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Quarter-End Insights

Our Outlook for Basic Materials Stocks

Basic materials have fallen down the rabbit hole.

  • Despite recent price declines, even the most marginal copper miner continues to dig the stuff out of the ground at a fraction of the price for which it can be sold. By contrast, prices for peer base metals aluminum, lead, nickel, and zinc are now eating into their respective cost curves.
  • The fate of iron ore rests on steel demand where the real question centers on what will happen outside the United States--namely in Europe and China. We assume that China's iron ore demand growth rates will slow from recent years' heady levels.
  • Signs of life continue to build in the U.S. housing market. While homebuilding activity still remains a shadow of its precrisis self, the scale of the improvement has exceeded most expectations.  

Basic materials have fallen down the rabbit hole, and we are now in Wonderland. China can no longer be easily relied upon to fuel heady demand growth for commodities, while U.S. housing activity is picking up in earnest and U.S. petrochemical manufacturers are globally competitive, thanks to cheap natural gas. Companies that spent the last half decade touting their exposure to China downplayed their investments in the Middle Kingdom during first-quarter earnings calls.

In our last quarterly outlook, we noted that basic materials stocks as a whole had performed well in the previous months, but we hadn't seen any fundamental improvement in outlook compared with our expectations in late 2011, and so we'd had little cause to raise many of our fair value estimates. As a result, three months ago only 6% of our basic materials coverage universe sported a Morningstar Rating for stocks of 5 stars (an indication that a stock is trading at an attractive price). Now that sentiment has soured, 22% of our coverage universe carries a 5-star rating. We've lowered our forecasts and fair value estimates in cases where we believe it's warranted. For example, our outlook for metallurgical coal producers has dimmed considerably. But in many cases we've stuck with our outlook, as we've always tried to incorporate an eventual return to normalized profitability in our valuation models (whether that means recovery from a cyclical trough or retreat from peak conditions).

Industry-Level Insights
Despite strong crop fundamentals, excellent farmer economics, and an early start to the spring planting season, potash and phosphate fertilizer sales have been weaker than we expected. While demand at the grower level has been relatively strong for spring planting in North America, sales volume at the producer level has been dented by dealer inventories that swelled before the buying season. With dealers striving to avoid price risk and end the spring season with minimal inventories, purchasing at the producer level has slowed. That said, potash and phosphate sales have not dropped off a cliff, and buyers have returned to the market after delaying purchases earlier in the season.  Mosaic (MOS) has said it expects to be at the upper end of the fiscal fourth-quarter volume ranges it previously gave for potash and phosphate. We think potash and phosphate purchasing will be strong during the fall season as dealers replenish inventory and international buyers resume purchasing. However, we caution that it's difficult to tell when India will return to normalized levels of potash imports. Fertilizer subsidies in India have shifted to favoring nitrogen over potash. Nitrogen is a domestic industry in India, whereas the country's potash needs are imported. Political pressure has probably led to the switch. From 2010 to 2011, the ratio of nitrogen/potash applied in India rose to about 6/1 from 4.5/1. We assume that India will eventually have to buy more potash, but the timing is hard to peg. Results have been better for North American nitrogen producers, as strong U.S. corn plantings led to solid demand and pricing for nitrogen fertilizers.  CF Industries (CF) again ran its plants at 100% of rated capacity in the first quarter to meet demand. In addition, record-low natural gas prices in North America are boosting the profitability of nitrogen producers in the region. In the near term, we believe the conditions related to strong nitrogen margins will persist, but over the long run, we predict a contraction in nitrogen profitability, as corn prices come down and natural gas costs rise.

Seed producers are performing well in 2012, as exemplified by  Monsanto , which recently raised its full-year forecast. An exceptionally warm spring planting season in North America allowed farmers to get into fields early and plant what could be a record corn crop. As always, weather will be a factor to watch in the coming months. Good weather in North America would probably lead to a large harvest and could put downward pressure on crop prices, particularly corn. Lower crop prices could lead to fewer planted acres next year, which may induce some volume pressure for seed and fertilizer producers.

Building Materials
The near-term outlook for building materials in the U.S. is better than it's been in recent memory.  Vulcan Materials (VMC), the largest aggregates producer in the U.S., reported a 10% increase in aggregates shipments in the first quarter compared with the prior-year period. The company expects full-year shipments to increase 2%-4%, which would compare favorably with 2011's 3% decline. Residential construction activity is contributing the most to this positive momentum in demand for building materials. Committee negotiations between the U.S. House and Senate over the fate of the next highway bill have been dragging out, and it's likely that more continuing resolutions will be necessary before a long-term solution is agreed upon. Until then, infrastructure construction activity will remain subdued.

In chemicals, many North American producers continued to benefit from lower feedstock costs driven by sinking natural gas prices, while struggling with tepid global demand. For example,  Dow Chemical (DOW) saw first-quarter softness in the Asia Pacific region, as sales to China slowed. It seems chemical companies now expect incremental improvements in the U.S. to help alleviate a tougher environment in Asia, a reverse of just a few quarters prior. With the U.S. recovery still shaky, Europe not adding to the demand picture, and China slowing down, it could be a tough demand situation for chemical companies over the near term. In this environment, we expect chemical makers to continue to lean on specialty products with less-cyclical end-market demand. For example, we think  DuPont's agriculture arm will continue to perform well, and fibers for cigarette filters should provide stability for  Eastman Chemical (EMN).

While the costs of many chemical raw materials continued to climb in the first quarter, natural gas costs in North America remained subdued. This is a major boost to the petrochemical industry in North America and has provided a measure of relief to Dow and other producers during a period of weak demand. As a result of current low gas prices, we expect a number of ethylene projects to be built in North America over the coming years.

It has been a disastrous year for U.S.-listed coal equities. Among our covered pure-play coal stocks, declines range from 19% for  Cloud Peak  to 58% for 
 Alpha Natural Resources . Central Appalachian miners fared the worst, with Alpha and  Arch Coal (ACI) down more than 50% and Patriot Coal  and James River  hovering near bankruptcy levels.

The cause of these declines is not a secret. Low natural gas prices led to substantial coal demand destruction and much lower coal prices. Plus, turmoil in Europe and a slowdown in China have led to gradually softening metallurgical coal prices, which had been a crucial pillar of coal industry profitability. With costs continuing to creep up, industry margins will be a lot lower in the next year than the last. 

Despite the stock price declines and associated bad news of the past nine months, coal companies are still groping in the dark, looking for the light at the end of the tunnel. Coal demand destruction continues, albeit at a much slower pace. The bigger problem is that, at spot prices, thermal coal production is unprofitable in most of Appalachia, and only barely so in the Powder River Basin. Since many coal companies had leveraged up during the boom to pursue merger and acquisition opportunities, balance sheets have come under stress.  Peabody Energy , Arch Coal, and Alpha Natural all made substantial deals involving metallurgical coal. Arch and Alpha are now in precarious financial positions, with forecast very high leverage ratios for the next two years at the minimum. Arch in particular has taken some steps to shore up its liquidity and loosen covenants, but free cash flow will remain very poor for an extended period.

The big hope for the most distressed coal miners remains in the metallurgical markets. Indeed, this is the only production on which they are still making a profit. After falling steadily for more than a year, benchmark metallurgical contract prices stabilized in the third quarter at $210 per metric. However, some "temporary" issues like miner strikes and weather-related disruptions restricted supply, giving some support to the price. Over the coming year, metallurgical coal prices will be driven by developments in China (and to a lesser extent, Europe). After slowing in the past few quarters, China's government has taken some fresh steps to reinvigorate the economy--including lowering the reserve ratio of its banks, lowering interest rates, and encouraging lending. In short, this was its basic recipe for skating by the global financial crisis, but without being backed by big direct stimulus measures. Thus far, we have not had enough time to observe the effects of these policies. However, if they fail to stimulate demand, especially in fixed-asset investment, it's more likely than not that met coal will weaken in 2013.

For investing in the industry, we continue to be very cautious on the leveraged, high-cost (Appalachian) miners. It's likely that production will continue to decline, especially if the summer remains mild and inventories continue to pile up. We believe balance sheet issues will remain a major overhang for several years, with weak free cash flow and EBITDA generation. Instead, investors interested in coal should look to higher-quality, less leveraged firms away from Appalachia. Our favorites remain Cloud Peak and Peabody. Cloud Peak is a pure-play Powder River Basin miner with a pristine balance sheet. Peabody recently consummated a major acquisition, but its asset quality and lower-cost position give it a much better chance to weather the storm in the next few years. 

Forest Products
Signs of life continue to build in the U.S. housing market, which bodes well for the long-suffering U.S. lumber market. Year to date through May, actual starts improved 27% versus prior-year levels, with single-family starts increasing 26%. On a seasonally adjusted basis, total starts were running at 719,000 units (496,000 single-family) in the first five months of 2012, easily outstripping the 609,000 units booked in 2011 (431,000 single-family). Permitting activity looks good too, up 28% from the first five months of 2011. The seasonally adjusted annual rate of 780,000 permits in May marked the highest reading since 2008.

While homebuilding activity remains a shadow of its precrisis self, the scale of the improvement has exceeded most expectations, including those of the country's lumber manufacturers. Lumber prices published by industry trade journal Random Lengths have surged in recent months, suggesting a supply side ill-equipped to accommodate the increase in lumber demand. For May, Random Lengths' composite price averaged $328 per thousand board feet, a huge increase from $256 in May 2011 and the highest May price since 2006.

Among the forest products companies we cover,
 Weyerhaeuser (WY) stands to benefit the most from rising lumber prices. The company's gargantuan wood product business suffered greatly amid the housing slump, generating negative $1 billion in cumulative EBITDA from 2007 to 2011. But EBITDA moved into modestly positive territory ($11 million) in the first quarter of 2012 on stronger volume and prices across all product lines. Stronger starts and higher lumber prices augur well for the remainder of the year. There's still a long way to go if the company is to come anywhere close to the results booked at the peak of the boom, though. In 2004, the firm saw $1.4 billion in EBITDA. For our part, we expect midcycle EBITDA in the neighborhood of $380 million.

Metals and Mining
Base metal prices have fared rather poorly in the second quarter on generally weaker-than-expected macroeconomic data coming out of China and most of the OECD, with the U.S. a relative bright spot. As of June 18, aluminum prices have slipped 10% and now trade at $0.86 per pound, copper trades at $3.40/lb, down 11% for the quarter, nickel prices have lost 7% and now stand at $7.52/lb, lead is off 8% to $0.85/lb, and zinc sits at $0.86/lb, down 5%. Producer share prices have largely followed suit, with higher-cost operators and development-stage companies getting hit hardest.

In the quarter to come, Chinese statistical releases will continue to play an outsize role in setting the tone for prices, as befits China's role as the dominant base metal consumer (about 40% of global demand). Through May, Chinese statistical releases broadly signaled a continued slowdown in the economy. Continued weakness in the Chinese economy represents the principal downside risk to base metal prices.

Owing to differing supply-side conditions, the downside risk varies from commodity to commodity. For example, despite recent price declines, even the most marginal copper miner continues to dig the stuff out of the ground at a fraction of the price for which it can be sold. By contrast, prices for peer base metals aluminum, lead, nickel, and zinc are now eating into their respective cost curves. We'd argue that the near-term risk to copper in the event of weakening macroeconomic conditions is more acute than for other metals, as copper has comparably less cost-curve support.

The fate of iron ore rests with steel demand, where the real question centers on what will happen outside the U.S.--namely in Europe and China. Price softness in late 2011 gave way to modest improvement to $140 per metric ton in the first quarter of 2012, but in the second quarter, prices again softened, briefly dipping below $130 per metric ton delivered to China. Weakening demand stems from soft global growth in the first half and concerns about the global economic outlook. Global steel production is up only 0.7% for the first four months of 2012. Over the same period last year, global steel output was up 9.1% over 2010 levels as output surged in almost all major producing regions. But that post-global financial crisis boom is over, replaced by renewed concerns about liquidity, contagion in Europe, and the potential spillover effects to the rest of the world.

Barring an outright collapse in Chinese steel production, we expect iron ore prices to remain elevated by historical norms in the remainder of 2012. We forecast full-year prices at $140 per metric ton, down from $169 per metric ton in 2011. Looking further out, we expect the iron ore market to become more balanced as low-cost producers like  BHP Billiton (BHP),  Rio Tinto (RIO), and Brazil's  Vale (VALE) expand at the expense of high-cost supply, particularly out of China. There is also potential for new high-grade, low-cost supply from Africa in the back half of the decade. As producers in the highest quartile of the cost curve exit, the iron ore price could fall sustainably. This jells with the outsize returns on new invested capital. With total cash costs of roughly $50 per metric ton and assuming a benchmark fines price of $140 per metric ton, low-cost miners are generating fat margins. Even at a record-high capital cost of $200 per annual metric ton of new installed capacity, spot prices generate a return on new investment well above miners' cost of capital. There is no scarcity of iron ore in the world, and over time new investment will encourage supply and drive down prices.

We assume that China's iron ore demand growth rates will slow from recent years' heady levels. Iron ore is an early-cycle commodity, as steel is used to build the heavy infrastructure like roads, buildings, and bridges in the initial stages of an emerging economy's move toward developed status. China already consumes as much iron ore per person as the West, and there is risk in assuming further robust growth. Negative real interest rates on deposits encourage speculative investment in other asset classes like real estate. This weak underpinning calls into question the long-term viability of the investment-driven economic growth model.

As for the precious metal mining sector, the big story during the second quarter (and really for the past year) has been the continued underperformance of gold and silver equities relative to the precious metals themselves. Gold miners in aggregate lagged gold prices more than 25% in 2011, and this performance gap has only widened thus far in 2012. We think the main driver behind this puzzling phenomenon is that safe-haven-seeking investors are piling into gold through easily investable products such as the  SPDR Gold Shares (GLD) exchange-traded fund rather than into gold-mining equity shares, which impose additional layers of geopolitical and operational risks compared with directly owning bullion. Concerns about rapidly escalating capital and operating cost inflation across the gold-mining sector has also helped to drive investment funds away from gold-mining companies.

Nevertheless, we see some light at the end of the tunnel, which could help bridge this performance gap between gold and gold miners. First, gold miners across the board are raising their dividend payouts as cash flows are buoyed by high bullion prices. We think these higher dividends, which now exceed the market's dividend yield for some of the larger gold miners, could help lure some investors back into the mining equities. The second thing is valuation. As the miners continue to lag gold, the ounces in the ground that are owned by these miners only become cheaper relative to bullion itself. We think investors will start to see that valuation disconnect, which could prove positive for the gold-mining equities. Certainly, some gold-mining executives have already acted on this perceived valuation disconnect, as evinced by  IAMGold's (IAG) purchase of Trelawney Mining and  Yamana Gold's acquisition of Extorre Gold during the second quarter. We think continued M&A activity in the gold-mining sector remains likely during the rest of 2012. 

Steelmakers in the U.S. are posed to buck the seasonal trend and report lower sequential earnings in the second quarter as a group, with risks on the horizon for the third quarter. Spot prices for scrap and steel are testing the lowest levels since 2010, with scrap pricing down 25% in June compared with the January peak, and hot-rolled coil has declined nearly 20% year to date, falling to only $600 per ton. This will weigh on margins, and lead times are short at the mills, indicating that demand is not strong enough to fully absorb the current supply base as new capacity has come on line in the last year. 

Strong steel imports in the U.S.--with March and April levels reaching the highest since 2007--further damp the supply picture. However, the source of imports remains broad-based, with NAFTA, Brazil, and Korea continuing as the key origins. Domestic demand continues to improve, as shipping volume at the mills and service centers are climbing year on year. Steel shipments from U.S. service centers are up 7.5% through May compared with the prior year, as reported by the Metals Service Center Institute, and first-quarter shipments at the U.S.-focused segments of major mills such as  ArcelorMittal (MT) and  U.S. Steel (X) were up 6%-7% over the same period of 2011. Year-to-date capacity utilization of 78% is higher than the 74% reported a year ago. However, June has thus far showed the lowest operating rate in 2012 and could set the stage for further weakness through the summer if recent trends continue. Production cuts will be needed to rightsize the ship.

We see similar trends outside the U.S., with 2012 steel consumption growth expected in the 4%-5% range for most major steelmaking regions, an improvement but a slower rate than needed to meaningfully improve earnings. The notable exception is Europe, where steel demand should decline slightly. Including Europe, global steel use is likely to climb 3%-4% in 2012, down from 6% in 2011 and 15% in 2010. This slower-growth environment weighs on raw-material prices globally--scrap, iron ore, and coking coal are all well below year-ago price levels. While this provides some cost relief, the drag on steel prices amid strong steel supply offsets much of this effect. Until we see a stronger improvement in end-market demand--probably a 2013-14 event--lackluster earnings will continue across the sector. Fragile economic conditions in the U.S., Europe, and China present downside risk as visibility on economic growth is still low and recent economic indicators present a mixed bag.

Top Basic Materials Sector Picks
  Star Rating Fair Value
Fair Value
ArcelorMittal $48.00 Narrow High $28.80
Compass Minerals $93.00 Wide Medium $65.10
Eldorado Gold $19.00 Narrow Very High $9.50
Potash Corp $56.00 Wide High $33.60
$28.00 None High $16.80
Data as of 06-19-2012.

 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-material sources is unmatched. On the raw-material 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 barely above 40% 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, its 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 that 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 24% discount to our fair value estimate. We think this is attractive. The stock could certainly get cheaper as the 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 it enhanced its legacy portfolio of attractive mining assets through its $2.4 billion purchase of European Goldfields, which closed in February. We thought the purchase was value-accretive and increased our fair value estimate as a result. However, the market was not as sanguine about the transaction, as Eldorado's share prices have dropped 24% since rumors of its interest in European Goldfields first leaked Dec. 6, 2011. As a result, the stock currently trades at more than a 30% 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 $260 per reserve ounce, well below recent transaction multiples in gold mining. 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 and 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.

 Potash Corporation of Saskatchewan (POT)
We think continued uncertainty creates an opportunity to buy Potash Corp. shares at a discount to our fair value estimate. Potash Corp.'s current enterprise value is about 7.7 times our 2012 estimate for EBITDA. We think this is too low, considering the long-term secular trends in agriculture. Further, Potash Corp. is nearing the end of its planned capital expenditure, which increased its potash capacity more than 70%. The large capacity ensures Potash Corp.'s long-term sustainability in profit generation even if potash fertilizer prices were to trend lower than the level reached in the past few months. We think Potash Corp. will generate solid earnings in the coming few years, which should support a sizable stock-repurchase program and a more generous dividend payment.

 Weyerhaeuser (WY)
Weyerhaeuser remains our top pick among U.S. timberland owners, with its significant land holdings in the Pacific Northwest and massive wood product business positioning the firm very well for an eventual recovery in U.S. housing starts. Importantly, the firm 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 any return to housing-start weakness.

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