Our Outlook for Basic Materials Stocks
Many factors are pointing in the right direction for 2010.
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In general, 2010 should award basic materials companies with stronger demand for their products, and cost-cutting measures should continue to drive profitability. Producer discipline will be critical to maintaining pricing and profitability in certain industries, however, given relatively low capacity utilization. Weather will also have important implications for how 2010 shapes up for coal and agriculture companies.
While many factors are pointing in the right direction for basic materials companies in 2010, longer-term headwinds include capacity expansions, which could cause oversupply, and demand shifts due to environmental concerns. And of course, Chinese demand saved many commodities in 2009, so a favorable 2010 depends on continued strength from that country.
Building Materials
North American building materials companies' 2010 will be defined by stimulus spending, the shape of the residential construction recovery, the magnitude of the downturn in nonresidential construction, and the outcome of the next federal highway bill.
We are optimistic that stimulus-driven infrastructure construction activity will have a positive impact on materials demand in 2010; only a small portion of total stimulus funding made its way to materials producers' top lines in 2009. Meanwhile, we believe that the bottom in housing starts occurred in spring 2009, and that next year will show a meaningful improvement, given that the amount of housing being produced today remains far below many measures of "normal" demand.
However, these positive demand drivers will be partially offset by an expected downturn in private nonresidential construction, although this end market accounts for a smaller portion of total demand for cement and aggregates. The gridlock surrounding the next federal highway bill is also creating uncertainty for highway spending, as the lack of resolution hampers states' ability to plan for larger, longer-term projects. Therefore, the passage of the next highway bill will be an important milestone for materials producers in the next 18 months.
Chemicals
Our outlook for the chemical industry in 2010 is mixed. 2009 started off with companies facing abysmal demand and sorry prospects for profitability. However, meaningful cost-cutting, inexpensive North American natural gas, and relatively strong demand in emerging markets have improved the picture.
Producers have been busy mothballing and closing plants and laying off employees, which lowered break-even sales levels. Meanwhile, North American petrochemical manufacturers' profits have been given a boost by weak natural gas prices. Although oil prices have improved since the beginning of 2009, North American natural gas prices have remained relatively weak. This has placed North American petrochemical manufacturers using gas feedstock at a significant advantage to competitors using relatively higher-cost naphtha feedstock (a byproduct of crude oil refining). The wider spread between oil and gas prices bucks the historically tighter relationship, and a narrowing of the spread could erase these producers' advantage.
Going forward, improved cost structures should help to improve profitability, but a wave of new petrochemical capacity coming online in the Middle East and China could throw a wrench in the works. What remains uncertain is the exact timing of this onslaught and, more importantly, the magnitude of the impact it will have on North American and European chemical producers' profitability. The supply coming online in the Middle East in particular is taking advantage of an abundance of relatively cheap feedstock, potentially placing incumbent producers at a significant cost disadvantage.
Chemicals players will likely continue to right-size commodity chemical assets in mature markets, seek access to low-cost feedstock in areas such as the Middle East, and look for exposure to above-average demand growth in Asia.
Coal
In the U.S. coal industry, demand will be key to eliminating excess coal inventory in 2010. Producers will likely keep U.S. production on a short leash next year. This makes sense, given our estimation that the U.S. currently has a material amount of excess coal inventory, as demand is on pace to decline nearly 10% due to the recession, lower exports, low natural gas prices, and uncooperative weather.
Production cuts generally lagged the demand drop and only recently succeeded in halting further inventory bloat. We view this bloat, the largest in recent memory, as a major overhang on coal prices in the next year.
The key to liquidating excess inventory lies in demand trends. Depending on natural gas prices, coal could regain some share in power generation in 2010. Higher domestic economic activity and exports, which are driven by the European economy, should also stimulate demand. Meanwhile, we expect production increases to lag any demand bounce. In this scenario, we think the excess inventory can be absorbed during 2010.
The winter burn will be critical. If a mild winter fails to deplete stocks, rationalizing the market may take significantly longer. Longer term, the domestic thermal coal industry faces coal-fired power plant closures (when environmental upgrade expenditures can't be economically justified) and a build-out of new natural gas plants.
Copper
Copper prices look set to end 2009 at levels few would have expected when the year began. As of Dec. 21, copper traded hands on the LME at $3.12 per pound, a price more than double that which prevailed a year ago. As has been the case for most industrial commodities, surging Chinese demand explains much of the impressive buoyancy for copper prices.
What might 2010 hold for copper? A glance at current inventories on the LME, COMEX, and SFE exchanges, which, on a combined basis stand at yearly highs, might be cause for concern. That said, in the event Chinese demand persists at 2009 levels and an economic recovery spurs a rebound in developed market demand, exchange stocks could be whittled away in a hurry, pushing prices higher.
Another factor to watch in the copper space will be investment flows into and out of the commodity. Copper has generated quite a bit of interest lately from financial (as opposed to industrial) buyers, who've plowed money into the red metal on the belief that it allows them to hedge against U.S. dollar weakness. A stronger dollar in 2010, precipitated perhaps by a more buoyant-than-expected economic recovery, could reverse these financial fund flows, exerting a drag on prices.
Fertilizer
The fertilizer industry is eagerly anticipating a turnaround in shipments next spring. 2009 was defined by a confluence of factors that drove fertilizer markets to a virtual standstill: relatively weaker crop prices in the first part of the year, tighter credit conditions, rapidly falling sulphur and natural gas prices (key inputs for phosphate and nitrogen fertilizers), dealer destocking, the psychological aftermath of record-breaking nutrient prices, many growers' ample stores of potassium in their soils, and a compressed fall fertilizer application window in North America.
We'd argue that the case for increased fertilizer shipments in the first half of 2010 is strong--the comparables are simply too easy to beat. However, we acknowledge the outside chance that growers use the next crop to test the limits of how little fertilizer they can apply before seeing a material impact on yields. And of course, weather and crop prices will continue to influence applications.
Iron Ore
Next year promises to be an interesting one for the always-entertaining iron ore benchmark price negotiations. Price talks between China, the world's largest steel producing nation, and the Big 3 seaborne iron ore players-- Vale (VALE), BHP Billiton (BHP), and Rio Tinto --will be closely watched.
Recently, we've seen assertions from Baosteel, China's biggest steel producer, that the prospect of a benchmark price increase for 2010 is "unlikely." With spot prices currently above the 2009 benchmark, we tend to view this assertion more as a negotiating tactic than an unbiased forecast of what 2010 may hold.
That said, Baosteel's voice will matter quite a bit in 2010, given signs that the firm will assume the lead role in price talks. Baosteel is taking over from the China Iron and Steel Association (CISA), which was widely viewed to have fumbled its duties this past year.
Valuations by Industry
Most industries in the basic materials sector appear to be reasonably valued. On a market-cap-weighted basis, the agriculture industry continues to be relatively undervalued, while the paper industry appears relatively overvalued.
| Basic Materials Industry Valuations | |||||
 | | | | | |
| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty Percentile** | |
 | |||||
| Agricultural | 3.56 | 1.00 | 0.86 | 16.3 | 65.9 |
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| Chemicals | 2.71 | 1.12 | 1.14 | -1.8 | 70.5 |
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| Coal | 2.73 | 1.15 | 1.13 | 1.8 | 88.6 |
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| Engineering & Construction | 2.96 | 0.97 | 1.08 | -10.2 | 75.0 |
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| Metals & Mining | 3.01 | 0.98 | 0.98 | 0.0 | 48.9 |
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| Paper & Paper Products | 2.00 | 1.57 | 1.50 | 4.7 | 79.5 |
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| Steel & Iron | 2.97 | 1.09 | 0.95 | 14.7 | 84.1 |
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| Data as of 12-14-09. |
Basic Materials Stocks to Keep on Your Radar Screen
Given the fact that most of our coverage universe appears fairly valued today, we're taking this opportunity to highlight companies with attractive business models and assets. We think it's a good idea to keep these companies on your radar.
| Top Basic Materials Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Arch Coal |  | $27.00 | Narrow | High | $13.50 |
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| Compass Minerals |  | $85.00 | Wide | Medium | $59.50 |
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| Nalco | | $26.00 | Narrow | High | $13.00 |
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| Peabody Energy | | $51.00 | Narrow | High | $25.50 |
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| Vulcan Materials | | $68.00 | Wide | Medium | $47.60 |
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| Data as of 12-22-09. |
Arch Coal (ACI)
Arch's crown jewel is its Powder River Basin (PRB) mine portfolio, which it recently upgraded by acquiring the Jacobs Ranch mine from Rio Tinto. We like Arch's strategic position within the U.S. (and global) coal industry, but the next year or two will be hairy thanks to a big inventory overhang, economic uncertainty, and Arch's heavy debt load.
Arch benefits from two long-term trends. First, the prolific Central Appalachia basin is in terminal decline thanks to poor geology, high costs, and strict regulation. PRB coal will gain market share and ride the coattails of any price appreciation as costs rise in Appalachia. Further, Arch's acquisition of Jacobs Ranch improved its PRB market position materially. We believe this and several other recent transactions in the PRB will result in a more disciplined basin, laying the groundwork for long-term margin expansion.
Compass Minerals (CMP)
Compass is a wide-moat producer of highway deicing salt and sulfate of potash specialty fertilizer and has unique, world-class, low-cost resources. Compass' Goderich, Ontario, rock salt mine expansion allows the company to serve highway deicing customers at a lower delivered cost than imports from outside the Great Lakes region, enabling Compass to gain share without sacrificing on price, while customers will actually be reducing their per-unit salt costs.
Nalco
Nalco offers investors an indirect way to play two global macro trends that look likely to persist in the coming years: water scarcity and oil scarcity. Nalco's water treatment business should benefit from the fact that its customers--industrial water users ranging from miners to manufacturers--will find themselves increasingly at odds with agricultural and consumer water users (not to mention political forces), as population growth and development place ever greater strain on the global supply of clean freshwater. In any "peak oil" scenario where oil producers scramble to maximize extraction rates in older reservoirs and develop new reservoirs in the ocean depths, we expect Nalco's expertise in enhanced oil recovery processes and ultra-deep-water oil extraction will be much sought after.
Peabody Energy
Peabody Energy's diverse and low-cost asset base is its greatest strength, and it's very well positioned to capitalize on industry trends. However, the next year will require painful production cuts to balance supply and demand and sop up the huge U.S. inventory overhang.
Peabody's operations are divided into three major components: Illinois Basin, Powder River, and Australia. Its U.S. mines are poised to ride two powerful secular waves: the slow decline of Central Appalachia and the rise of higher-sulfur coal. Central Appalachia is still responsible for 20% of U.S. supply, but its decline should accelerate because of stricter regulation and the exhaustion of viable reserves. Coal from the Powder River and Illinois basins will fill this void. Meanwhile, Peabody's presence in Australia is a big boon. Asian demand has rebounded from recession nadirs, and regional prices are the highest in the world.
Vulcan Materials (VMC)
Vulcan Materials is a leading provider of aggregates in the United States. In certain markets, the company enjoys oligopoly-like dynamics thanks to a fairly consolidated supplier environment. Given its size and broad geographic coverage, Vulcan also enjoys economies of scale in its truck, rail, and low-cost water distribution network. In the long term, we believe Vulcan's quarries will be an increasingly valuable asset, as we expect supply growth to be constrained given the regulatory challenges for opening new quarries.
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Daniel Rohr and Michael Tian contributed to this article.
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