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Quarter-End Insights

Our Outlook for Basic Materials Stocks

China's appetite for commodities could lose some momentum in the fourth quarter.

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Most basic materials stocks staged an impressive rally during the third quarter. China's commodity purchases continued to provide a much-needed boost to weak global demand, although the pace of imports for copper and iron ore slowed in July and August compared with the record-breaking levels seen during the first half of the year. The restart of marginal Chinese iron ore mines is a likely contributor to the fall-off in iron ore imports. Meanwhile, increased copper scrap availability and the completion of a restocking program are likely causes of the easing in copper imports.

In addition to these relatively weaker imports, Chinese steel prices have recently taken a significant breather from their August high. Taken together, these factors could indicate that China's appetite for commodities will lose some momentum in the fourth quarter. Further, the fall in Chinese steel prices, combined with blast furnace restarts among steel producers in developed countries, could test North American steel prices in the very near term.

The potash industry is one area of basic materials that hasn't enjoyed a recovery yet.  Potash Corp. (POT), the industry leader, expects its potash sales volumes this year to be down about 60% versus 2008, marking the lowest level in well over a decade. The outlook for the remainder of the year looks dim, given expectations for a small fall application window in North America and weak commodity prices and cash constraints during South America's spring planting season. That said, we believe that science is still on the side of the fertilizer producers long term. A record crop in the U.S. will remove a huge amount of nutrients from the soil, nutrients that will ultimately have to be replaced to maintain the productive capacity of the land. Therefore, we continue to believe that a rebound in potash volumes remains a question of "when" and not "if." At this point, we think that the spring of 2010 will mark a turning point in the market.

The stage is set for a 2010 recovery in volumes in the domestic construction materials industry as well. By that time, we expect stimulus spending on roads and infrastructure and a recovery in residential construction to drive growth in demand for construction materials, which will be somewhat offset by declines in nonresidential construction spending. Starting in 2011, we expect an improving economy will support construction spending growth across end markets, including the nonresidential segment (which currently accounts for about 20% of demand for construction materials).

Meanwhile, the shape of the housing recovery matters quite a bit for wood products producers. With significant idle capacity ready to come online at a moment's notice, price increases this year and next will be very hard to sustain, throwing a wrench in efforts at margin improvement. For this reason, we continue to see significant downside risk for shares in financially fragile firms like  Louisiana-Pacific (LPX), which bank on a V-shaped recovery. We'd argue that wood products investors seeking exposure to the housing market's long-term upside are better served by investing in healthier enterprises such as  Weyerhaeuser (WY) that are better situated to weather a U- or W-shaped housing recovery.

Valuations by Industry
Most industries in the basic materials sector appear to be reasonably valued. On a market-cap-weighted basis, the agriculture industry continues to be relatively undervalued, while the paper industry appears relatively overvalued.

 Basic Materials Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%) Uncertainty Percentile**
Agriculture 3.66 0.86 0.89 -3.4 10.6
Building Materials 3.16 0.89 0.99 -10.1 39.47
Chemicals 2.81 1.14 1.03 10.7 76.6
Engineering & Construction 2.81 1.08 1.02 5.9 77.7
Metals & Mining 3.08 0.98 1.17 -16.2 44.7
Paper & Paper Products 1.83 1.50 0.87 72.4 100.0
Steel & Iron 3.04 0.95 1.04 -8.7 47.9

Data as of 09-14-09.
*Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

Basic Materials Stocks to Keep on Your Radar Screen
Given the fact that most of our coverage universe appears fairly valued today, we're taking this opportunity to highlight interesting and unique business models and special situations. We think it's a good idea to keep these companies on your radar.

Unlike the other fertilizer producers we cover, Agrium has a significant retail distribution network. Next we have Sasol, which converts lower-cost coal and natural gas into higher-value liquid fuel and petrochemicals. Meanwhile, Steel Dynamics is a smaller, low-cost producer of steel. And Weyerhaeuser will likely convert into a timber REIT. Finally, Yanzhou Coal is a low-cost coal producer in China with new and interesting growth opportunities in Australia.

 Top Basic Materials Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Agrium Inc. $50.00 None High $25.00
Sasol Ltd. $45.00 Narrow High $22.50
Steel Dynamics Inc. $18.00 Narrow High $9.00
Weyerhaeuser Company $50.00 None High $25.00
Yanzhou Coal Mining Company $12.00 None Very High $4.80

Data as of 09-24-09.

 Agrium (AGU)
From fertilizer manufacturing to retail seed sales, Agrium is well-positioned to capture value throughout the entire agricultural input chain. Agrium is North America's largest retail distributor of agricultural inputs. The distribution segment has a broad geographic footprint that gives it eyes and ears in the field and reduces its exposure to regional weather-related risks. This allows it to nimbly navigate local markets to more effectively address the unique needs of various regions, responding quickly to changing conditions in weather, soil, and insect and weed pressure.

Agrium's wholesale fertilizer business boasts some of its own advantages, primarily linked to its access to raw materials. The firm's nitrogen production, which accounts for roughly 60% of total segment output, enjoys cost-advantaged sources of natural gas in Canada and South America. This is a key consideration because natural gas constitutes 60%-80% of the total cash cost of nitrogen production. Agrium's potash unit, which has about 2 million metric tons of annual production capacity, is a solid gross margin contributor and should benefit from growth in global demand for potash in coming years.

Phosphates round out the firm's wholesale portfolio. We think a wave of capacity rationalization within the phosphate sector should make for more consistent profitability within this line in the future.

 Sasol (SSL)
Sasol has an established high-margin synfuels business producing liquid fuels and petrochemicals from low-cost feedstock, plus an option to grow via new coal-to-liquids (CTL) and gas-to-liquids (GTL) projects. The company mines more than 40 million tons of coal each year in South Africa, which it then uses as a feedstock (supplemented by gas) in its 160,000 barrel per day (b/d) Secunda, South Africa, synfuels facility to produce transportation fuels and petrochemical feedstock.

Sasol's polymers and solvents chemical plants are backward-integrated and feed off the petrochemical stream from the synfuels plant. Sasol's margins have averaged a handsome 20%-plus during the last five years because of the firm's lower-cost feedstock for the production of fuel and chemicals. Although a good chunk of the global supply base for these products uses oil as an input, Sasol's synfuels plants feed off coal and gas, which are typically less expensive than oil on a heating-value basis. Therefore, Sasol benefits from the spread between product prices which are influenced by oil and lower-cost coal and gas.

Sasol's opportunities for growth lie in new GTL and CTL projects, though the path ahead is paved with uncertainty. GTL is an option for resource holders looking to monetize abundant reserves of stranded gas, and Sasol is one of few players with GTL experience. Sasol is also pursuing a CTL feasibility project in China to tap into the country's abundant coal reserves.

 Steel Dynamics (STLD)
Steel Dynamics is one of the lowest-cost steel producers in the United States because its minimills produce steel from scrap and consume less energy in the production process than traditional integrated steel mills. Also, Steel Dynamics has relatively modern facilities compared with other minimills. This helps it register one of the highest operating profits per ton of steel sold among all domestic steelmakers.

 Weyerhaeuser (WY)
Once among the most diversified firms in the forest product industry, with product lines spanning paper, packaging, and lumber, Weyerhaeuser is on a dramatically different path after management's strategic shift. Not long after shedding its paper business, Weyerhaeuser cut another branch from its corporate tree, selling its packaging business to erstwhile competitor  International Paper (IP). The end game likely entails operation as a timber real estate investment trust in order to take advantage of associated tax benefits.

 Yanzhou Coal Mining Company (YZC)
Blessed with great assets in attractive locations, Yanzhou is an extremely profitable coal producer. However, as its mature production base is slowly declining, Yanzhou is hoping to rejuvenate itself with acquisitions, with the latest being the $2.9 billion handed out for Felix Resources in Australia.

Yanzhou's core assets consist of six underground mines characterized by high reserve quality and superb accessibility, making Yanzhou an admirably efficient operator. First, the majority of Yanzhou's output is high in heating content and low in ash and sulfur, attributes that command a premium in the market. Second, Yanzhou's mines possess extraordinarily thick coal deposits. Generally, the thicker the deposit, the easier and cheaper it is to extract the coal. In fact, all of Yanzhou's coal is produced using a special technique known as "longwall top coal caving." Virtually unique to China, this method is extremely efficient but can be used only with very thick and uniform coalbeds.

To offset the decline of its maturing core mines, Yanzhou is increasingly looking outside its home base, particularly in Australia. Thus, the Felix acquisition came as no surprise. Felix, unlike Yanzhou, has the potential to grow rapidly over the next several years as it develops its Moolarben mine in New South Wales.

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Elizabeth Collins has a position in the following securities mentioned above: WY. Find out about Morningstar’s editorial policies.