Basic Materials: Recent Commodity Rallies Leave Few Opportunities

• Optimism continues to reign in the basic materials sector year to date, but investors are overestimating the sustainability of recent commodity price rallies. The basic materials sector remains severely overvalued, with a market-cap weighted price/fair value estimate of 1.26 as of May 31.
• The reasons for rallies in steel, iron ore, and gold differ, but we don't expect any of the price gains to hold. Limited impact from steel trade cases and significant oversupply will bring pain to steelmakers and iron ore miners, respectively, in the second half of 2016. The recent Brexit vote helped extend the 2016 gold rally as interest rate hikes are potentially delayed through the second half of the year. However, pending rate hikes--though now further out--still weaken the outlook for gold miners into 2017.
• While multifamily starts and permits have slowed down amid tighter lending standards, strengthening housing formation still bodes well for housing starts in the long term.
• A bumper crop of seed and crop chemical mergers is reshaping the industry as competitors try to jumpstart their businesses amid a stagnant operating environment. However, consolidation is unlikely to generate significant synergies or improved competitive positioning.

 

Optimism continues to reign in the basic materials sector year to date, but investors are overestimating the sustainability of recent commodity price rallies. The basic materials sector remains severely overvalued, with a market-cap weighted price/fair value estimate of 1.26 as of May 31. Nevertheless, the sector is not without opportunity, as U.S. housing still offers significant upside for investors.

Mergers and acquisitions have significantly picked up in seed and crop chemicals. But consolidation is unlikely to either generate significant benefit for the combined companies or destroy shareholder value.

Steelmakers have rallied sharply year to date, but we maintain a negative outlook on the steel industry. Every U.S. steelmaker under our coverage is trading well above our estimate of fair value, and we urge investors to approach the space with caution. We argue that U.S. steel prices are at or near a cyclical peak and will likely decline materially by the end of 2016. In our view, the benefits of steel trade cases that are currently under investigation will prove less impactful than many investors expect. Additionally, market fundamentals remain highly unattractive amid weak demand and massive overcapacity in China. Looking forward, improved second-quarter earnings results that will be filed in late July might inspire hope that a recovery is in store. However, we anticipate that market conditions will deteriorate in the second half of the year and see more pain ahead.

Although the iron ore rally has lost some steam, we think the decline in prices isn't done. After rallying more than 80% from their December trough to a peak of $69 per metric ton in April, iron ore prices have since given back some ground to trade around $50 per metric ton. Still, we see more downside as the long-term outlook for demand remains weak. The recent acceleration in Chinese fixed asset investment, driven by debt-burdened SOEs, looks fragile. Meanwhile, private FAI continues to decelerate.

We continue to expect Chinese steel demand to decline by roughly 60 million metric tons by 2020, with iron ore demand faring worse as scrap availability improves. Despite tempering near-term production expectations, the major miners ( BHP Billiton (BHP),  Rio Tinto (RIO),  Vale (VALE), and  Fortescue (FMG)) continue to grow production and reiterated their long-term volume targets. The recent rally in iron ore prices has also increased the likelihood of smaller, higher-cost iron ore miners to remain in or return to the market, exacerbating the supply glut. We continue to believe iron ore prices should fall to $35 per metric ton in 2017 and to $30 per metric ton (in real terms) by 2025.

The massive 2016 gold price rally has continued to hold. Furthermore, the June jobs report spooked the Federal Reserve, with chances of rate hikes falling amid much weaker-than-expected job creation in May. Worse still, the passing of the June referendum for the United Kingdom to leave the European Union severely hurt the chances for interest rate hikes this year.

Although the outlook for rate hikes in 2016 is now more muted, we think rate hikes will at least continue in 2017, which leads to a weaker outlook for gold. When it comes to gold investment, it's not just interest rates that matter, but inflation, too.

While unemployment and Brexit have caused a change in the rate outlook, inflation weakness continues to linger, as well. While flat rates mean it remains relatively "cheap" to hold gold for now, its attractiveness only improves if inflation rises, too. We continue to consider gold and gold miners overvalued given what we see as over-exuberant market views on future interest rates.

In one of the few bright spots in basic materials, we continue to see opportunity in U.S. housing. In the first four months of 2016, multifamily residential starts and permits have contracted amid apparently tighter lending standards for new projects. As a result, we've reduced our residential construction forecast to 1.22 million starts in 2016, down from 1.30 million starts. While a decrease of 80,000 starts may appear substantial, we believe this merely represents the continued deferral of household formation. Our long-term outlook on U.S. housing remains unchanged. We continue to expect starts to peak at nearly 1.9 million in 2020, as household formation strengthens amid tighter labor markets and looser financial constraints. Longer term, we expect starts to fade to 1.5 million as this source of pent-up demand is fully exhausted.

A stagnant operating environment has driven a recent bumper crop of seed and crop chemical deals, poised to reshape the industry. Yet in contrast to emerging consensus, we doubt the integrated seed-chemical model is likely to generate meaningful synergies or strengthen competitive advantages. For example,  Syngenta (SYT) has employed an integrated model for years with middling results compared with its agriculture peer group. We do think that agriculture moats could be strengthened and even widened through long-term innovation that develops novel seed and crop chemical systems similar to Roundup, but we question whether merger and acquisition activity is necessary to achieve these benefits. We view collaborative agreements, which are common in the industry, as a cleaner and more effective path to innovation.

Still, we don't view the deals as value destructive, as they occur amid a cyclical trough for the industry and fairly depressed share prices. We doubt antitrust regulators will stand in the way of the consolidation trend as product overlap between the various merger partners is fairly limited. Modest seed divestitures would allow the  Bayer (BAYRY)/ Monsanto (MON) and  Dow (DOW)/ DuPont (DD)  deals to clear regulatory hurdles. The likelihood of the ChemChina/ Syngenta (SYT) deal closing is only a coin flip because of U.S. government scrutiny of a Chinese acquisition.

Top Picks

 Canfor (CFP)
Star Rating: 5 Stars
Economic Moat: None
Fair Value Estimate: CAD 26
Fair Value Uncertainty: High 
Consider Buying: CAD 15.60

Canfor is a softwood lumber company that also owns around half of Canfor Pulp. It is active throughout North America, with lumber mills in British Columbia, Alberta, and the Southeastern United States.

We like Canadian lumber producer Canfor for its leverage to U.S. housing. Rising housing starts should lead lumber demand higher, driving up industry capacity utilization and, with it, prices. Our bullish housing outlook is predicated on the notion that tighter labor markets and improved mortgage availability will unleash enormous pent-up demand from the extended housing bust. Canfor is particularly attractive in light of recent poor share price performance, which is disconnected from fundamentals. As of June 10, shares are down 46% from June 2015. Meanwhile, framing lumber prices are up 13% from the same period last year. As momentum continues to build for U.S. housing, we see nearly 85% upside in the stock.

 Cameco (CCJ)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $18
Fair Value Uncertainty: High
Consider Buying: $10.80

Cameco produced 27.2 million pounds of uranium in 2015, making it one of the world's largest uranium producers. The flagship McArthur River mine in Saskatchewan accounted for 50% of output. Cameco intends to increase annual uranium production substantially over the next several years. In addition to its large uranium mining business, Cameco owns a uranium marketing business and operates uranium conversion and fabrication facilities.

Shares of blue-chip uranium miner Cameco have fallen in concert with the rest of the mining sector over the past two years, losing nearly 50% of their value in the process. Cameco's sympathetic sell-off affords investors an attractive entry point into one of the last remaining China-led commodity growth stories. While China's structural slowdown will continue to weigh on the mining industry's main moneymakers--copper, coal, and iron ore--the country's uranium demand is set to quadruple over the next decade. We expect Cameco to outperform mining industry peers over the next several years as impending uranium supply shortfalls catalyze higher prices and a re-rating of Cameco shares.

 West Fraser Timber (WFT)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: CAD 60
Fair Value Uncertainty: High 
Consider Buying: CAD 36.00

West Fraser Timber is a softwood lumber company that also produces wood panels and pulp products. The company is active throughout North America, with lumber mills in British Columbia, Alberta, and the southeastern United States.

The firm is well positioned to take advantage of rising U.S. housing demand. Nearly 40% of lumber capacity now resides in the southeast United States, close to its core end use, U.S. housing. A swelling portion of the population is now entering their peak homebuying years, and this will be further incentivized by easing loan standards and rising wages. West Fraser trades at a nearly 45% discount to our fair value estimate, out of step with lumber and panel prices, which remain above levels seen last summer.

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