Our Outlook for Basic Materials Stocks

• Our basic materials coverage universe has approached fair value compared with three and six months ago, when we saw many more undervalued names in the sector.
• Coal stocks have been hard-pressed by weakening metallurgical coal prices and low natural gas prices.
• Policy statements from Beijing and monthly data from the National Bureau of Statistics on fixed-asset investment, industrial production, retail sales, and real estate spending will be required reading for investors in the second quarter.

Basic materials stocks as a whole have performed well in recent months. However, we have not seen any fundamental improvement in outlook compared with our expectations in late 2011, so we've had little cause to raise many of our fair value estimates. As a result, the price/fair value ratio for the basic materials sector is currently 0.87, compared with 0.77 three months ago. The biggest changes in sentiment for basic materials companies within the past year or so has been for coal miners and fertilizer producers. It wasn't too long ago that investing in metallurgical coal exposure was all the rage, but the fundamentals are no longer supporting that trade given a pullback in metallurgical coal prices. We think the market's dimmer view of miners with metallurgical coal exposure is largely warranted. In contrast, we'd argue that caution in the fertilizer industry is less warranted. Crop fundamentals and farmer economics remain strong.

Industry-Level Insights
Agriculture
In our opinion, crop fundamentals point to a strong spring planting season in North America for corn and soybeans. Despite crop prices that remain above historical levels, North American fertilizer dealers have taken a step back recently, delaying purchases amid economic uncertainty. With inventories piling up,  Potash Corporation of Saskatchewan (POT),  Mosaic (MOS), and Russian fertilizer giant JSC Uralkali  have announced production curtailments of potash and phosphate to better match supply with demand. With farmer economics remaining excellent, we expect the dam will break soon and phosphate and potash buyers will return to the market ahead of the spring planting season in the United States. 

Crop fundamentals and farmer economics remain strong despite a move down in crop prices from mid-2011. However, it is important to remember that many farmers can skip a season of phosphate and potash application without doing major damage to crop yields. Currently, we think it is unlikely that farmers will skip phosphate and potash application this year, as the fact that many bypassed application as recently as 2009 makes this less likely, in our opinion. Further, current potash prices are nowhere near the highs seen before the 2009 collapse. If Potash Corp. and the other major potash producers are right, and 2012 demand is ultimately robust, then the current production cuts could lead to a tight market and higher potash prices later in the year.

Building Materials
Building materials companies with exposure to the United States can look forward to another extension of the highway bill before a longer-term solution is in place. The Senate has passed its version which calls for slightly higher spending compared with current levels over a two-year period, while the House's version has faced greater delays. The good news for the building materials industry is that the House's tune has changed considerably since early 2011, when it was calling for a significant reduction in highway spending. Now, the early iterations of the House's highway bill have also called for a slight increase in highway spending. That said, controversy abounds. The Senate bill was temporarily bogged down by several nongermane amendments, most notably by Sen. Roy Blunt's (R-Mo.) contraception coverage amendment. Meanwhile, the House's highway bill has come under attack for its link to expanded oil drilling. Although the construction industry will have to do with another short-term extension, it's good news that neither part of Congress is looking for a reduction in highway spending.

Chemicals
In the chemicals space, companies have continued to struggle with raw-materials cost inflation and tempered worldwide demand, particularly in Europe. At  Dow Chemical (DOW), fourth-quarter companywide volumes were flat year over year, as declines in developed markets (the U.S. was down 2%, Western Europe 5%) were offset by continued strength from emerging economies, particularly China. Dow's price increases were fully able to offset higher purchased feedstock and energy costs. However, year-over-year profitability declined dramatically as the company's operating rate in the fourth quarter of 2011 fell to 72% compared with 81% in the fourth quarter of 2010. Weak demand and customer destocking forced Dow to lower its capacity utilization. Similar to its chemical peers, Dow's high fixed costs make operating rates an important driver of profitability. 

We saw similar stories play out across the chemicals industry. In the fourth quarter,  PPG Industries (PPG) also experienced flat year-over-year volumes. PPG was able to increase revenue 4% on the back of pricing increases the company has been implementing to stave off rising raw-materials costs, but profitability declined on lower operating rates. Adding to the list,  E.I. du Pont de Nemours also experienced volume pressure caused by customer destocking and economic uncertainty. Looking ahead, we think the themes of flat to negative volumes and higher prices to offset higher input costs will have continued once we see the final results of the 2012 first quarter. Furthermore, we think depressed operating rates caused by slow demand will put pressure on margins. In this environment, we think specialty chemical producers with tight customer relationships and pricing power will have the most success.

Low natural gas prices have been one bright spot for chemical producers. Basic chemical producers in the United States cracking light feedstocks to produce ethylene are currently benefiting from low natural gas prices in the region. We think companies like Dow, with core U.S. operations and considerable feedstock flexibility, will continue to hold a cost advantage over companies using heavy (oil products) ethylene feedstocks.

Coal
Coal stocks have been hard-pressed by weakening metallurgical coal prices and low natural gas prices. Since the beginning of the year, our coverage universe has greatly underperformed the broader market. In particular, Central Appalachian-exposed miners such as  Alpha Natural Resources ,  Arch Coal (ACI), and 
 James River Coal  are down around 20%.  CONSOL Energy (CNX),
 Peabody Energy , and  Cloud Peak Energy  fared better, but their stocks still retrenched 8%-12%.

Unfortunately, the pain is probably not over for many of these miners. Central Appalachian producers are facing a crisis unseen in more than a decade. Prompt delivery CAPP coal is under $60 per ton, where mining costs average more than $65. In response, the region's producers have curtailed operations aggressively, but in the face of $2.30 natural gas prices, dramatically higher coal prices are unlikely. To add to this mess of troubles, because no flooding disturbed Australian metallurgical coal production this winter, met coal prices have fallen to roughly $200 per ton from $330 reached last spring. In recent years, Central Appalachian miners have come to depend on met coal for the majority of their profits. Therefore, this price decline will fall almost straight to the bottom line.

Coal's troubles have not stopped in Central Appalachia. The impact from low natural gas prices rippled through the coal industry, hitting prices for Powder River Basin coals, as well. When combined with the effect of a warm winter which caused utility inventories to balloon, hitherto stable stocks such as Cloud Peak fell, as well. Without a warm summer to draw down stockpiles, PRB prices might remain weak into the 2013 contracting season, forcing the region's producers to lock in below-average margins for more than a year.

2013 might be a greater danger for many coal companies than 2012. When current contracts were made, demand and price conditions for both thermal and metallurgical coal were healthier. This bought many companies, especially Appalachian-exposed ones, some breathing room. However, if gas prices stay low and metallurgical coal prices remain soft, 2013 may witness further production and margin contraction as previously made contracts are reset. Companies like Arch Coal and Alpha Natural Resources, which took on significant debt to pursue Appalachian acquisitions, will be especially vulnerable. We suspect many Appalachian miners will have to cut production and scrimp on capital improvements to hoard cash or service debt.

Going forward, we continue to be more bullish on less leveraged, non-Appalachian-exposed companies. Our favorite miner is Cloud Peak Energy, which has the lowest costs as well as strongest balance sheet in the industry. While 2012 profits are already locked in via contracts, 2013 and beyond depends on U.S. coal demand and pricing. Peabody Energy is another name to consider. Even after buying Macarthur Coal at the peak of the market, the company retains a world-class portfolio of mines. The company is the only Australian-exposed U.S.-listed coal miner, and is still benefiting from robust thermal coal prices in the Pacific markets.

Forest Products
Are there emerging signs of life in the U.S. housing market or are we simply bouncing along the bottom? Shifting investor sentiment on the matter will prove a crucial determinant of share prices in the forest-products industry in the second quarter. For our part, we expect 2012 will be a better year than 2011 for homebuilding and, by extension, timberland owners  Plum Creek Timber ,  Rayonier (RYN), and  Weyerhaeuser (WY). Barring a fallback into recession, we expect materially higher starts in 2012. Admittedly, however, this will be coming off a rather weak base. So even though we're somewhat heartened by recent data that suggest a turning point, we'll need to see much stronger U.S. housing starts if timberland and wood-products profits are to materially improve, and much more bullish investor sentiment about future starts if share prices are to appreciate. Neither seems especially likely in the second quarter. But given strengthening macroeconomic readings, nor does a severe deterioration on either front. ​

Metals and Mining
Thus far, 2012 is shaping up fairly well for metals prices, as sentiment pertaining to both the European sovereign debt situation and the Chinese macroeconomic picture--the two fundamental demand-side drivers we highlighted in our last outlook--has improved from late-2011. As we write, copper trades at $3.87 per pound in the spot market, up from an average $3.43 per pound in December. Iron ore stands at $144 per ton (delivered China basis) versus December's $136 per ton. And even nickel and zinc, two metals defined by looser supply conditions than copper or iron ore, have fared well, improving to $8.73 per pound from $8.28 per pound and to $0.94 per pound from $0.87 per pound, respectively.

With much of the near-term risk associated with the European sovereign debt crisis apparently mitigated for the time being, we expect China to play an increasingly dominant role in metals prices and mining shares for the second quarter. Although we've been highlighting for quite some time now the likelihood that metals-hungry fixed-asset investment growth was bound to weaken from the feverish pace of recent years, the issue has assumed greater prominence of late.

Much of increased attention paid to the matter stems from Chinese Premier Wen Jiabao's recent statements regarding the need to rectify unsustainable imbalances in the economy (with the objective of shifting away from investment and export-driven growth and toward consumption-driven growth) and the government's commitment to maintaining tight policy controls in real estate as it seeks to take some of the steam out of elevated home prices. With this in mind, policy statements from Beijing and monthly data from the National Bureau of Statistics on fixed-asset investment, industrial production, retail sales, and real estate spending will be required reading for investors in the second quarter.

Steel
The second quarter is seasonally the strongest for the steel sector in the U.S., with demand peaking for construction-related products and the mills yielding the most benefit from the upswing in steel prices that occurs in the winter. This year we expect a more modest sequential improvement as steel prices had already run out of steam by February. This was partly because of a pullback in scrap prices due to mild winter weather, which should help support margins for the minimills in the second quarter. Lead times have compressed but demand appears to be holding up with most commentary pointing to about a 5% increase in U.S. steel demand for the year.

The real question centers around what will happen outside the U.S., namely in Europe and China. Shipping volumes and pricing in Europe seem to have bottomed in November/December, but there is little question that 2012 will unfold to be weaker than 2011 for steel mills in Europe. Although we expect only around a 2% contraction in steel consumption, visibility is low. In China, even the most optimistic forecasts of around 7% annual growth represents a considerable slowdown from the last several years, and most expectations are closer to 4%-5%, in line with that of the U.S. but would still create some oversupply in our view. The majority of steel companies under our coverage have no direct exposure to Chinese steel demand but are likely to face some competitive pressure on the import front from this excess supply. Still we maintain that this is to some extent offset by positive impacts on the raw-materials front. The slowdown in China has caused some easing in iron ore and coal costs, with iron ore prices down some 20% from year-ago levels and coking coal even lower because of the lack of last year's supply constraints out of Australia.

Top Basic Materials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
ArcelorMittal		$48.00	Narrow	High	$28.80
Compass Minerals		$93.00	Wide	Medium	$65.10
Eldorado Gold		$19.00	Narrow	Very High	$9.50
Foster Wheeler		$31.00	None	High	$18.60
Mosaic		$69.00	None	High	$41.40
Data as of 03-21-2012.

 ArcelorMittal (MT) (
)ArcelorMittal is by far the largest player in a highly fragmented sector giving it a stronger ability to adjust to regional changes in demand. Its scale in distribution and diversity of raw-materials sources is unmatched. 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. Its European exposure and high financial leverage are valid concerns, but we think these risks are fully priced into the shares, which are currently trading at 50% of their 52-week high. Consistent with our long-term view of the steel sector, we believe the stock price fails to take into account the company's earnings potential in the eventual cyclical upturn.

 Compass Minerals (CMP) (
)Unfavorable weather events are hurting Compass' near-term earnings. This company has very strong and sustainable competitive advantages for the production of highway deicing salt and sulfate of potash specialty fertilizer. The company's rock salt mine in Goderich, Ontario, is the world's largest and has access to a deep-water port, which allows Compass to deliver salt cost-effectively to customers throughout the Great Lakes region. Furthermore, the company's Great Salt Lake solar evaporation facility allows the company to produce sulfate of potash specialty fertilizer at a much lower cost than most other producers who use ore mining or a chemical process. Compass' Great Salt Lake facility is one of only three in the world. We think the stock is currently depressed because the company's near-term profitability is being weighed down by a trio of unfavorable weather events: tornado damage costs and production interruptions at the Goderich rock salt mine, rainfall-related production shortfalls at the Great Salt Lake facility, and mild winter weather in the Midwest that is hurting demand for deicing salt. Compass' earnings should increase long term as these issues are resolved, and as the company expands its sulfate of potash fertilizer production and grows into its expanded rock salt capacity. Long term the main valuation uncertainty is sulfate of potash prices. We look for prices to trend down long term as global potash producers ramp up brownfield expansions, but we actually think Compass' sulfate of potash earnings will grow as its production increases. The stock is trading at a 23% discount to our fair value estimate. We think this is attractive. The stock could certainly get cheaper as the extent of mild winter weather's impact on profits plays out, but we'd view that as an opportunity to add to a position in one of the highest-quality companies in our basic materials coverage universe.

 Eldorado Gold (EGO) (
)Eldorado Gold is attractively priced as a result of investors' concerns about its European Goldfields acquisition, which we regard as being overblown. Eldorado enjoys a narrow economic moat because of its industry-leading cash production costs and long mine life, and we think the company further enhanced its legacy portfolio of attractive mining assets through its $2.6 billion purchase of European Goldfields, which closed in February 2012. We thought that the purchase was value-accretive and increased our fair value estimate for the company as a result. However, the market was not as sanguine about the transaction, as Eldorado's share prices have dropped 17% since rumors of its interest in European Goldfields first leaked Dec. 6, 2011. As a result, the stock currently trades at a 25% discount to our fair value estimate. We think investor negativity is not based on Eldorado's purchase price, as the company picked up multiple low-cost gold deposits from European Goldfields at a bargain price of roughly $280 per reserve ounce, well below recent transaction multiples in the gold mining space. Rather, we believe investors are concerned about Greece's historical legacy of environmental opposition to gold mining, as two of European Goldfields' advanced-stage gold projects, Olympias and Skouries, are located in the country. However, we are confident that Eldorado will bring its Hellenic gold projects into production given that Athens has already approved environmental impact assessments and construction permits for both Olympias and Skouries, and that Greece is desperate for additional foreign investment and tax revenue as it navigates its sovereign debt crisis and fiscal austerity measures. In fact, the current Greek environmental minister, Giorgos Papakonstantinou, is a former minister of finance, which we think can only help expedite the construction process for Eldorado. Furthermore, Eldorado's ability to succeed in other difficult mining jurisdictions such as China gives us additional confidence that the firm will be able to successfully deal with Athens and generate substantial shareholder value from its European Goldfields acquisition. Finally, given that Eldorado's cash costs are in the lowest industry quartile as well as the firm's net cash position on its balance sheet, we don't think development-project funding will be a problem for the firm even if gold prices suffer a sustained correction.

 Foster Wheeler The market is overlooking Foster Wheeler's exposure to oil and gas. Although most engineering and construction companies in our coverage universe have services catering to oil and gas companies, Foster Wheeler's performance is even more highly correlated with the crude oil and natural gas prices, as the company generates more than 80% of its top line from oil and gas companies. In contrast, diversified E&C companies like  Fluor (FLR) generate roughly only 25%-35% of total revenues from oil and gas companies. We think it was no accident that Foster Wheeler enjoyed 40%-60% growth in revenue when oil and gas prices were shooting upward during 2006-08, and the focus on serving oil and gas customers should continue to grant the company more leverage to oil and gas fundamentals than traditional E&C companies. Oil majors, independent exploration and production firms, and national oil companies have finally started to release medium- to large-sized projects for the next couple of years, creating a positive momentum for Foster Wheeler, which has experienced multiple years of revenue contractions. We think the market believes that E&C companies tend to lag general economy recoveries and that the industry will not see a broad earnings uptick until 2013. Although we acknowledge that E&C companies are still facing some headwinds as European and Asian economies are slowing down, we highlight that Foster Wheeler's earnings are more geared toward the oil and gas industry's capital expenditure cycle rather than other construction activity. We expect higher capital expenditures by integrated and independent oil and gas companies to support a better operation performance by Foster Wheeler in the next few years.

 Mosaic (MOS) (
)We think short-term uncertainty creates an opportunity to buy Mosaic shares at a discount to our fair value estimate. Mosaic's current enterprise value is less than 6 times our fiscal 2013 estimate for earnings before interest, taxes, depreciation, and amortization. We think this is too low for Mosaic considering the long-term secular trends in agriculture and the company's potash expansion opportunities (planned potash expansions will increase capacity by about 50%). Furthermore, the settlement to resolve litigation concerning the South Fort Meade phosphate rock mine removes an overhang on Mosaic's stock price and should lead to lower near-term costs for the company's phosphate fertilizer operations.

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