Our Outlook for Basic Materials Stocks

• Demand softness in China and Europe continues to take its toll on the sector, weighing on operating rates and selling prices for steelmaking materials, coal, and commodity chemicals.
• Following a strategic pivot to less cyclical "specialty" chemicals and agriculture, diversified chemical producers are now better positioned to weather macroeconomic headwinds.
• Lower yields and fewer nutrients drawn out of the soil have raised some concerns that farmers may apply less potash and phosphate next season.

As we write, basic materials stocks have been enjoying a strong conclusion to the third quarter. From Sept. 1-14, the median coal company we cover gained 24% (a figure bolstered by the industry's heavy indebtedness). Meanwhile, our median miner was up 18% and the median steel producer gained 15%. Domestic aggregates producers gained 23%. Performance was more muted in the less cyclical corners of the basic materials space, with packaging firms up 3% and paper producers gaining 9%. The S&P 500, for reference, was up 4%.

Much of the recent buoyancy in shares stems not from better fundamentals, which remain generally weak, but improving sentiment, driven in large part by the efforts of Brussels, Beijing, and Washington to stimulate the global economy of its current doldrums. Most recently, we've seen basic materials shares react strongly to the European Central Bank's Sept. 6 offer to buy bonds of needy southern sovereigns, the Chinese National Development and Reform Commission's Sept. 7 approval of multiple infrastructure projects, and the U.S. Federal Reserve's Sept. 13 statement that it would undertake efforts to put downward pressure on longer-term interest rates, support mortgage markets, and make broader financial conditions more accommodative.

While the statements from U.S. and European officials will obviously impact basic materials share prices, the sector remains more China-centric than any other, with particular leverage to the trajectory of Chinese fixed-asset investment. According to our read of cement and steel figures, Chinese fixed-asset investment is doing much worse than the official macroeconomic statistics would suggest. That's bad news for the economy as a whole, since fixed-asset investment currently accounts for roughly half of GDP. And it's bad news for the many basic materials companies that have enjoyed the fruits of China's fixed-asset investment boom. While the NDRC's September project approvals signaled to many a renewed stimulus push, we viewed it as "business as usual" for the NDRC and expect Beijing to remain circumspect on the matter of a major infrastructure push.

Industry-Level Insights

Agriculture
Severe drought in the United States has been the main headline in agriculture over the last few months. Unusually hot and dry weather across the country has damaged crops and sent yield estimates for the fall harvest plummeting--the most recent USDA estimate for corn yield is 123 bushels per acre compared with the initial spring estimate of 166 bushels per acre. As a result, crop prices, particularly corn and soybean prices, have jumped significantly. At this point, it looks like crop prices will rise high enough to fully offset the negative impact of lower yields on farmer cash receipts. U.S. farmer income was particularly strong in 2011, and 2012 looks like another solid year for farmer economics. In our opinion, the U.S. drought has been a net positive for fertilizer makers. With crop prices high, farmers will have incentive to plant another large crop in spring 2013. We think another big planted-acres number will drive fertilizer sales, and with farmer incomes more or less intact post-drought, growers should have the resources to fertilize their fields at suggested levels.

Looking to each of the three main types of fertilizers, we think nitrogen producers, such as CF Industries (CF) are set to benefit the most as corn prices remain high and natural gas prices, a key input, remain relatively low. Corn requires nitrogen application each season, and we're expecting another huge planted corn acres number in the United States next season. After a tough year highlighted by high dealer inventories and shrinking purchases from India, we're expecting a stronger potash market in the coming months, as producer inventories are starting to approach more normal levels. The phosphate market has firmed up in the last quarter, and producer inventories are now more or less in line with the five-year average. We'll be watching the potash and phosphate market in the coming months to look for signs that farmers may decrease nutrient application for the 2013 season. Lower yields and fewer nutrients drawn out of the soil have raised some concerns that farmers may apply less potash and phosphate next season--potash and phosphate buildup in soils and can be "banked" for future growing seasons if not used by plants. For potash producers, the sporadic and unpredictable buying patterns of China and India will have a big hand in determining the near-term strength of potash prices.

Building Materials and Engineering & Construction
The biggest positive news that impacts the building materials industry was the successful passage of the new two-year Federal Highway Bill. Public infrastructure accounts for over half of aggregates sales volume, and the passage of the bill boosted hopes that state and local governments will start releasing large-scale, pent-up infrastructure projects, which in turn should provide some baseline demand for aggregates and other building materials for the next few years. The Highway Bill provides a total of $105 billion in funding through fiscal 2014, which is basically equal to the funding level in the previous years. In addition, the bill authorizes another $1.75 billion in the Transportation Infrastructure Finance and Innovation Act, or TIFIA, funding, which serves as a popular vehicle testing the social appetite for public-private partnerships in building infrastructure projects. Assuming a typical project that can source 10% of the capital through public funding and raise 90% privately (which will be later repaid by user fees such as tolls), we think the TIFIA funding should add 10%-15% to the $105 billion in potential transportation projects. Besides, tapping private funding sources for large infrastructure projects should also speed up the timeline to a project launch as approvals for government funding tend to take considerably more time. We think the bill has greatly lifted the uncertainty that has cast a shadow over the prospects of building materials and engineering and construction companies. In the absence of the Highway Bill, relying purely on fuel taxes for funding would have reduced spending levels by about 35%, by our estimation.

While both industries collectively breathed a sigh of relief as this worst-case scenario was by and large avoided for at least another two years, we think a long-term solution on funding highway transportation through fuel taxes should still be revisited when the political environment becomes less polarized. Relying on fuel taxes to fund transportation projects makes logical sense, but low tax rates makes this form of funding a poor means to match demand and supply. While the top priority for the federal government may be reducing the long-term deficit, we think innovative funding mechanisms, higher fuel tax rates, and other options may need to be fully explored in the coming two years.

Chemicals
In the second quarter, chemical makers continued to struggle with demand softness from China and Europe. In general, the sluggish global economy has created a weak demand environment for chemicals and has put pressure on producer operating rates. For example, Dow Chemical (DOW) saw its second quarter operating rate drop to 78% compared with 84% in the prior-year period. Further, a cautious customer base has increased destocking efforts. Previously, we had expected chemical demand to pick up in the second half of 2012, but that forecast now looks overly optimistic.

All this adds up to a tough but not impossible environment for chemical-makers. Many large and diversified chemical companies should be able to lean on less cyclical specialty products, while the global recovery continues its slow push forward. For example, both Dow and E.I. du Pont de Nemours have agriculture divisions that have performed well in recent quarters and should continue to pump out profits despite weakness in many other parts of the economy. In fact, many chemical producers have made a point in recent years to shift toward higher-margin and less-cyclical specialty offerings. Further, petrochemical producers in North America should continue to get a boost from low natural gas prices, which have moved North American producers down the industry cost curve compared with European ethylene makers using higher priced naphtha as feedstock.

Coal
After a terrible year, coal company stocks stopped to catch their breath this summer. Returns were generally flattish, ranging from negative 16% by Alpha Natural Resources to plus 12% by Cloud Peak Energy . At the same time, fundamentals seem to have stabilized somewhat. On the plus side, coal companies caught a break when a federal court struck down the EPA's emission-restricting CSAPR rule in August, ruling that the EPA exceeded its authority in promulgating the rule and sending it back to the drawing boards. Although this is of limited near-term significance, it does improve the long-term outlook for coal demand by a touch. Also, in recent days, China's government indicated that it might be loosening the credit spigot for infrastructure investments a bit, causing materials stocks, including coal, to shoot up. On the negative side, the world economy continues to be slow, especially in Europe and Asia. China is showing further signs of decelerating, judging by recent economic figures. Furthermore, the U.S. summer, which started off extremely warm, has cooled a bit late in the season. Meanwhile, U.S. coal miners have picked up a bit from a nadir hit in the spring, which is both good news and bad (good for near-term earnings figures, bad for the overall inventory picture, which is still too high). The cooler weather also caused natural gas futures to fall recently toward $2.60 per MCF, though they are currently hovering around $3. Unfortunately, although gas prices are well off the $2 it set earlier this year, Powder River Basin coals are only marginally economic at current levels, and Appalachian coals remain deeply out of the money.

We continue to expect the next year at the minimum to be very challenging for U.S. coal companies. Earnings will come down materially as contracts are reset to less favorable levels, and balance sheets remain a perennial worry with the Appalachian producers. We hesitate to strongly recommend any of the coal miners. However, our favorite names remain Cloud Peak Energy and Peabody Energy , and we would continue to stay away from the more levered Eastern players like Arch Coal (ACI) and Alpha Natural Resources.

Forest Products
In August, the major domestic containerboard producers announced a $50 per ton price increase on linerboard and corrugating medium. This was somewhat of a surprising move because many of the industry's main input costs--particularly old corrugated containers and natural gas--had been trending lower in addition to North American box demand being flat. The containerboard producers cited the lack of a price increase in more than two years and tight containerboard supply as the primary reasons for the pricing move. Following two large acquisitions in the industry over the past 18 months ( International Paper (IP)/Temple-Inland and Rock-Tenn (RKT)/Smurfit-Stone), the top four containerboard producers (including Georgia-Pacific and Packaging Corporation of America (PKG)) now account for 71% of domestic production and, as a result, likely have a stronger bargaining position than in the past.

We think the producers will likely see some initial benefit from higher prices, but it remains to be seen if the new price levels will be sustainable. In the end, containerboard mills need to run at near-full capacity to generate strong profits, and a sharp decline in volumes in response to the price increase could subsequently lead to a retreat from the manufacturers' new position. If the prices stick, however, it would likely confirm a new competitive paradigm in the containerboard industry that is more favorable to the manufacturers.

It's been another eventful quarter for Sealed Air (SEE). A poor second-quarter earnings report in early August was followed a few weeks later by the announcement that the CEO of 12 years, William Hickey, would be retiring in March 2013. Hickey will be replaced by former Dow Chemical executive Jerome Peribere, who assumed the chief operating officer role at Sealed Air on Sept. 1. We think Hickey's retirement was hastened by the board due to poor results following the Diversey acquisition, and we consider Peribere to be a good fit on paper, given his experience running a major division of Dow (advanced materials) and integrating Dow's large Rohm & Hass acquisition in 2009. Shortly after the CEO change was announced, rumors began to surface that Sealed Air could be an acquisition target for a diversified chemicals company looking to move further downstream, such as Dow or DuPont. Another potential suitor is the other global cleaning solutions company, Ecolab (ECL), which might be interested in adding Diversey's strong position in Europe, at a good price.

We continue to stand by our opinion that the core Sealed Air and Diversey businesses remain solid and that the company's leverage and poor execution have been the primary drags on the stock price. As such, we can see good reason for potential suitors to consider Sealed Air, but we do not think an acquisition will occur until Sealed Air finally pays out the asbestos settlement related to its acquisition of Cryovac from WR Grace in 1998. Sealed Air needs WR Grace to emerge from Chapter 11 bankruptcy before it can pay out the settlement, but the case has dragged on for years and it remains uncertain when WR Grace will finally exit bankruptcy.

Metals and Mining
When China's National Development and Reform Commission (NDRC) announced in September that it had approved a variety of big-ticket infrastructure projects, it signaled to many that Beijing was returning to its 2008-9 stimulus playbook. No industry rallied harder on the news than mining, the China-levered industry par excellence. Higher cost producers that would suffer most from slumping Chinese investment outlays enjoyed the biggest bounces. For instance, shares of iron ore miner Cliffs Natural Resources surged 14%, after enduring a pummeling in the several weeks prior, as spot iron ore prices plunged to $88.50 per metric ton from $135.25 at the end of June on deteriorating Chinese steel market conditions.

For our part, we'd caution against getting too excited over the prospect of infrastructure stimulus 2.0. For starters, it isn't immediately clear whether the recent project approvals actually constitute a renewed stimulus push or simply "business as usual" for the NDRC. We understand that most of the newly approved projects aren't really "new" at all, but were already in the pipeline as part of various local government five-year plans. And for its part, the NDRC did not describe the projects as "stimulus." Funding for the various approved projects also remains an open question. Local governments that would be responsible for footing the bill aren't exactly in the best fiscal shape, struggling with swollen debt burdens from the last round of stimulus, tepid tax receipts from a decelerating economy, and low land sales revenue from a weak real estate market. And despite the NDRC seal of approval, banks may be reticent to open the spigot for local government borrowers with less than pristine credit quality.

Whether we'll ultimately see a major infrastructure push in China in the months ahead will depend largely on where the party consensus shakes out with respect to two competing policy imperatives. On one hand, unleashing another round of infrastructure spending is probably the surest way to prop up an economy struggling with flagging domestic and foreign demand. But in doing so, the government would undermine its longer-term objective of putting the economy on a path to a more balanced and sustainable growth trajectory and, in the process, risk stoking inflation, exacerbating existing overcapacity issues, and aggravating a bad debt problem as well. All told, we don't expect to see a surge in infrastructure spending in China unless employment conditions worsen materially. After all, arguably the biggest impetus for the 2008-09 stimulus was the massive unemployment among migrant workers, which the government viewed as a potential incubator of social unrest.

Generally speaking, we continue to favor miners with the kind of cost profile and balance sheet characteristics necessary to endure a prolonged slump in commodity prices, including narrow-moat names such as BHP Billiton (BHP) and Rio Tinto (RIO).

As for the precious metals sector, the big story during the third quarter was some signs of life among the gold mining equities, which have been left for dead by many in the investment community after underperforming bullion during the past several years. While gold miners are still underperforming the yellow metal for 2012, we've seen gold mining equities in aggregate slightly gain ground versus bullion so far during the third quarter. We attribute some of the gold mining equities' outperformance to higher dividend payouts across the sector as well as attractive valuations relative to bullion, which we believe helped lure some investors back into the mining equities from bullion bars and ETFs. Also, gold mining executives across the board have been singing a new tune about maximizing economic returns rather than chasing production growth at all costs. Indeed, at the two gold mining companies who dismissed their CEOs earlier this year, Barrick Gold (ABX) and Kinross Gold (KGC), the new executives have already made moves to abandon low-return projects and divest non-core assets.

We think investors have been encouraged by this paradigm shift among the major gold producers, especially as one of the key concerns that helped drive investors away from gold mining equities was surging capital costs for developing new projects, especially projects with questionable economics. While the shrinking performance gap between gold miners and bullion during the third quarter was certainly encouraging, we believe gold mining equities still have their work cut out for them in terms of attracting investor inflows due to the additional layers of operational and geopolitical risk that mining equity investments overlay. As such, we think the gold miners who do the best job of limiting production and capital cost inflation while operating in stable mining jurisdictions have the best shot at outperforming the yellow metal going forward.

Steel
U.S. demand for steel has been a relative bright spot in the global market of this key construction metal but too much supply has created a larger issue. Steel imports surged more than 30% for the first four months of 2012 before stabilizing through the summer as steel prices slumped to match weakness in Europe and China. Raw material prices remain high by historical standards, but we believe we are past the worst of the margin contraction from an input cost perspective and are starting to see some sustained relief. The price of coking coal has fallen some 20% year to date and although the price of iron ore has plummeted in the last few weeks in what we think could be a short-term blip, it has averaged about 30% below last year's peak for most of 2012. However, we expect U.S. steel prices to continue to struggle until Europe and China regain their footing. This sets up a lackluster second half of 2012 for steel producers and near-term visibility is murky, but given our long-term view of lower raw material prices and better supply/demand balance, we believe market valuations significantly discount the normalized earnings power for much of the sector.

Top Basic Materials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Alcoa		$19.00	Narrow	High	$11.40
Potash Corp		$56.00	Wide	High	$33.60
Steel Dynamics		$22.00	Narrow	High	$13.20
Data as of 09-18-2012.

Alcoa
Aluminum demand continues to expand with consumption growth likely to notch mid- to high-single-digit rates in 2012. Alcoa's downstream businesses now produce stronger revenue and margin than they had even before the recession. But we think Alcoa's stock price--and earnings for that matter--are much more dependent on the price of aluminum, which reached a three-year low in August. We think this level is unsustainable as much of the industry is currently producing at a loss. While improved economic sentiment remains the largest catalyst and timing is highly unpredictable, we see at least 25% upside to aluminum prices in the next few years. Alcoa operates with considerable scale as the largest producer of alumina, which we think has even more pricing upside as the industry shifts to de-link alumina pricing from aluminum.

Potash Corporation of Saskatchewan (POT)
We think continued uncertainty creates an opportunity to buy Potash Corp. shares at a more than 25% discount to our fair value estimate of $56 per share. We think the current market price is too low, considering the long-term secular trends in agriculture. Despite near-term uncertainty, we estimate fertilizer usage to rebound from the lull of the 2012 growing season in the coming few years. Further, Potash Corp. is nearing the end of its planned capital expenditure that increased its potash capacity by more than 70%. The added capacity ensures Potash Corp.'s long-term sustainability in profit generation even if potash fertilizer prices were to trend lower than the levels of 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.

Steel Dynamics (STLD)
Steel Dynamics tends to trade at a discount to its closest peer Nucor (NUE) 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 earnings drag when it fully ramps with internally sourced iron ore concentrate in 2013. 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. Steel Dynamics is the only U.S.-based steelmaker under our coverage to be profitable every quarter since the start of 2010, despite the continued depressing state of the construction markets, which in normal times make up roughly 40% of its business.

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