Our Outlook for Basic Materials Stocks
Companies with more exposure to the United States should fare better than those tied to demand in Europe and China in 2013.
Quarter-End Insights
- Fundamentals in U.S. thermal coal should continue improving next year, thanks to rebounding natural gas prices, a hot summer in 2012 that helped whittle down overflowing coal inventories, and significant curtailment in domestic coal production.
- We think pricing pressure for most industrial metals will continue in 2013, as China--the most important source of demand--inevitably shifts away from its investment-driven growth model.
- The outlook for steel demand growth in 2013 is strong in the Americas, but we think there is downside risk in Europe and China.
The outlook for basic materials companies in 2013 is quite mixed. Broadly speaking, companies with more exposure to the United States should fare better than those tied to demand in Europe and China, in our view. In particular, our outlook for companies leveraged to U.S. construction activity is much more favorable than that for the miners dependent upon Chinese consumption. This is a sharp reversal of the landscape that has prevailed over the last several years. Today only 6% of our basic materials coverage universe sports a 5-star rating, compared with 9% three months ago.
Industry-Level Insights
Agriculture
While the scorching temperatures in the United States are several months in the rearview mirror, crop supplies remain tight and prices elevated. This is good news for farmers, many of whom will see the volume component of their revenue calculation drop because of lower yields. Given recent USDA estimates, it looks like total farm income in 2012 will end up in the same ballpark as 2011, which was a very strong year. For this reason, we think growers will have ample resources to purchase crop inputs for the 2013 growing season. Further, we're expecting another big number of planted acres in the U.S., as farmers look to take advantage of high crop prices.
With North American growers likely planting fence row to fence row in the spring, demand for crop inputs should be strong in 2013. In potash, producer inventories are working down after Russian imports and dealer uncertainty caused inventories to balloon early in 2012. However, near-term global uncertainty for potash remains. China and India have yet to sign new contracts for potash. This has led not only to lower volumes shipped to the two countries, but has also led to hesitation from other international buyers expecting potash prices to come down when new contracts are signed. Meanwhile, in the United States there has been talk that potash application rates could be pressured in the hardest-hit drought areas. All of this makes for heightened near-term uncertainty. However, none of the recent developments have materially changed our long-term view of the potash market. We're still expecting prices to creep down in the long run, as supply grows faster than demand.
With corn prices remaining high and natural gas costs low, conditions are still very favorable for North American nitrogen producers. Corn requires nitrogen application each season, and we're expecting another huge number of planted corn acres in the United States next season. The phosphate market has shown some softness recently, but inventories remain relatively tight. Along with potash, phosphate application rates could see pressure next year from the drought in the United States. Also, the Indian subsidiary policies that are supporting nitrogen application and harming potash buying are also denting phosphate demand in the country.
Building Materials
The stocks of most building materials producers performed quite well over the course of 2012 thanks to improving conditions in U.S. infrastructure and housing starts as well as cost-cutting and price improvements across the globe. The outlook for demand in 2013 in the U.S. is solid thanks to housing starts, an increase in private nonresidential awards, and an expected increase in contract awards following the recent passage of a new highway bill. The outlook for demand in Europe is much more muted. However, building materials companies are engaging in massive cost-cutting programs and pricing initiatives that are both lowering their break-even levels during this time of weak demand and increasing their leverage to improving volumes once demand eventually improves. However, most building materials producers shares imply that some of that future profit improvement is expected. We don't see a sufficient margins of safety in valuations in our coverage universe at this time.
Chemicals
The third-quarter story for chemical producers was similar to the first half of 2012, with demand softness in China and Europe constraining revenue. The slow demand environment has led several prominent players including Dow Chemical (DOW) and DuPont to restructure operations to better fit demand. Many cuts will focus on downsizing European operations, where demand is especially weak. Further, operating costs for companies making basic chemicals in Europe have also been higher relative to costs in the U.S., due to the discrepancy between natural gas and naphtha costs in the two regions. Despite a tough environment, demand has not fallen off a cliff, as exhibited by Dow's flat year-over-year operating rate in the third quarter. Prices for some chemical players are under pressure, but this has been at least partially offset by lower feedstock costs.
As we have mentioned before, we expect large diversified chemical players to lean on less cyclical specialty products in this uncertain demand environment. In particular, companies have been steadied by results from crop chemicals and genetically-modified seeds. We think chemical players will continue shifting portfolios to specialty products in an effort to improve margins and reduce cyclicality, and recent restructuring could help speed this transition.
Coal
The last three months of 2012 have provided some respite for the beleaguered coal mining equities after they endured a painful thrashing during the first nine months of the year. We believe domestic coal prices are due for a rebound in 2013, which could help many of the U.S. coal miners we cover. However, recovery will not arrive evenly across the coal sector, in our view, with thermal coal producers faring better than metallurgical coal miners, and coal miners producing from the western United States (particularly from the Powder River Basin) outperforming peers focused on the eastern regions of the country.
2012 saw extreme looseness within the domestic coal supply and demand dynamic, which was at its loosest during the second quarter of 2012. Supply and demand for domestic coal began to gradually tighten during the back half of 2012, however, boding well for coal prices heading into 2013. The improving fundamentals of the U.S. coal market are due to a number of factors, including natural gas prices rebounding from their nadir, a hot summer that helped whittle down overflowing coal inventories, and significant curtailment in domestic coal production, particularly from the eastern U.S. coal miners. The EIA projects 2013 domestic coal burn for power generation to rebound by 40 million-50 million tons from the dismal 2012 levels, assuming that normal weather patterns return, and natural gas prices remain at current levels. With natural gas prices now hovering around $3.50 per MMBtu, lower-cost coal from the western parts of the U.S. can effectively compete against natural gas on a price/energy basis. Low-cost coal from the Powder River Basin (PRB), in particular, looks underpriced versus natural gas at its current spot price of roughly $10 per ton. Coal miners with large exposure to the PRB include Peabody Energy , Cloud Peak Energy , and Arch Coal (ACI), with Cloud Peak representing the purest play on PRB coal prices.
Despite our optimistic outlook, coal inventories at the utilities still remain well above the historical average, which we think will hinder domestic coal prices from rising to higher normalized levels. Nevertheless, we are looking for domestic coal prices to slowly rebound in 2013 as this inventory overhang continues to be worked down, continuing the trend that started this summer. We believe rising domestic coal prices will not lift all coal miners equally, however. Higher-cost Appalachian coal still cannot compete versus natural gas at current prices, and many of the production curtailments and mine closures announced by the Appalachian coal miners this year may very well become permanent. Coal miners with heavy exposure to Appalachian coal basins include Arch Coal, Alpha Natural Resources , and Consol Energy (CNX). We are also not as sanguine about the prospects for metallurgical coal, which is affected more by global economic activity than by domestic power generation dynamics. We project slower global steel-making activity combined with significant supply expansions in response to recent high metallurgical coal prices to cap gains in met coal prices over the long term. Coal miners we cover with significant exposure to metallurgical coal include Arch, Alpha, and Consol. For Arch and Alpha, our tepid price outlook for metallurgical coal is exacerbated by the fact that these two firms leveraged their balance sheets to gain additional exposure to metallurgical coal via major acquisitions in 2011.
Forest Products
The recovery in U.S. housing starts continues to benefit timber and wood products companies like Weyerhaeuser (WY), only partly offset by weaker conditions in the export market due to a slowing China. We see prospects for strong improvement in 2013. While domestic residential construction activity has recovered substantially from trough-level lows, the pace of new building remains well below the potential underpinned by U.S. demographic drivers.
A number of major bleached eucalyptus kraft, or BEK, producers, such as Fibria Celulose , Suzano, and Ence aim to increase BEK prices starting Jan. 1. This comes on the back of an October price increase that had mixed results, as BEK inventory remains slightly overstocked. Buyers generally resisted the announced price increases to the point where producers needed to offer larger discounts to retain volumes. Further, Eldorado recently launched a large BEK mill in Brazil that should more than offset the supply lost from capacity closures elsewhere in the market. As such, we are not convinced that a planned BEK price increase will be a major driver for narrow-moat Fibria in 2013. Rather, we think much of Fibria's outlook depends on a stronger Brazilian real relative to the dollar.
Metals and Mining
Industrial metals prices enjoyed a fairly strong fourth quarter, buoyed by encouraging macroeconomic readings from China, the announcement of QEIII in the U.S., and improved sentiment on the European debt crisis.
Notwithstanding a fairly strong conclusion to the year, 2012 must be regarded as a disappointment for bulls that had expected to see fresh price records set in many commodities. As it turned out, 2012 will go down in the books as a down year for every major industrial metal we cover. This marks a sharp contrast to what has been a fairly strong year for equities, at least in the U.S., where the S&P 500 is up 14% YTD as we write.
Decelerating growth in China, particularly on the metals-hungry investment side of the economy, was the biggest downdraft for prices this past year. Notably, the biggest price declines in 2012 were in those commodities most levered to the Chinese investment boom. That list is topped by iron ore and metallurgical coal, where China accounts for over half of global demand.
Recent indicators ranging from the manufacturing PMI to production data from the steel and cement industries have been interpreted by many that Beijing has successfully engineered a "soft landing" and expect growth to accelerate strongly into 2013, which would augur very well for industrial metals prices.
This interpretation of the data seems predicated on the idea that the slowdown was principally a cyclical phenomenon wrought by some combination of monetary tightening, policy-induced weakness in the all-important real estate market, and poor external demand. In other words, for China, it's back to "business as usual" in 2013.
We'd suggest that this interpretation ignores the possibility that the investment-driven growth model that defined the Chinese economy for the past decade is wholly exhausted. From this perspective, the recent uptick in investment spending is likely to be short-lived. For our part, we think this will mean renewed pricing pressure on most industrial metals in 2013, making most of our metals mining coverage list a comparably unattractive place to be.
As for the precious metals sector, the big story during the second half of the year was the mining strikes in South Africa that paralyzed the platinum, palladium, and gold miners in the country. While work has now resumed at most of these South African mines, we believe the recent labor strikes illustrate the ongoing labor tensions that have relegated South Africa as the marginal cost supplier of precious metals around the globe, especially for gold. In addition to the labor woes, South African gold miners are contending with geological headwinds as they chase thin subterranean gold reefs ever deeper. Power cost inflation also remains a major headache on the cost side for South African gold miners, as national power provider Eskom is proposing double-digit power rate increases over the next several years in order to fund investments in the country's aging power infrastructure. All of these factors will cause South African gold miners to remain as the marginal cost producers of gold going forward, in our opinion.
We believe the recent South African mining strikes have reminded investors in both the precious and industrial metals space of the importance of controlling one's geopolitical risk. Of the gold miners we cover, we regard Agnico-Eagle Mines (AEM), Goldcorp , and Yamana Gold as exhibiting relatively lower geopolitical risk based on where their mining assets are primarily located. We believe the continued underperformance of the marginal-cost South African gold miners also reinforces our notion that gold mining investors should focus on low-cost gold miners that would be more insulated from downward movements in the bullion price. Along that front, we would mention Eldorado Gold (EGO) and Yamana Gold as being the two lowest-cost gold miners we currently cover.
Steel
The fourth quarter typically ends with a surge in U.S. steel pricing but this has yet to materialize this year, partially because raw material costs have shown little strength. Seasonal trends usually dictate scrap pricing in particular, but hesitant demand appears to be the primary driver in the current environment. An uncertain steel demand outlook for Europe and China combined with "fiscal cliff" concerns in the U.S. are causing steel buyers to be more selective than typical for the season, a trend we're also seeing in steel producers with their raw material purchases. Lead times are reportedly only one month for hot-rolled coil, compared with previous years that had order books full through February by the time the winter holidays were in full swing. There seems to be some slowing in certain end markets, namely agriculture and energy, but this is balanced by brighter signs from residential and non-residential instruction. Any improvement in these anemic markets could really move the needle on domestic demand in 2013. Meanwhile, the supply/demand balance in the U.S. appears to have stabilized, with capacity utilization moving back into the 70%-75% range after dipping below 70% in October.
Any concerns about the U.S. are playing second fiddle, however, with the World Steel Association lowering its 2013 demand growth expectations for most of the world, while raising the U.S. forecast. The outlook for Latin American steel demand remains strong, but China and Europe are less encouraging, particularly if raw material demand can be used as a gauge. Scrap exports from the U.S. plunged in recent months, with Europe and Asia the top destinations, and iron ore inventories at the major Chinese ports have also fallen sharply. Current forecasts for steel demand growth in Europe and China for 2013 are around 3%, but we believe these have more downside risk than forecasts for the U.S. and Latin America.
Our Top Basic Materials Picks
| Top Basic Materials Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
 | |||||
| Cloud Peak |  | $28.00 | Narrow | High | $16.80 |
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| Compass Minerals | | $93.00 | Wide | Medium | $65.10 |
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| Nucor | | $57.00 | Narrow | High | $34.20 |
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| Potash Corp. | | $50.00 | Wide | High | $30.00 |
| |||||
| Steel Dynamics | | $22.00 | Narrow | High | $13.20 |
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| Data as of 12-12-2012. |
Cloud Peak Energy
Cloud Peak is a pure play on Powder River Basin, or PRB, coal prices, which we believe will head much higher over the intermediate to long term. While investors wait for PRB coal prices to head higher, Cloud Peak should provide a relative safe haven to ride out current low domestic thermal coal prices thanks to the firm's sturdy balance sheet, low production costs, and conservative contract pricing. The company enjoyed a nice pop in its stock price after the firm released third-quarter earnings, but we still see considerable upside in Cloud Peak shares given our fair value estimate of $28 per share. Our investment pitch on Cloud Peak is largely driven by our bullish forecast for PRB coal prices, which are currently trading for roughly $10 per ton in the spot market. This price is significantly below the marginal production cost in the basin of roughly $11 per ton on a cash basis, in our estimation, and we regard this situation as being unsustainable. Also, with natural gas prices now hovering above $3.50 per million BTUs, we estimate that PRB coal would be cost-competitive versus gas in large regions of the country even if PRB coal prices were to rise to $15 per ton. Also, the U.S. Energy Information Administration expects domestic coal burn to increase 40 million-50 million tons in 2013 from 2012 given the unusually warm winter and low natural gas prices that prevailed earlier this year. In the meantime, we believe Cloud Peak's modest financial leverage, low-cost position in the PRB, and contract pricing that have fixed 2013 coal selling prices at favorable rates for more than 80% of the firm's estimated production next year, should help shield investors from low PRB coal prices over the near term.
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. Further, 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 that use ore mining or a chemical process. 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. Contract prices between highway deicing salt producers and government entities are determined during the summer bidding season. The mild winter of 2011-12 has resulted in excess inventory at both the producer and customer level. Customers have reduced their bid volumes for 2012-13 (they assume normal winter weather but adjust for inventory on hand). This has resulted in pricing that's weaker than the 3%-4% annual average increase that the industry is used to. Compass' earnings should grow 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.
Nucor (NUE)
Nucor's favorable cost structure and low financial leverage should withstand tepid U.S. steel fundamentals. Nucor's operational flexibility with a more variable cost structure and captive raw material sources help navigate a volatile demand environment and provide a hedge against the potential for higher raw material costs. Scrap costs have trended lower this year despite still strong iron ore and coking coal costs, which should play to Nucor's benefit as the company still depends heavily on ferrous scrap metal for its steel production. While flat-rolled steel has seen the most demand recovery due to strong auto and machinery sectors, Nucor still has considerable upside potential from its exposure to long products, which typically comprise 40% of sales and have less overcapacity risk. These products are more commonly used in the construction sectors, which have been anemic for the last three years. While an eventual recovery might still be a few years ahead, any signs of life there would be a bonus. Our fair value estimate for Nucor implies an EBITDA multiple only one turn above its historical average, a premium we think is justified in a year of cyclically low earnings. Further, with a conservative approach to financial leverage, Nucor has historically had one of the strongest balance sheets in our steel coverage. Nucor also has one of the highest dividend yields among developed-economy steel companies.
Potash Corp. (POT)
Potash Corp. is one of the lowest-cost producers of potash fertilizers in the world, and its capacity expansion projects should further entrench that competitive position. The company is nearing the end of its capital expansion program, leaving management and the board plenty of dry powder to further increase its dividend payments and initiate sizable stock repurchases. In our opinion, uncertainty concerning near-term potash purchases by India and China is holding down Potash Corp.'s stock price. Over the long run, we expect India and China will return to the potash market, as both countries will need to feed growing populations. Even given our forecast for potash price declines in the long term, we think Potash Corp. looks undervalued. The stock is currently trading at about 80% of our fair value estimate.
Steel Dynamics (STLD)
Steel Dynamics has been one of the most profitable U.S. steel producers during the four challenging years since the onset of the recession. As a relative newcomer to the steel sector and still in an early stage of its growth story, it represents an attractive way to play the cyclical upturn, in our view. With nearly 100% exposure to North America, the company is shielded from the most fragile regions, namely Europe and China. We expect another tepid earnings year in 2013 with midcycle margins unlikely to materialize before 2014-15, but there are a few earnings catalysts in the near term. Its largest capital project--the Mesabi Nugget iron ore operation--will begin to ramp up next year with low-cost iron concentrate that should yield some margin expansion. The company has invested in new retail yards and recovery technology to improve margins in metal recycling. Some of these initiatives will roll out in early 2013. On the demand front, steel consumption continues to gradually improve but Steel Dynamics has seen only the early signs of life from its largest end market, construction. The construction-focused Fabricated Products segment finally reported a profit for the last two consecutive quarters following three years of losses. Backlogs have steadily grown and while the pace is slow, Steel Dynamics is highly leveraged to any improvement in the U.S. construction markets. The company's balance sheet still carries a lot of debt at nearly 3 times trailing EBITDA, but we think this is manageable for a company that has not reported a quarterly loss since 2009 (a rare achievement across the steel sector) with 70% of capital spending on growth initiatives.
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