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Quarter-End Insights

Our Outlook for Basic Materials Stocks

China's expected infrastructure spending slowdown should pressure commodity prices.

Elizabeth Collins
  • North American farmers have the means and the incentive to utilize a good amount of agricultural inputs this year.
  • Chemical firms are combatting continued soft end markets in Europe with restructuring and cost cuts.
  • China's expected infrastructure spending slowdown should pressure commodity prices, but this could create an attractive opportunity in low-cost miners’ shares.

 

It seems hard to find many bright spots in basic materials companies’ near-term outlooks this quarter. For China--the primary driver of many companies' earnings power--we expect a slowdown in the infrastructure spending that had significantly boosted demand for several commodities in the past decade. European end markets remain weak, which is hurting the chemical companies and building materials firms with exposure there. The European situation is even more dire for papermakers, as weak demand is both cyclical and secular, given that electronic media is replacing printed material. Finally, while we expect a near-term boost to demand for potash fertilizer as China and India return to the market this year, we ultimately expect a slight decrease in potash prices as supply growth outpaces demand increases.

However, there are some causes for optimism. We expect aluminum prices to eventually increase materially. While we agree that near-term aluminum prices are likely to remain volatile, our long-term price forecast for aluminum is $2,400 per metric ton (in real terms). Our price forecast is supported by our expectations for continued robust demand growth, cost support, and capacity closures following an end to irrational production by loss-making smelters. We’re also bullish on U.S. residential construction activity, given strong demographically driven demand for new homes. In agriculture, we expect strong demand growth for high-tech seeds, which should benefit companies like  Monsanto ,  DuPont , and  Syngenta . And last but not least, we're positive on Powder River Basin coal prices, which we think are unsustainably low, given their cheapness compared with natural gas prices from an electricity generation standpoint.

Further, we think this general lack of enthusiasm for basic materials companies’ outlooks means that we could see more opportunities to invest in producers whose long-term profits are protected by economic moats, or sustainable competitive advantages. If investors’ expectations overshoot to the downside, we anticipate more chances to invest in cost-advantaged commodity producer shares. For example, we’ve recently seen shares for  Vale (VALE)—the Brazilian iron-ore mining giant—drift lower relative to our fair value estimate. This is a company we’d be very interested in at the right price, given its cost-advantage-based narrow economic moat.

Farmers in North America got off to a later-than-normal start to spring planting this year, as wet and cold weather kept growers out of fields. Coupled with an exceptionally early start to spring planting a year ago, the late start pressured year-over-year comparisons for several agricultural input producers. We see this is a timing issue and still expect a strong season for crop inputs in North America, as farmers strive to rebuild depleted stocks and benefit from continued high crop prices. Farm income remained solid in 2012, as yield declines were offset by higher selling prices. Thus, we're not expecting last season's drought to hurt 2013 purchases of crop inputs.

Volumes for potash producers have rebounded with strong demand from China and India. Further, volumes to North American customers have also seen gains with farmers set to plant another big crop this season and potash dealers carrying limited inventory into 2013 compared with last year. Despite the higher volumes, potash prices have been pressured, with the major potash marketing organizations--Canpotex and BPC--employing price cuts to entice buyers back to the market. We think prices could firm up later in the year as a result of better demand, but long term, we expect additional pressure on prices as supply grows faster than demand.

Industry-Level Insights
Chemicals
Chemical producers continued to deal with soft end markets, particularly in Europe. Companies continue to restructure operations and cut costs to grapple with the current environment. For  Dow Chemical (DOW), these cuts paid off as the company was able to drive first-quarter adjusted EBITDA up 10% compared with the previous-year period, despite sales that were down roughly 2% year over year. Further, North American petrochemical producers continue to benefit from cheaper input costs compared with their European counterparts.

Chemical companies with exposure to housing and construction are starting to finally see a turnaround, with signs of a housing recovery more apparent. In the long run, companies will continue to look to specialty products for higher margins and less cyclicality, in particular crop chemicals and genetically modified seeds. Dow and DuPont both posted solid agriculture results in the first quarter of 2013, and we're expecting continued strength through the remainder of the year.

Forest Products
European forest products companies  Stora Enso (SEOAY) and  UPM-Kymmene (UPMKF) continue to seek calmer waters amid a secular decline in developed market printing and publishing paper demand and a stubbornly weak European economy. The European paper industry is in the midst of sweeping capacity closures to better match supply with demand and boost mill utilization rates. Though we think these moves are very necessary to improve industry profitability in the short-term, we think further cuts and consolidation are necessary for the European paper industry participants to generate returns near their costs of capital. Both Stora and UPM are hoping that emerging market investments and nonpaper operations will offset some of the weak European demand, but we would prefer to see Stora and UPM instead further consolidate the European paper industry.

Even though Brazil-based eucalyptus pulp producer  Fibria Celulose has made substantial progress with deleveraging its balance sheet over the past year, it aims to sell another $500 million worth of land to further deleverage and potentially bring its credit rating to investment grade. We think the low-cost producer of eucalyptus pulp has been operationally quite strong in recent quarters having kept a lid on cash costs and generating consistent free cash flow. Fibria has also benefited from higher eucalyptus pulp prices in recent quarters, but a number of large eucalyptus mills are starting up and the new supply will likely restrict the industry's ability to further raise prices in the near-term. We also believe Fibria will increase its own capacity through brownfield expansion over the next few years. With significant potential for a eucalyptus pulp capacity rush to ensue in the coming years, we believe investors considering this narrow moat name should demand a large margin of safety before buying.

Metals and Mining
The second quarter of 2013 wasn't terribly kind to mined commodities or the shares of their producers. Copper prices now sit around $3.20 per pound on COMEX as of June 17, off 7% from $3.43 at March 31. Iron ore at $115 per metric ton according to TSI is down 16% from $137 to begin the quarter. On a combined basis, these two commodities underwrote a majority share of mining industry profits amid the multi-year commodity boom. Shares of most major diversified miners have sagged in sympathy with prices for their flagship metals, falling between 10% and 15% in the quarter.

We don't expect much let-up in the third quarter, as the principal drivers of second-quarter weakness show little sign of abating. The Chinese economy, after a shot of infrastructure adrenaline in the fall of 2012, has been on a path of decelerating growth. Barring a return to the old stimulus playbook, China looks unlikely to exhibit the sort of investment-heavy growth needed to accelerate demand for "hard" commodities like copper and iron ore. Meanwhile, supply additions plotted amid the heady environment of the past several years will continue to come online in the remainder of 2013. To us, this looks like a recipe for further pricing pressure.

We'll be on the lookout for buying opportunities in such an environment, as mining shares can have a habit of overshooting when shareholders run for the exits. Our bias will continue to be toward low-cost producers that could sustain a lengthy slump in prices, such as low-cost iron ore miner Vale. We're also interested in producers that play in commodities less tied to the fortunes of Chinese infrastructure and real estate spending, a category that would include a name like uranium miner  Cameco (CCJ).

Top Basic Materials Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Allegheny Technologies $39.00 Narrow High $23.40
Cloud Peak $28.00 Narrow High $16.80
Intrepid Potash $24.00 Narrow High $14.40
Vale $19.00 Narrow High $11.40
Vulcan Materials $65.00 Wide Medium $45.50
Data as of 06-18-2013.

 Allegheny Technologies (ATI)
Allegheny's near-term profits have been subdued, but the long-term demand picture looks promising. The company's profits have slipped in recent quarters as project delays, customer destocking, and low base prices for stainless steel products have dented results. We still expect the firm will benefit over the next few years as large commercial aircraft manufacturers work through considerable backlogs. Its titanium and nickel alloys are making their way into more parts of an airplane, as plane makers demand lightweight and heat-resistant metals to improve jetliner fuel efficiency. Also, the recent acquisition of Ladish adds to Allegheny's specialty portfolio and increases exposure to the aerospace market. With long-term contracts in place, we think Allegheny will ride the wave created by more plane builds. For example, Boeing recently extended its titanium product supply agreement with Allegheny to run through 2018. Surcharge pricing helps Allegheny weather spikes in scrap and metals used as raw materials. In fact, Allegheny generally performs better when metal prices are high, as this can be a sign of strong demand for its downstream products. Its narrow economic moat gives us confidence that the company will grab its share of the growing aerospace market. We think the high-performance metal business benefits from switching costs, and competition in the industry will be largely limited to existing players. In our opinion, switching costs are high for specialty metals because of the critical nature of the materials.

 Cloud Peak Energy  
Cloud Peak is a pure play on Powder River Basin coal prices, which we believe will head much higher over the next couple of years. While investors wait for PRB coal prices to rise, Cloud Peak should provide a relative safe haven to ride out current low domestic thermal coal prices, thanks to its sturdy balance sheet and low production costs. Our investment pitch on Cloud Peak is largely driven by our bullish price forecast for PRB coal, which is trading for just over $10 per ton in the spot market. This price is below the marginal production cost in the basin of more than $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 near $4 per MMBtu, we estimate that PRB coal is cost-competitive versus gas in large regions of the country even if PRB coal prices rise to $15 per ton. The huge disconnect between PRB coal's current price and what it should fetch relative to stronger natural gas prices is probably caused by bulging coal stockpiles among the domestic utilities, and PRB coal prices should spike higher once this inventory overhang is removed. Domestic coal burn should increase in 2013 relative to 2012, thanks to the unusually warm winter and low natural gas prices that prevailed in early 2012. This forecast increase in domestic coal burn coupled with stagnant domestic coal production growth in 2013 should help coal inventories to fall to more normalized levels over the next several quarters, clearing the way for PRB coal prices to move higher, which should correspondingly benefit Cloud Peak.

 Intrepid Potash (IPI)
With potash mines close to its U.S. customers, Intrepid benefits from lower freight costs and higher realized sales prices compared with companies operating Canadian mines. Intrepid is a small player in the potash market, but that does not preclude it from benefiting from positive industry dynamics, including barriers to entry and oligopolistic pricing behavior. In fact, Intrepid can actually benefit as a smaller player. While  Potash Corporation of Saskatchewan (POT) and other large producers generally curtail production during periods of weak demand in an effort to preserve pricing, Intrepid can continue to run its mines at high operating rates because its production makes up such a small portion of global production. In this regard, Intrepid can be a sort of free rider. Intrepid's potash costs per ton should start to decline in 2014 with the ramp-up of production at the company's new solar solution facility. This new facility (and its ability to lower the company's production costs per ton) is the main driver of Intrepid's positive moat trend. However, the project also brings a substantial level of risk to an investment in Intrepid. The capital expenditures for the project could increase, and the new supply makes it more difficult to predict long-term operating costs for Intrepid.

 Vale (VALE)
As the world's largest iron ore producer and the most iron ore-reliant of the major diversified miners, Vale's fortunes are inseparably linked to the sustainability of China's investment-led growth model, which has pushed China's share of global iron ore demand to two thirds. We expect significantly lower Chinese fixed asset investment growth in the years to come as the country rebalances toward consumption, hitting iron ore prices hard as new supply comes on line, thereby pressuring profits at Vale. But by virtue of an enviable cost position--the basis of our narrow-moat rating--such a development is far from the existential threat it might be for higher cost producers.

 Vulcan Materials (VMC)
With the passage of a highway bill in mid-2012 and the recent uptick in residential construction (although from an extremely low base), the outlook for aggregates demand is brighter than it has been for several years. During the downturn, Vulcan Materials and its peers worked hard to lower operating costs and maintain pricing power. Many of these efforts seem to have been successful. As construction activity and Vulcan's sales volume gradually improve, the lower costs and higher prices should have a powerful impact on profits. We expect Vulcan's profit margins to eventually improve considerably from their currently depressed levels. The past few years have shown that Vulcan's profits are subject to powerful cyclical forces. For example, returns on invested capital are currently falling short of the cost of capital. However, we think that in a normal demand environment, Vulcan should post strong economic profits. And thanks to its wide economic moat, these returns should be sustainable long-term. As proof of Vulcan's moat, despite the severe downturn in demand for aggregates, pricing has remained mostly intact thanks to industry consolidation, a low value/weight ratio, barriers to permitting new quarries, and flexible production methods. Our fair value estimate is based on the assumption of an eventual return to more normal circumstances.

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