China Weighs Heavily on Basic Materials

• While the sector is far from deeply undervalued at a median price/fair value of 0.99, we see slightly more value in materials than in the market as a whole (median price/fair value of 1.06).
• China's real estate market continued to sag in the second quarter, weighing heavily on many metals prices. We expect this pressure to persist.
• In developed markets, construction activity remains well below prior high-water marks. But signs of life are emerging, manifesting in improved pricing for materials companies. 
• North American natural gas has been cheap for several years now, but the impact of low prices has yet to fully manifest in many industries. That's beginning to change as many of our companies are in the midst of growth projects aimed at leveraging this cheap energy source. 

 

The Chinese economy continued to decelerate in the second quarter, with weaker readings on everything from industrial production to retail sales. Much of the slowdown originates in a deceleration in credit expansion that began in the second half of 2013. No sector has been hit harder than real estate. Residential floor space sold dropped 9.2% in the first five months of the year, compared with an 18% increase in 2013. Meanwhile, residential floor space for sale increased 25%. Deteriorating demand amid swelling supply sets the stage for continued weakness in the third quarter.

This is particularly troubling given then importance of real estate to China's economy. On a direct basis, it's one quarter of all fixed-asset investment, which itself accounts for half of GDP. Both are outsize shares by global standards. Indirectly, real estate is even more important. Accounting for all the products and services that feed real estate development, from cement and steel to mortgage banking and home décor, the share of GDP swells to roughly one quarter. Then there are the knock-on effects of weaker real estate activity to worry about: Bank balance sheets, local government finances, and household wealth are all heavily leveraged on the real estate market.

The impact for commodities is significant as well. Real estate has been the single largest driver of China's demand growth. In the case of steel, real estate directly accounts for half of China's usage, which in turn accounts for half of global usage. The slowdown in real estate has already put significant pressure on prices for globally fungible commodities, including iron ore and copper. We do not expect that pressure to abate.

In most developed economies, construction activity remains well below precrisis levels. However, tentative signs of life are emerging and feeding through to regionally priced commodities with low value/weight ratios, such as cement. In the first quarter,  Cemex (CX) saw both volume and price growth on a like-for-like basis in cement, ready-mix concrete, and aggregates. Through the rest of 2014,  Lafarge is forecasting 2% to 5% cement volume growth across its markets, driven by U.S. residential and commercial demand, stabilization in Western Europe, and growth in most of its emerging markets, as well as improved pricing for both aggregates and ready-mix concrete.

Cheap North American natural gas continues to reshape the competitive landscape for several basic materials industries. In steel, a number of companies are exploring the opportunity to invest in the production of direct-reduced iron, which involves the reduction of iron ore by use of natural gas rather than metallurgical coal.  Nucor (NUE) is leading the charge, and the trend is likely to pick up steam in the years to come.

In chemicals, the shale gas revolution in the U.S. has caused a marked shift in the cost curve for global petrochemicals and nitrogen fertilizer. North American chemical producers continue to hold an input cost advantage over their European counterparts. Multiple companies are working on expansion projects in the U.S. Gulf Coast. We caution that strong chemical and fertilizer demand for natural gas in North America should have a positive effect on natural gas prices in the region, thus shrinking the current robust margins of North American petrochemical producers. Additionally, the glut of projects that have been announced in reaction to low natural gas cost threaten to create an oversupplied market, a situation that is all too common in fully commoditized markets.

Top Basic Materials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Newcrest Mining		22 AUD	None	High	13.20 AUD
Alumina		2.60 AUD	None	High	1.56 AUD
Rio Tinto		$70.00	Narrow	Medium	$49.00
Data as of 06-23-2014

 Newcrest Mining
Newcrest Mining Ltd. is engaged in exploration, mining, and development of gold and gold-copper concentrate in Australia, Indonesia, and Papua New Guinea. Its projects include Cadia Valley, Telfer, and Lihir, among others. Newcrest's long reserve and resource life is a key differentiator and supports future growth. The market is disinterested in the large reserve base, but it provides valuable long-term options.

 Alumina (AWC)
Alumina Ltd. is involved in bauxite mining and alumina refining, with some minor alumina-based chemicals businesses, aluminum smelting, and the marketing of those products. Five of AWAC's eight refineries are in the lowest-cost quartile globally, and the company is firmly in the bottom half of the cost curve. Meanwhile, the ongoing move toward spot alumina pricing following the gradual breakdown of aluminium-referenced alumina contracts should underpin solid price growth.

 Rio Tinto  (RIO)
Rio Tinto PLC is an international mining group engaged in finding, mining, and processing the Earth’s mineral resources. Its main products are bauxite, alumina, copper, gold, molybdenum, silver, nickel, diamonds, and rutile. A world-class asset base and capable management make Rio Tinto one of the few miners to earn more than its cost of capital through the commodity cycle.

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