Look Forward to More Buying Opportunities in Basic Materials
As second-quarter earnings season starts, we'll be on the lookout for more profit warnings and disappointments on a host of issues.
In contrast to what we reported in our last quarterly outlook, some of the shine has come off the basic materials sector as a whole in the past few months. China has ratcheted up bank-reserve ratios several times in an attempt to hold down inflation rates that are getting too high for comfort. This could hamper the country's heady fixed-asset investment. Supply-chain disruptions related to Japan's natural disaster have hit the manufacturing sector, in particular the automotive industry, an intense user of basic materials. Economists are worrying that commodities-fueled inflation will derail an economic recovery. This summer's end of the second round of quantitative easing could see any speculation-related air let out of commodities markets. And last but not least, the Greek debt crisis has come to a head recently, with Band-Aid solutions increasingly hard to come by and those only likely to delay a day of reckoning.
Equity markets have responded in kind, and as a group our basic materials universe looks (slightly) more attractive in valuation than it did three months ago. In our last report we suggested that high commodity prices and producer earnings would ultimately lead to some demand destruction and eventually increased supply. The volume of news on weaker demand and macroeconomic uncertainty has definitely increased lately. The second leg of response to higher commodity prices--increased supply--should naturally take longer given the long lead times necessary to bring significant projects on line.
As second-quarter earnings season starts, we'll be on the lookout for more profit warnings and disappointments on a host of issues: disruptions as a result of weather or the Japan disasters, raw-material cost inflation and margin compression, and government-budget related demand weakness. In the first quarter, our companies were more often than not able to pass along higher costs through higher prices, due in no small part to strong demand. Temporary supply shortages in specific markets or sticky customer relationships also helped on the pricing front. As second-quarter earnings are unveiled, we could see more basic-materials companies suffer margin compression, as it's likely that conditions have not been as favorable. As such, we expect to see more buying opportunities in the coming months than we have for some time in the basic materials sector.
The agriculture market continued the status quo of the last few quarters with supply constraints supporting elevated crop prices. Fertilizer makers benefited during the period as year-over-year fertilizer prices rose in tandem with crop prices. On the volume side, wet weather in the Midwest prevented farmers from getting seeds in the ground on schedule and damped volume growth for a handful of fertilizer producers, including Agrium (AGU) and Intrepid Potash (IPI).
Planting has accelerated in the last few weeks, but the wet weather caused the U.S. Department of Agriculture to trim its expectation for planted corn acreage in the U.S., sending the anticipated stocks-to-use ratio even lower. In our opinion, fertilizer and seed volume lost to lower-than-expected acreage in 2011 will merely be pushed into next year's growing season. Furthermore, with supply remaining tight, we don't see relief in crop prices in the near term, which is unqualified good news for crop-input providers such as Potash Corp of Saskatchewan (POT) and Monsanto (MON), among others. We think it looks increasingly likely that it will take multiple growing seasons to return crop supplies to a more comfortable level, and we think crop-input companies are set up for a nice run of robust profit generation. Weather is always a wild card, and Mother Nature's effect on yields this summer will shed more light on the future of crop prices and the crop-input market.
The U.S. Senate recently voted 73-27 to terminate two ethanol subsidies, the $0.45-per-gallon blending credit and the $0.54-per-gallon tariff on imports. The vote by itself does not end the subsidies, as senators voted on the ethanol tax credit and tariff as an amendment to an economic development bill that might not pass in the Senate. Moreover, the bill would still need to be taken up and passed by the House. That said, the lopsided (and bipartisan) vote sends a strong message that the days of U.S. ethanol subsidies are numbered. In our opinion, corn demand from ethanol will not move much if the subsidies disappear; largely because a federal renewable-fuels mandate to blend corn ethanol into gasoline remains in place. The standard will actually require an increase in the amount of ethanol blended in the U.S. during the next few years before leveling off at 15 billion gallons in 2015, with the mandate continuing through 2022. As such, we don't think the recent news does much to move U.S. corn demand, of which ethanol production accounts for about 40%. However, if serious efforts are made to wipe out the ethanol mandate, we would need to revisit our assumptions. Currently, we place this outcome in the "unlikely, but possible" category.
The building materials industry continues to be the weakest corner of the basic materials universe, particularly in developed markets. Building materials' low value/weight ratio means producers in weak markets can't take advantage of strong demand elsewhere on the globe; the transportation costs are oftentimes an insurmountable barrier. Exacerbating this situation for the companies we cover is the fact that many building materials companies entered the current downturn with arguably overleveraged balance sheets. Despite several years of belt tightening and capital raises, several building materials companies (such as CEMEX (CX), Vulcan Materials (VMC), and Lafarge) must continue to look to capital markets and asset sales for breathing room.
In the United States, only a minimal recovery in demand for construction materials is expected for 2011, which speaks to the depth and longevity of the current downturn given how far activity has fallen since 2006. Highway construction activity should be supported in the near term by unspent stimulus funds and continuing resolutions under the last multiyear federal highway bill. Residential construction activity is likely to grow but from a tiny base. Finally, commercial construction activity is expected to bottom soon, given the slowing rate of decline in contract awards. And while demand remains strong in most emerging markets, competition, higher costs, and political unrest are damping cement companies' profitability outside of North America and Western Europe.
Much like many parts of the basic materials sector, the most prominent recent theme in the chemical industry (the battle to pass on rising raw-material costs) continued in the first quarter of 2011. Across the board, chemical firms are pushing price increases to customers in an effort to stem the tide of rising costs; some with more success than others. Counted among the winners were BASF (BASFY), DuPont (DD), Eastman Chemical (EMN), and Rockwood Holdings (ROC). BASF has announced a series of price increases varying from resins to special additives in the second quarter, which we think will contribute directly to the firm's bottom line, as energy prices have moderated in recent weeks. Eastman posted stellar first-quarter results, as price and volume increases more than kept pace with higher costs.
The company is currently benefiting from the increased gap between prices for propane and propylene; printing money from a wider cracking spread. DuPont and Rockwood's quarterly results were bolstered from higher titanium dioxide prices. The TiO2 market is very tight at the moment and these companies should continue to reap rewards throughout 2011. DuPont has announced a multiyear expansion in its TiO2 capacity, which aims to increase capacity by 350,000 metric tons. Looking further down the road, we're not sure how successful both Rockwood and DuPont will be in continuing to consistently pass higher TiO2 prices to customers as large buyers, such as PPG Industries (PPG) and AkzoNobel (AKZOY), could begin sourcing cheaper Chinese-produced titanium dioxide. Hoping to gain a pricing advantage, AkzoNobel formed a Chinese partnership in June to supply TiO2 for its Asian operations.
Firm's that did not do as well passing on higher raw-material costs include Ecolab (ECL) and Ashland (ASH). Although we wouldn't call Ecolab your typical chemical company, the firm is nonetheless dealing with higher costs for raw materials. However, we think the company will be able to recover costs over time. In our view, Ecolab's scale uniquely positions the company to service the needs of corporations with a global footprint, and we think Ecolab's clients are likely to accept modest price increases, with few substitutes available. Ashland is encountering problems in its water-treatment business as it strives to steal share from entrenched competitor Nalco (NLC). In an effort to recoup higher raw-material costs, Ashland has raised prices in its water-technologies business more steeply than competitors, which has led to pressure on volume and could lead to market share losses.
M&A remains a focal point in the coal industry. Arch Coal (ACI) announced in early May that it would acquire International Coal Group for about $3.4 billion. This caps off a series of coal deals the world over during the past six months. U.S. coal companies are feeling flush from high metallurgical prices. For example, less than two years after the debt-funded acquisition of Jacobs Ranch, Arch felt that its financial health was sound enough to stalk International Coal. Similar stories have played out across the universe. With relatively little opportunity for green or brownfield investment, and with U.S. thermal coal demand likely to be weak for the foreseeable future, companies are increasingly looking for acquisitions to bolster production. Of the publicly traded U.S. companies, Cloud Peak (CLD), James River (JRCC), and Patriot Coal (PCX) are the most likely targets (being virtually the only remaining small firms that aren't master limited partnerships). In particular, coal producers are hunting for high-quality metallurgical coal, which is still in short supply worldwide and commands the highest prices and margins. Of these three companies, only Patriot Coal fits that bill.
Aside from the acquired companies, coal equities have performed relatively poorly during the last few months. The sector is perhaps 25% off its peak in April. One driver has been weak domestic demand, which has been driven by uncooperative weather combined with the old hobgoblins of low natural gas prices and weak industrial activity. In addition, one of the strongest tailwinds behind the sector seems to have faltered recently. Rocketing Chinese imports was one of the biggest stories of 2010, and predictions from six months ago presaged another big surge this year. However, Chinese government policies have shot some holes in this thesis. For example, China did not allow domestic electricity prices to rise with coal prices. As a result, generator margins have been crushed, hampering both investment and operations. At the same time, demand is increasing along with the economy. As a result, China is facing a record power shortage this summer. Because generators are not making money, they are not importing as much coal as before. Through May, China coal imports are down 16.6% from the previous year. Earlier this year, the industry was hopeful that China would cut its 17% import value-added tax to lower the all-in price of imported coal. This move could dramatically boost imports, which would reverberate through the global supply chain. However, it does not appear that this is forthcoming in the near future, and this has damped some of the enthusiasm of coal investors.
We remain bullish on the outlook for our internationally diversified and Powder River Basin-focused miners. Our favorite companies are Cloud Peak and Peabody Energy (BTU). We think metallurgical coal focused miners, such as Alpha Natural (ANR) and, increasingly, Arch Coal (ACI), face a great amount of macroeconomic risk, especially with respect to Chinese government policies. China is in the midst of a concerted credit-tightening campaign, and there are some signs that the domestic real estate sector is weakening. Considering China's pivotal role in the global steel industry, any slowdown could be very harmful to metallurgical coal prices, which are currently near all-time highs.
While North American box shipments appear to be slowing down, appropriate inventory levels and improving industry consolidation should benefit North American containerboard makers in the intermediate and long term. Box shipments on an average-week basis were down 4.2% in May compared with the numbers a year ago and are roughly flat on a year-to-date basis. Slowing box demand can be seen as a bellwether for the general state of the nation's economy. While the amount of North American corrugated box shipments for the trailing 12 months is up 4% from the depths of the recession, it is still down about 10% from prerecessionary levels.
Offsetting the lackluster trend in box demand is a rather appropriate level of containerboard inventory. Containerboard inventories during May remained at 3.8 weeks. Maintenance downtime and flood-related downtime at International Paper's (IP) Vicksburg, Miss., mill have helped to prevent the escalating inventory levels which could trigger falling prices.
Longer term, industry consolidation could help to shift more economic power into the hands of containerboard producers. In early June, International Paper announced a hostile takeover offer to acquire Temple-Inland (TIN). While the $30.60 per share (all-cash) offer was significantly above Temple-Inland's recent stock price, Temple's board viewed the offer as opportunistic and too low of a price. Consequently, the company initiated a poison pill in order to dissuade a hostile acquisition and, we believe, to encourage a higher price. Should the acquisition get approved by Temple-Inland and antitrust regulators, the combined company will control roughly 40% of North America's containerboard supply. We believe that such a consolidating acquisition would be a step forward in improving the industry's underlying competitive structure.
Metals and Mining
Heading into the second quarter, we highlighted two issues that we had expected to dominate the picture for metals prices and mining stocks: Can China's heady fixed-asset investment growth sustain further tightening by an increasingly hawkish People's Bank of China? Is the recovery in the U.S. and Europe getting weak in the legs? On both issues, it seems the market has grown increasingly worried, with clear negative implications. Looking at base metals price performance quarter to date through June 16, lead is down 9%, zinc down 5%, and even much-ballyhooed copper has dropped, falling 4% as London Metal Exchange inventories of the red metal have increased 7% despite widespread expectations of a China-led inventory drawdown and continued supply disruptions. No base metal has performed worse than nickel, which has dropped 17% as the market incorporates expectations of new supply coming on line around the globe.
Not surprisingly, mining shares have performed rather poorly quarter to date, with the median large miner on our coverage list falling 14% versus the S&P 500's 5% decline. Following the across-the-board declines in our mining coverage, we now view the industry as fairly valued in the aggregate: diversified miners Anglo American (AAUKY), Teck Resources (TCK), Vale (VALE), and Xstrata now trade within 5% of our fair value estimates. By contrast, we think copper pure plays Freeport-McMoRan (FCX) and Southern Copper (SCCO) remain overvalued (despite 14% and 23% price declines quarter to date), as prevailing share prices seem to reflect expectations of extremely elevated copper prices for the foreseeable future. As we've previously discussed, we expect the industry's supply response to heady prices will be stronger than many expect.
Heading into the third quarter, we expect the themes of Chinese fixed-asset investment sustainability and OECD economic strength will be no less dominant than they had been in the second quarter and are likely to cap mining share price appreciation. However, negative news on either front could present the kind of buying opportunity that we haven't seen in quite a while in mining.
Another topic we expect to gain in prominence is mergers and acquisitions. Although many corners of the basic materials sector have seen a notable uptick in large acquisitions (see, for example, forest products and coal), large-scale deals in metals mining have been notably absent (the last proposed mega-deal being BHP Billiton's (BHP) abandoned bid for Potash). As we've previously discussed (see Morningstar Market Outlook reports from September 2010 and December 2010), big miners have thus far exhibited a marked preference for organic growth, as opposed to the kind of transformative mega-deals that defined the last cycle (for example, Teck's acquisition of Fording, Vale's acquisition of Inco, Xstrata's acquisition of Falconbridge, and Rio Tinto's (RIO) acquisition of Alcan). Although corporate bond spreads have widened in the past several weeks, absolute yields remain very compelling, and cash balances at most mining firms continue to swell, two factors that could set the stage for an uptick in mining M&A in the third quarter.
U.S. steel prices overshot global levels early in the year, and we're starting to see the effects. The tag on a ton of hot-rolled coil has slipped about 10% from its April peak even while scrap and iron prices remain elevated. The capacity utilization rate has been roughly unchanged at 75%, but we believe this has the potential to slide. Although demand is improving for most sectors outside residential and nonresidential construction, it continues to be a very slow recovery.
It is unlikely that any order rate improvement would be enough to absorb new or restarted capacity from ThyssenKrupp, Severstal, and RG Steel this year. As we move past the seasonally strong second quarter and end the restocking that took place throughout the supply chain, order rates could stay constant or even decline in the latter half of 2011. Furthermore, high steel prices in the U.S. have invited a resurgence in imports, which reached a 2.5-year high in April at 2.3 million metric tons and are tracking even stronger in May.
As we look outside the U.S., we see that Europe battles similar challenges, and Brazil, while continuing its strong growth path, has become a fiercely competitive marketplace for steel producers with import pressures from a strong currency keeping a lid on steel prices. The only bright spot we see on the horizon is China, where steel production could decline from its May peak in response to mill shut-downs during the summer months to conserve scarce electricity. Monthly steel production has been tracking above the country's estimate for growth in 2011, meaning that some mills might have ramped up production to compensate for the reduced output later in the year. As China represents nearly 50% of global steel production, any output declines could benefit steel prices and ease raw-material prices globally.
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We think recent pricing weakness and volatile order rates overshadow the steelmaker's solid positioning for long-term growth. The company's outlook appears to indicate greater stability in the business which suggests to us the negative macroeconomic data of late is unlikely to cause a significant deterioration in results for the back half of 2011. Nucor is using the downturn as a time to buckle down and make investments to improve its cost position, namely its scrap-substitute project in Louisiana. Its mills are operating at 80% of their capacity despite a lag in beams and bar products with construction--the primary end market for Nucor--still 60% off its prerecession activity level. Leverage to late-cycle nonresidential construction and increased focus on exports and expansion in areas outside the U.S., such as Mexico, give the largest U.S.-based mini mill plenty of room to grow. A solid balance sheet and strong dividend yield also make Nucor a safer play as the U.S. steel sector continues to battle the slow economic recovery.
Steel Dynamics (STLD)
Better-than-expected performance in recent quarters indicates Steel Dynamics can more nimbly navigate the cycle than before in our view. The company tends to trade at a discount to its closest peer Nucor because of its smaller size and higher financial leverage but we feel that gap could have room to close. Progress in new products such as rail has mitigated the effects of the downturn, and its innovative Mesabi Nugget project should remove a major headwind when it becomes profitable in 2012. A more attractive long-term growth story given its smaller size and status as a relative newcomer to the U.S. steel sector also bodes well for the company. The stock has traded down in recent weeks as U.S. flat-rolled prices pulled back, but pricing has since leveled off which might mark a good entry point for the shares.
This Latin American steel conglomerate's diversified exposure keeps it isolated from the more competitive Brazilian market that is attracting new entrants and import pressures, while much of Latin America enjoys a similar growth profile. Ternium had the third-highest earnings before interest, taxes, depreciation, and amortization per ton in our steel universe in 2010, yet it currently trades 2.5 EBITDA turns below its Latin American peers compared with a historical average discount of 1.5 turns. The company also boasts the strongest balance sheet with near-zero net debt and has several potential growth projects in various stages of planning. Although Ternium's equity float is still small (only 25% of shares), it increased from 14% in February following the exit of a major shareholder, and we think this new liquidity and additional power given to minority shareholders should be a positive for the stock. Finally, we believe the downside risks of operating in less stable Argentina are overplayed and don't justify the significant valuation divergence, as Ternium has experience operating in similar jurisdictions (its Venezuelan mill was nationalized in 2008), lower relative pricing in Argentina makes exports an attractive alternative, and the company is well-diversified with significant NAFTA exposure from its two Mexican mills.
We believe that shares of Timken, the Ohio-based bearing manufacturer, look attractive as the company is on pace to meaningfully expand revenues and earnings per share versus last year. The company's long-term strategy and recent acquisition of Philadelphia Gear should enable the company to continue to expand earnings in future years. Timken's strategy is to improve its profitability by expanding its footprint in the higher-margin industrial sectors (such as heavy industries, aerospace and defense, and wind energy) as well as expanding its presence in Asia. Because Timken is sowing the seeds of growth in industrial end markets and Asia, we believe that in future years the company will benefit from an increasing mix of higher-margin aftermarket sales. Additionally, Timken's recently announced $200 million purchase of Philadelphia Gear should bear economic fruit as the combined company should be able to recognize meaningful top-line and cost synergies. Because Timken is currently in a net-cash position, we expect that in the coming years Timken will look to make more acquisitions similar to that of Philadelphia Gear.
Yamana Gold (AUY)
Yamana is a midtier gold producer that operates a portfolio of six mines in Central and South America. The firm is one of the lowest-cost producers in the gold-mining space and has a quartet of near-term projects that is scheduled to start gold production during the next few years. Yamana is currently trading at one of the lowest enterprise value/reserves ratios among the major gold miners, which we believe is unwarranted given the firm's low cost profile and promising growth trajectory. We think one major overhang on the stock is the market's misgivings about Yamana's ability to execute on its growth projects. However, we believe that Yamana will be better able to focus on internal-development projects after spending the last few years digesting major acquisitions. In fact, three out of Yamana's quartet of advanced-stage gold-mining projects have already broken ground, with the first mine, Mercedes, expected to start production in mid-2012. The other major driver of negative investor sentiment toward Yamana stems from its higher exposure to copper than the average gold miner, which erodes Yamana's gold premium. However, the company has taken steps to reduce its exposure to copper through the recent sale of its stake in the Agua Rica gold-copper deposit. Furthermore, we think the company will become further leveraged to the yellow metal as the company's quartet of advanced-stage projects comes on line during the next few years.
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Elizabeth Collins has a position in the following securities mentioned above: VALE. Find out about Morningstar’s editorial policies.