Our Outlook for Basic Materials Stocks
The near term will surely be bumpy, but valuations look prettier today than they have in years.
Quarter-End Insights
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- Excessive heat in the Midwest has damaged yield potential for corn. As a result, production will be lower than expected and prices are likely to remain elevated.
- The tremors coming out of Europe and the slowing U.S. economy have certainly played their part in pushing down coal valuations, but the real battle will be fought in China.
- The trends in steel fundamentals this year are eerily similar to one year ago, but with one key difference--they're much better this time around.
In our last quarterly outlook, we wrote that we were looking forward to more buying opportunities in basic materials, as we expected profit warnings and earnings disappointments on a host of issues. We have been surprised with how quickly and severely equity markets have dimmed their view of basic materials companies. In some cases we have trimmed our fair value estimates, but in many others we've kept our long-term forecasts intact. As a result, our coverage universe looks much more attractively valued today than it did three months ago. In late June, our average price/fair value estimate ratio was 0.92, and only 1% of our basic materials companies sported a Morningstar Rating for stocks of 5 stars. Now, our average price/fair value estimate ratio is 0.78, and 15% of our companies are in 5-star territory.
Given macroeconomic uncertainty, the ride is likely to be bumpy for basic materials investors. However, we attempt to value our companies based on long-term earnings expectations reflecting normalized prices, demand, and costs. As such, most of our valuations didn't keep pace with the equity market rally that led into the beginning of 2011. But now that the market's expectations have weakened, we find ourselves with a much more attractively valued basic materials universe than we've seen in several years.
Industry-Level Insights
Agriculture
Agricultural markets remained strong in the second quarter of 2011. Historically tight supplies have kept crop prices elevated, lending demand and pricing support to crop inputs, especially fertilizers. Potash Corporation of Saskatchewan (POT), Mosaic (MOS), Agrium , and CF Industries (CF) all posted stellar results in the most recent quarter, as farmers used more fertilizer to boost yields and accepted higher prices upon the backdrop of excellent farmer economics. We think these dynamics will persist over the near term, as both fertilizer and crop supplies are expected to remain tight. Canpotex, the marketing arm of Canadian potash producers, recently announced a long-awaited deal with India for potash shipments in the fourth quarter of 2011 and the first quarter of 2012, with pricing $60 per metric ton higher for the later shipments; this is a sign that supplies are expected to remain tight.
On the crop side, the most recent estimates from the U.S. Department of Agriculture show that excessive heat in the Midwest has damaged yield potential for corn. As a result, production will be lower than expected, and prices are likely to remain elevated. With this year's corn crop not set up to alleviate supply pressure, we think 2012 could be a record year for planted acreage in the United States. Our thesis that it would take multiple growing seasons to return stocks/use ratios to more normal levels seems to be playing out. For seed producers such as Monsanto and E.I. du Pont de Nemours , continued high crop prices should mean solid volume and less resistance to planned pricing increases. In the coming quarter, we will be closely watching harvest results for final production numbers, yield from competing seed brands, and share fluctuations in the highly competitive corn and soybean seed markets.
Building Materials
A crisis in funding for U.S. infrastructure has been averted--for now, at least. The most recent extension of the federal highway bill was set to expire Sept. 30. By coincidence, the government's authority to collect gasoline and diesel taxes was also set to expire. Typically, "clean" temporary extensions are routine while the two political parties hammer out their differences for longer-term plans. However, the recent shutdown of the Federal Aviation Administration after a short-term extension failed to pass illustrates that the situation in Washington, D.C., is acrimonious. Most players (President Obama, Rep. John Mica (R-Fla.), and Sen. Barbara Boxer (D-Calif.)) lent their support to a temporary extension.
However, the construction industry couldn't breathe a sigh of relief until the extension actually passed, given the 11th hour wrangling that Washington has seen lately. Fortunately for building-materials companies, the extension passed both the House and Senate, and Congress now has until March 30 to either agree on a new bill or another extension of the current plan. Both the Republican-led House and the Democrat-led Senate have proposed new bills on the table. The House's proposal calls for six years of highway construction funding at a level 30% less than the current bill. This would keep construction spending within gasoline and diesel tax receipts. The per-gallon gasoline tax has not risen since 1993, greatly reducing the purchasing power of the program. The Senate version calls for two years of funding at current levels plus inflation. The Senate Finance Committee will attempt to find additional revenue to shore up fuel tax receipts.
Chemicals
In the third quarter of 2011, we think the performance of the chemicals industry will likely waiver from the stronger first half, particularly as most end markets are facing sluggish demand. Despite low inventory levels, this could translate into weak demand for chemicals in the latter part of 2011. Fortunately, commodity chemicals producers, such as BASF (BASFY), Dow Chemical (DOW), Eastman Chemicals (EMN), and DuPont, are contending with a much more benign energy environment as crude oil prices have declined from above $100 per barrel to below $90 per barrel. Furthermore, price increases enacted in the second quarter are likely taking full effect in the third quarter, expanding commodity chemicals margins beyond what we saw in the first half of the year.
Downstream chemicals companies will have varying degrees of success in the back half of 2011, depending on end-market exposure. The construction materials market has been anemic so far this year, and we do not anticipate any significant recovery in the near term. Paint and coating companies are the prime examples of weaker construction demand driving earnings lower. AkzoNobel (NLD: AKZA) was the first company to revise its earnings expectations downward, but we suspect it will not be the only one. AkzoNobel and PPG Industries (PPG) are also getting squeezed by higher titanium dioxide prices, a situation unlikely to be alleviated for at least a few more quarters. Automotive end markets, on the other hand, have been the bright spot for the chemicals industry, particularly after automakers restarted production following the broad disruptions caused by the March earthquake in Japan. However, a stubbornly high unemployment rate in the United States and a heightened sense of economic uncertainty in Europe are troubling indicators, which might potentially delay or reduce new car demand and hurt chemicals suppliers feeding into a weaker vehicle-construction season in the third quarter.
Most chemicals companies in our coverage universe have at least some auto exposure, ranging from supplying paint and coatings, and plastic tubing and engine covers, to interior materials and other products. If auto demand turns downward, we expect these chemicals companies to face some earnings weakness, as well. Meanwhile, the consumer products market remains stable, with some small degree of uncertainty given increasing macroeconomic concerns. We think chemicals companies that support consumer products--such as Koninklijke DSM (NLD: DSM) that produces food and feed ingredients and BASF that produces specialty polymers for consumer products--should continue to perform reasonably well in the near term.
Coal
The coal industry had a rough third quarter. A combination of macroeconomic fears and recent untimely acquisitions pummeled many of the companies in the sector. In general, firms involved in big-ticket acquisitions or heavily concentrated in metallurgical coal did the worst. For example, Alpha Natural Resources , which paid through the nose to acquire Massey Energy, is down nearly 40% for the past three months. Arch Coal (ACI), which snapped up International Coal Group, is down 30%. The worst performer was James River Coal , our worst-in-breed Central Appalachian miner. That stock is down 60%. In contrast, the conservative Powder River Basin thermal coal miner, Cloud Peak Energy , is just about flat for the last three months.
We think the coal sector stands at a critical inflection point. The tremors coming out of Europe and the slowing U.S. economy have certainly played their part in pushing down equity valuations, but the real battle will be fought in China. We have mixed data on that front. On one hand, steel production has continued to be quite strong, and the economy is expanding. However, we have abundant anecdotal evidence that government efforts to curb real estate speculation and tamp down inflation are having some effect. For example, real estate price appreciation and auto sales have slowed. Of course, both are vital end markets for steel and hence metallurgical coal. Throughout the past two years, as metallurgical coal clearly outpaced thermal coal in price and profitability; the idea that metallurgical coal was in an extended secular bull market gained tremendous currency in the industry. Virtually all of the recent coal merger and acquisition activity in North America was predicated on this thesis. Plus, as costs rise and thermal coal prices stagnate, the industry is more reliant on metallurgical profits than ever before.
Because of the aforementioned worldwide macroeconomic headwinds, and as Australian production slowly recovers following devastating floods in late 2010, metallurgical prices have weakened slightly from their historical highs and now sit at just less than $300 per metric ton. This price allows companies to make a healthy profit, but if these prices weaken further, operating leverage will eat into margins quickly. To a great extent, the market is extrapolating these trends. We are not bullish on metallurgical prices, but in some instances, the recent stock price declines might have been overreactions. For example, Peabody Energy and Arch Coal are both trading under our fair value estimate. Peabody has a world-class, highly diversified asset base that should enable it to do fairly well in most economic environments. We believe Arch erred in acquiring International Coal and are somewhat uncomfortable with the firm's current financial leverage in the face of economic weakness, but the shares present a favorable risk/reward profile.
Our favorite, however, remains Cloud Peak Energy. We believe this world-class miner specializing in the Powder River Basin benefits from a variety of long-term tailwinds. Furthermore, Cloud has no metallurgical exposure, insulating it from some macroeconomic worries. In Appalachia, our favorite is CONSOL Energy (CNX). The firm is now less a coal miner than a natural gas producer. It has recently unlocked a lot of value via a series of joint ventures with its gas assets, and the coal operations are highly efficient with low costs. We continue to shun James River and Alpha Natural Resources, as they are exposed to the ravaging deterioration of Central Appalachia. Alpha's acquisition of Massey was particularly value-destructive, and the firm is clearly not hitting its production and cost targets.
Forest Products
Moribund U.S. residential construction activity in the third quarter and percolating signs of a weakening economy translated into rather feeble stock price performance for U.S. forest products firms Plum Creek Timber , Rayonier (RYN), and Weyerhaeuser (WY). Year-to-date, the lone bright spot for U.S. timber demand has come from across the Pacific, with strong Chinese demand growth benefiting producers with significant exposure in the U.S. Pacific Northwest. With few signs of life coming from the domestic housing market, we don't expect much good news for forest products firms in the fourth quarter.
Metals and Mining
Mounting signs of weakness in the Organization for Economic Co-operation and Development economies seem likely to weigh on metals demand and prices in the near term, putting the onus on China and other emerging economies to support the global demand picture. Judging by the August read of China's fixed asset investment (25.0%-plus year to date, nominal terms) and industrial value-added (14.2%-plus), the drivers of Chinese metals demand remain strong at the moment, which should provide near-term support for metals prices. That said, we have significant doubts about the economy's ability to sustain such heady fixed-asset-investment growth rates for much longer without risking a sharp and wrenching rebalancing of the economy.
After peaking in April, aluminum prices on the London Metals Exchange have fallen amid global economic fears to an eight-month low of around $1.05 per pound, which is likely just a few cents below the cash cost of production for many of the high-cost aluminum smelters primarily in China. With energy and carbon prices continuing to rise, and easy financing making warehousing an attractive avenue to absorb new production, we think aluminum prices will find support even as the market faces the uncertain macro environment. This is also supported by a more promising demand front. Aluminum producers globally have forecasted double-digit consumption growth rates for 2011 and 2012, saying they do not see any softening in demand as they monitor their order books, with impressive rebounding in North America and Europe supplementing continued strong demand in developing countries, namely China. High input costs will cut into producers' margins, but top-line growth, while slow and at times volatile, should continue.
Steel
The trends in steel fundamentals this year are eerily similar to one year ago but with one key difference: They're much better this time around. In 2010, steel prices soared in the early months of the year amid high input costs, lean inventories, and choppy improvements in demand. When the supply chain had caught up, more capacity was brought on line. However, the seasonal bump in consumption during the spring subsided, and steel prices and margins took a dive, drastically hurting third-quarter profitability.
This year, we watched a similar rise in pricing and margins, but we're seeing a much more moderate fall, which should lead to a sequential decline in profitability in the third quarter but impressive year-over-year improvement. Steel prices sagged in the early summer months but have since staged a rebound, and most end markets outside of the construction sector have shown continued demand improvement. Although raw-materials prices remain high, they have been far less volatile, which supports stability in inventories as well as order rates.
Global economic fears make the outlook for steel demand uncertain, with the market pricing in a return to the dismal steel fundamentals of early 2009. Many steel stocks have plummeted 30%-50% since the spring, putting valuations in line with where they were early in the recession when capacity utilization in the U.S. was at 40% and nearly all producers reported quarterly losses. We think the actual sector fundamentals are much stronger now than they were two to three years ago. Capacity utilization is currently at a post-crisis peak of 76%, and steelmakers across the board are solidly profitable. As such, we believe there is plenty of room for valuations to improve barring a dramatic decline in order rates in the coming months.
| Top Basic Materials Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buy | |
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| ArcelorMittal |  | $52.00 | Narrow | High | $31.20 |
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| BASF |  | $91.00 | None | High | $54.60 |
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| Cameco | | $27.00 | None | Very High | $13.50 |
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| Monsanto |  | $73.00 | Wide | Medium | $51.10 |
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| Weyerhaeuser | | $28.00 | None | High | $16.80 |
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| Data as of 09-20-11. |
ArcelorMittal (MT)
ArcelorMittal is by far the largest player in a highly fragmented sector giving it a stronger ability to capture regional pockets of strength. Its scale in distribution and diversity of raw material sources is unmatched. All major growth projects are in emerging markets where capacity utilization is the highest and expected to experience the highest rate of new demand growth. On the raw-materials side, we are just starting to see the increased earnings contribution from its mining investments, which not only give the company more leverage over less integrated players, but are highly profitable assets themselves. The stock underperformed during the last rally in early 2011 and yet has fallen 46% since July 1, much more than we think is justified even in light of the heightened uncertainty in the sector given global economic fears. In the second week of September, the company traded mere pennies above $17, a level not breached since 2004. We think the market is pricing in a worst-case scenario--a deep recession that would bring consumption back to the dismal levels of early 2009. We think this is unlikely and believe the stock price fails to take into account the company's earnings potential in the eventual cyclical upturn.
BASF (BASFY)
Within our chemicals coverage universe, we think BASF is a solid chemicals conglomerate, and its stock is attractively priced. BASF has its operations servicing almost all industrial and consumer products markets, varying from ingredients for coatings, specialty polymers and plastics, and agriculture products to building materials. In addition, the company operates profitable upstream oil and gas exploration and production businesses, providing a partial hedge to its feedstock volatility. BASF is a solid operator, in our opinion. We concede that the company has a large footprint in Western Europe and might face some near-term headwinds as the eurozone gyrates through its currency and economic challenges. However, we think BASF's aggressive growth strategy in Asia and other emerging markets has the potential to outshine the weakness in Europe and support the company in the long term.
Cameco (CCJ)
Uranium miner Cameco has seen its shares take a pounding with the rest of the mining sector in the third quarter, dropping 21%, compared with average declines in the range of 20%-25% for the rest of our large miner coverage. Given the role of uranium in baseload power generation, we would expect underlying demand for the metal to exhibit less covariance with general economic conditions, than say, copper or iron ore. Consequently, the extent to which Cameco shares have traded in sympathy with producers of these more economically sensitive metals has been somewhat surprising.
Although we think Cameco shares are currently undervalued, the discount to our fair value estimate is insufficient to merit a table-pounding call on the stock. Notably, under our bear-case scenario, which considers the implications of a much lower long-term uranium price than that incorporated in our published fair value estimate, we value Cameco at $13 per share.
Monsanto
Of the agricultural names in our coverage universe, we think Monsanto is currently the most attractive. Although the stock looks fairly valued at the moment, Monsanto is a wide-moat operator that, in our opinion, will generate shareholder value for years to come. After a difficult 2010, Monsanto has taken measures to right the ship, and 2011 looks like a bounceback year for the company, with pricing and marketing strategies corrected. For the 2012 growing season, Monsanto will introduce its next promising product, refuge-in-the-bag corn, which has the potential to tilt the scales back in Monsanto's favor.
Weyerhaeuser (WY)
Weyerhaeuser is very well-positioned for an (eventual) recovery in U.S. housing starts. Importantly, Weyerhaeuser sits on an ample cash balance and has limited debt maturities in the coming years, a favorable liquidity profile that should mitigate the downside risk associated with continued housing-start weakness.
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