Our Outlook for Basic Materials Stocks

China continues to lend support to the basic materials sector, and deal activity is heating up

Elizabeth Collins, CFA 30 September, 2010 | 11:47AM
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Despite early-summer concerns about China's economy and the government's efforts to cool property markets, subsequent economic releases have shown strong fixed asset and industrial production growth year-to-date. Meanwhile, the government's steps to increase energy efficiency and trim emissions by enforcing production cuts in steel and aluminium are bolstering the fortunes of global producers. Overall, the basic materials complex remains highly leveraged to China given OECD's relative weakness, so any reversal of these trends would likely pressure commodity prices, earnings, and share prices.

Meanwhile, diversified global miner BHP Billiton has made a hostile takeover attempt for fertiliser producer Potash Corp, and robust gold prices are enhancing the yellow metal miners' ability and willingness to pursue acquisitions at seemingly premium valuations. Will this deal mania spill over into other parts of the basic materials sector? Few companies have the balance-sheet strength to pull off a deal the size of BHP's attempt at Potash Corp, so medium-sized transactions will likely be the name of the game.

Finally, we note that with the change in the pricing mechanism for seaborne iron ore earlier this year, the steel industry is likely to see increased volatility in the future. Now, quarterly contacts are based primarily on the average spot price of iron ore for the three months prior, with a one-month lag. One result of this new mechanism is that it creates the incentive to overproduce steel during periods of rising spot iron ore prices, setting up cycles of greater volatility in prices for steel and raw materials.

Industry-Level Insights
The China story remains dominant in the base metals space, as markets continue to exhibit the sort of sensitivity to Chinese economic releases once reserved for US data points. This is not surprising given China's preeminent status as a metals consumer. Concerns about a slowdown in Chinese demand--which were prevalent in the second quarter--seem to be diminishing with each economic release, pushing copper prices higher. Chinese fixed asset investment growth (up 25% year to date through August) and industrial production growth (up 17%) both remain strong. Needless to say, given the support the Chinese economy has lent to big red metal prices and producers, a significant slowdown in either of these key economic metrics could result in a pullback in copper prices and the shares of producers such as Freeport-McMoRan and Southern Copper.

Meanwhile, data coming out of China have been less kind to iron ore (but friendly to global steelmakers; see more on that below). Chinese crude steel output growth has slowed in recent months. After growing 21% year to date through June, steel output fell 2% year over year in July and 1% in August, according to China's National Bureau of Statistics. Spot iron ore prices have dropped as a result, setting the stage for a pullback in fourth-quarter contract prices (which will be set according to the average spot prices prevailing in June, July, and August). Considered in the context of strong industrial output and fixed asset investment data, and the steel price increases that have accompanied the output declines, we'd caution against viewing the negative numbers as a sign of mounting end-demand weakness in China. Rather, government orders to close old steel mills (to reduce energy consumption) by the end of September likely account for some of the pullback.

Strong commodity prices continue to swell the cash hoards at global mining companies. With balance sheets considerably stronger than mere quarters ago, management teams find themselves coping with the kind of problem they couldn't have imagined in the depths of the crisis: What to do with all that cash? Big M&A seems increasingly enticing. Which begs the question: Could BHP Billiton's massive cash bid for Potash be a sign of things to come? Probably not. Few in the industry have the balance sheet strength to put together a takeout bid on par with BHP Billiton's. In addition, shareholders of companies that "bought high" in the last cycle (e.g., Teck's acquisition of Fording, Vale's acquisition of Inco, Xstrata's acquisition of Falconbridge, Rio Tinto's acquisition of Alcan) would likely raise quite a stink over a big, pricey deal. Consequently, we expect mid-sized deals will be the name of the game in the coming quarters. The wheels will be greased by credit markets that continue to exhibit a ready willingness to lend to mining companies at attractive rates, so taking on a modest amount of additional leverage to consummate a deal wouldn't be out of the question.

US steelmakers recently offered updated third-quarter guidance that paints a gloomy picture of weaker demand and lower margins compared to the second quarter. While the magnitude of the earnings decline may be a bit more than the market originally expected, we believe this is mainly old news--confirming initial guidance given during last quarter's earnings results as well as the dynamics we have seen in the marketplace.

Capacity utilisation in the US dropped to around 70% in August compared with 75% in June; iron ore prices jumped more than 20% in the third quarter, while average steel prices are down 15%. The combination of weaker steel prices and utilisation coupled with stronger iron ore prices will certainly be felt on the bottom line. However, we continue to maintain that the third quarter represents a blip rather than a trend. The months ahead look brighter with steel prices already rising from their August lows, input costs expected to fall, and production rates starting to climb as we move out of the late summer seasonal slowdown.

The mills appear to agree. Steel Dynamics said current order rates for flat-rolled steel are stronger than at the beginning of the quarter and earnings at its metals recycling segment should improve if current conditions persist. China gives us even more confidence as steel output declined for the third consecutive month to 1.67 million metric tons per day in August. We expect this trend to continue into September as previously announced electricity controls take effect, reducing China's oversupply of steel and supporting steel prices globally.

Aluminium market trends largely echo those in steel markets, with slight price declines since the second quarter and little relief on the cost front. However, as in global steel markets, China's recent moves to force energy efficiency by shutting down aluminium production give us some reason for optimism. Indeed, China's production of primary aluminium in August was down 5% from July's levels.

Paper and Packaging
Thanks to supply rationalisation, lean inventories, and strengthening demand, paper and packaging producers did quite well during the summer of 2010. Pulp and containerboard prices rose strongly in early 2010, and even surpassed pre-recession peaks. Meanwhile, uncoated free sheet paper prices--while not as strong as pulp and containerboard prices--still recovered nicely in 2010 and are roughly flat compared with peak-2008 levels. Major industry players have themselves to thank (with a small nod to strengthening demand, of course); industry leaders took economic downtime during the recession to prevent an excessive build-up of inventories, and the result was much healthier margins in early and mid-2010.

Looking ahead, however, containerboard producers are looking at announced price increases that have failed to take hold and inventory levels that are slowly creeping up. August's attempted containerboard price increase was unsuccessful. Supply and demand dynamics are instrumental in the success or failure of price increases, and since inventories hit record-low levels of 3.2 weeks' supply in May, 2010 stockpiles have grown to 3.9 weeks in August and could climb higher in September as containerboard buyers stockpiled inventory in attempts to beat the failed price increase. This means that pricing as well as profitability could come under pressure for containerboard producers.

Engineering and Construction
Engineering and construction companies in our coverage universe have fared reasonably well after the recent downturn, mostly because of their high backlogs and record level of cash balances. We expect them to have stable revenues generated from existing long-lifecycle projects and a slight uptick in new orders because of relatively healthy key commodity prices and government stimulus funding.

However, companies with more diversified project portfolios (including work in the government, infrastructure, mining, and energy industries) will improve faster than companies that are heavily concentrated in commercial and residential construction areas.

Our Top Basic Materials Picks
The last two years have been difficult for steel producers, and a brighter picture is still off in the distance. Although we believe that consumption has bottomed and is rebounding, the journey to recovery is going to be slow. However, this doesn't mean decent profits are a pipe dream. Thanks in large part to China, industry fundamentals are slowly improving, but it is often a game of two steps forward and one step back, especially when you look at how steel prices and raw material costs have behaved this year. No matter which way demand and prices are headed, the best any steel company can do in this environment is prepare for volatility. Steel Dynamics and Nucor are two companies we believe are prepared to deal with this volatility.

We are also highlighting label-maker Avery Dennison, as well as two miners--Teck and Xstrata--which focus on copper and coal.

Xstrata Since assuming control of the company in late 2001, Xstrata's management team has demonstrated a penchant for M&A. This strategy served investors spectacularly well during the upward march of commodity prices through mid-2008, but it left the firm undercapitalised when the downturn hit, forcing Xstrata to tap shareholders for additional capital when it was most precious. Going forward, we expect the primary path to expansion will come from brownfield and greenfield options accumulated from prior purchases rather than further forays into M&A. As such, in contrast with prior years, the biggest risk facing Xstrata will be execution-related, particularly as it pertains to ambitious greenfield projects like Koniambo (a laterite nickel project in New Caledonia) and Las Bambas (a copper porphyry project in Peru).

Teck The worldwide search for economically viable mineral deposits often brings mega-miners to far-flung locales where success depends on the goodwill and good faith of governments that have historically possessed such qualities in short supply. This kind of country risk is a lesser concern for Teck, whose assets are mostly in jurisdictions with well-established legal and political institutions, such as Canada, Chile, and the United States. While these jurisdictions, like any other, extract a portion of the economic rents accruing to the resource in the form of royalties and taxes, policy implementation tends to be consistent and the possibility of outright expropriation remote.

Steel Dynamics Mini-mills such as Steel Dynamics will generally outperform their blast furnace competitors in a quickly changing environment due to lower operating leverage. The company is also very well-managed. Steel Dynamics only lost $0.04 per share in 2009 on a 51% decline in revenue, when most competitors posted significant losses.

Nucor Nucor has substantial product diversification, with not more than 30% of total sales generated by any major product group. A highly flexible production process and efficient labour allow Nucor to almost instantaneously adjust output to match market demand. Nucor also has superior financial flexibility, and has strategically timed debt and equity raises in the past few years, whereas many cash-strapped rivals found themselves cornered into raising equity at depressed prices.

Avery Dennison We believe that Avery Dennison's scale and focus will enable the firm to continue to outearn its cost of capital. The company's size and scope in the markets of pressure-sensitive materials, or PSM, and labels and tags are unmatched. Already Avery has about two thirds of its revenues coming from outside its domestic market (the US), and we believe international opportunities will continue to spawn future growth for the company's top and bottom lines.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Elizabeth Collins, CFA  is an associate director of equity research with Morningstar.

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