of these companies provide valuable services in addition to products: Ecolab (ECL) helps institutions and companies with their cleaning and sanitizing needs, Nalco administers water treatment services, and Sigma-Aldrich helps researchers find the chemicals they need. We're also highlighting Cameco (CCJ), the world's largest uranium miner. Finally, Martin Marietta (MLM) is a leading producer of aggregates (sand, gravel, and stone) for the construction industry. While a good chunk of its business is exposed to the ongoing slowdown in residential and nonresidential construction, this could be partially offset by stimulus package spending on roads, bridges, and railways.
| Top Basic Materials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Cameco Corporation |  | $25.00 | None | High | $12.50 |
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| Ecolab, Inc. |  | $47.00 | Narrow | Low | $37.60 |
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| Martin Marietta Materials | | $105.00 | Wide | Medium | $73.50 |
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| Nalco Holding Company | | $23.00 | Narrow | High | $11.50 |
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| Sigma-Aldrich Corporation | | $55.00 | Narrow | Medium | $38.50 |
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| Data as of 03-20-09. |
Cameco Corporation (CCJ)
Cameco is the world's largest uranium miner, boasting high-grade reserves and low-cost operations. Renewed global interest in nuclear energy as a clean and reliable source of power should position the firm for growth and continued profitability. We think the mismatch between global uranium demand and production will ensure that these profits are rather large. Global uranium consumption has risen steadily during the past few decades. Because of an extended period of low uranium prices that provided miners little incentive for exploration and development efforts, global mine output failed to follow suit, producing a shortfall that persists to this day. Various secondary sources have filled the gap, including decades-old inventories held by utilities and governments, as well as down-blended uranium sourced from dismantled warheads. As secondary sources dwindle, we think sustained high prices will be necessary in order to get mine investments to close the gap between consumption and production.
Ecolab, Inc. (ECL)
Ecolab produces and sells cleaning products and services to institutional, hospitality, and industrial customers. Its offerings include textile and ware washing systems, detergent, and vehicle-care and pest-elimination products. Ecolab's major customers are restaurants, hotels, hospitals, food and beverage plants, and schools. It aims to become a one-stop shop for its clients' cleaning and sanitizing needs. To this effect, the company has made substantial strides toward increasing sales and improving operating performance in its kitchen equipment repair service and expanding its presence in the health-care market. Although the hospitality and food service industries are facing softer demand from consumers, Ecolab should be able to make up for some slower revenue growth by gaining additional market share.
Martin Marietta Materials (MLM)
Martin Marietta Materials is a leading producer of aggregates for the construction industry. We think Martin has a sustainable competitive advantage, thanks to its collection of quarry assets across North America, which is complemented by its land- and water-based distribution network. We believe Martin's quarries will be an increasingly valuable asset, as we expect aggregate supply growth to be constrained by regulatory challenges for opening new quarries and high transportation costs for competitors with quarries in more-remote areas. These factors, combined with recent consolidation by large aggregate companies such as Martin, should support better-than-inflation pricing in the medium and long term.
Nalco Holding Company
Nalco provides integrated water treatment and process improvement services, as well as chemicals and equipment programs for industrial and institutional applications. These can include anticorrosion techniques, papermaking process improvements, and upstream and downstream energy services. Nalco has been able to establish itself as the premier name in the water treatment market by offering a combination of innovative products and high-touch service that is unmatched by its competitors. Nalco owes much of its success to its service-driven business model. The company stations engineers at many of its clients' sites, where they are able to leverage their knowledge of their customers' assets to meet their ongoing water treatment needs and capitalize on opportunities to cross-sell other Nalco solutions.
Sigma-Aldrich Corporation
Sigma-Aldrich is a leading producer and supplier of research biochemicals, organic chemicals, and fine chemicals. Sigma's products are sold to universities, government institutions, and biotechnology and pharmaceutical companies, as well as other industrial and high-tech firms. The firm has been able to distinguish itself in the crowded chemical market by stocking an enormous array of compounds and focusing on creating a superior distribution network. Unlike many of the chemical companies in our coverage universe, Sigma receives a narrow economic moat rating, which stems from the company's pricing power and customer loyalty. Sigma largely sells consumable products necessary for the research process, and its customers typically spend only 5% of their budgets on these items. This combination of necessity and the relatively small price tag of these items makes demand highly inelastic and allows Sigma to consistently pass on price increases as its internal cost structure changes. In addition, Sigma has a high customer retention rate, in part because of its best-in-class Web site.
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