Our Outlook for Basic Materials Stocks
Supply and demand should eventually respond to today's high commodity prices.
Nearly across the board, prices for basic materials commodities have been quite strong in the early part of 2011. In some cases, tight supply is driving robust prices. This is certainly the case for crops and coal, for example. In other cases, strong end-market demand is partly to thank--we'd highlight the chemical industry here. In fact, most end markets for basic materials producers have been very solid, with only a few, albeit glaring, exceptions: construction activity and paper demand, primarily in mature markets.
Strong demand and increasing prices are allowing basic materials producers to mostly absorb cost increases for everything from energy to labor. Given the cyclicality of the sector, higher prices should eventually drive one or two changes: First, commodity producers will work furiously to expand supply. We highlighted these moves in our last sector outlook. Second, consumers may begin to purchase less in response to higher prices. However, we've only begun to hear the rumblings of concern over demand destruction. Further, significant supply expansions will take time. Therefore, relatively strong prices should largely continue for at least a few more years, barring any major shifts, such as a significant slowdown in Chinese fixed asset investment, for example.
Prices of most major field crops--including corn, soybeans, wheat, and cotton--have been on quite a bull-run since mid-2010. According to the latest estimates provided by the U.S. Department of Agriculture (USDA), the stocks-to-use ratio (a measure of supply and demand that historically exhibits negative correlation with crop prices) for U.S. corn is 5.0%, its lowest level since the 1995-96 growing season. For soybeans the U.S. stocks-to-use ratio stands at 4.2%, the lowest figure on record. Low stocks and high crop prices send strong signals to farmers that agricultural inventories must be rebuilt. As a result, more acres should be planted in 2011. The USDA's chief economist expects 9.8 million additional acres, a 4% increase over the prior year and the largest year-over-year increase in the U.S. since 1996. With more acres planted, we expect sales volumes for crop inputs, such as fertilizer, seed, and crop chemicals, will increase. High prices also spur growers to increase yields through greater use of agricultural inputs.
On the company level, we saw high crop prices (and expectations that high prices will persist) drive strong fourth-quarter results for crop-input producers and sellers, including Potash Corporation of Saskatchewan (POT), Agrium (AGU), and Mosaic (MOS). Market dynamics are strong for all three primary crop nutrients (nitrogen, phosphate, and potash). In addition to fertilizer producers, makers of crop chemicals and genetically modified seeds--including Monsanto (MON), DuPont (DD), and Syngenta (SYT)--should also benefit this year from increased acreage and the desire to increase yields.
Although near-term prices may show high volatility, we think high crop prices will continue well into 2011 and perhaps beyond. In our opinion, even a bumper harvest around the world may not return agriculture ending stocks to more normal levels. Thus any further adverse weather could send crop prices even higher this year. Finally, a further rise in oil prices would likely boost ethanol demand, and thus corn prices, further improving the outlook for crop input producers.
Additionally, we will be keeping an eye on the unfolding situation in Japan following the devastating earthquake and tsunami. Without enough arable land to feed its population, Japan is the world's third-largest importer of agricultural products. The U.S. Grains Council has noted that ports, feed mills, and livestock operations in northern Japan have been damaged. A decline in global grain trade is a negative for agricultural traders such as Archer Daniels Midland (ADM) and Bunge (BG). That said, these companies are sometimes able to benefit from market dislocations, and potential opportunities could arise. Finally, crop prices could see near-term weakness if feed mill and livestock operations in Japan are significantly impacted. Japan is the largest importer of U.S. corn, and it also ranks high in wheat and soybean imports.
There are signs that U.S. demand for building materials should be less dismal in 2011. Residential construction activity should continue to improve, although the expected growth is coming off a very small base. Given the slowing in the rate of decline in contract awards for private nonresidential construction, this sector could finally turn the corner in 2011. However, this would probably be a second-half phenomenon, given the area's leverage to employment growth and lending activity.
Last but certainly not least, public construction activity, most importantly for highways, should continue to support demand for aggregates in 2011, as long as Congress is forthcoming with the continuing resolutions necessary to keep funds flowing until a multiyear highway bill can be agreed upon. Longer term, it seems clear that industry and Congress will need to be more creative with funding mechanisms for highway construction, given that the fuel tax that funds the program is not enough to cover current spending, and most politicians seem loath to raise the gas tax. Public-private partnerships (toll roads) are common and effective in Canada and Europe, and industry and Congress might look to these mechanisms to fund improvement for infrastructure, which most agree is in a sorry state.
Similar to the third quarter of 2010, many chemical makers dealt with higher raw-material costs in the fourth quarter, and the rising price of oil means further increases in 2011 are likely for some producers. Backed by recovering demand in just about every end-market except for construction, chemical companies are raising sales prices to battle higher material costs. Even with capacity underutilization decreasing, some companies are having mixed results raising prices.
The chemical industry was rife with examples of materials cost inflation in the fourth quarter of 2010. Quarterly operating margins for Eastman Chemical's (EMN) coatings and adhesives segment fell sharply despite higher year-over-year sales, as rising material and energy costs depressed profitability. Driven primarily by higher propylene prices, Cytec Industries' (CYT) coatings and resin raw-material costs rose during the fourth quarter. The company was unable to offset higher costs in this business, despite a 9% increase in year-over-year prices. In the paint and coatings industry, AkzoNobel (NLD: AKZA) has been successful in pushing through price increases, and PPG Industries (PPG) plans to implement 2011 price increases to fully offset rising raw materials costs. However, some pricing lag generally occurs in the coatings industry, especially through the retail distribution channel. As a result, paint companies could see lower profits if cost inflation accelerates. DuPont and BASF (DEU: BAS) have aggressively announced price increases in various commodity chemicals, including titanium dioxide (a main ingredient in paint), resins, and plastic additives, among others.
In our opinion, chemical companies should be relatively successful in passing along cost increases as long as demand remains strong. That said, steady price increases could choke off the very demand that is allowing companies to pass along higher costs in the first place; a dynamic that could leave downstream specialty players without a chair when the music stops. Higher oil prices are creating a backdrop that is making price increases from commodity chemical producers more palatable. Downstream manufacturers, such as coatings companies PPG and AkzoNobel, could be squeezed if they are not ultimately able to pass further cost hikes down the value chain.
Similar to other basic materials industries, the Japanese earthquake has the potential to impact chemical makers. With some Japanese operations shut down, we expect to see regional tightness in petrochemicals, particularly acrylonitrile and propylene. In our opinion, prolonged production declines would be positive to U.S. and European-based petrochemical companies that export products to Asia and the Middle East. Further, Japan is a major importer of naphtha. A decline in naphtha demand should certainly help companies such as BASF operate at better crack margins in the near term.
The last few months have been terrific for the coal industry. In November 2010, La Nina-driven rains produced catastrophic flooding in Australia's prolific Bowen Basin, the heart of its metallurgical coal industry. As demand remained strong on the back of a continued global economic recovery, metallurgical coal prices quickly soared to over $300 per ton, a price that seems to be holding.
Pacific thermal coal prices appreciated as well, from roughly $100 per ton last November to $130 today. The immediate beneficiaries were companies with a presence in Australia or Asia. For U.S.-listed miners, this is primarily Peabody Energy (BTU). Because of the very high shipping costs involved with exporting coal from the U.S. to Asia, U.S. domestic prices are lagging the world indexes. Central Appalachian coal is languishing in the mid-$70s per ton for prompt delivery, little changed from the beginning of the year. However, producers with good quality products and access to ports, such as Alpha Natural Resources (ANR) and CONSOL Energy (CNX), will surely benefit from increasing export volumes at very attractive margins.
For the first time ever, export opportunities are also opening up for the Powder River Basin. Potential margins are extremely attractive, but the U.S. lacks port capacity on the West Coast. The industry is working hard to mitigate this, as we saw two announcements from Arch Coal (ACI) and one from Peabody Energy to develop sizable export terminals in the Pacific Northwest. We are optimistic that this trend will drive margins upwards for Western miners and expect more announcements in the next 12 months.
However, all this good news is offset by a few negatives. First, production costs all across the U.S. (and indeed across the world) are rising. In the Western U.S., higher diesel prices will be a big culprit. The East continued to be impacted by the same old worries of poor geology, tighter regulations, and labor shortages. In general, costs for Eastern miners are reaching record highs, a trend that will probably continue in 2011.
Higher costs and falling production are helping to drive M&A. Alpha Natural Resources announced the acquisition of Massey Energy (MEE), a deeply troubled Central Appalachian miner. The combined company will be one of the largest in the U.S. and will have a dominant presence in U.S. metallurgical coal. However, we expect synergies to be rather elusive, and Alpha paid a very rich price for Massey. We would not be surprised by a wave of M&A in 2011, especially involving small private miners, which Central Appalachia has in abundance. For example, James River (JRCC) just paid $475 million for a small private metallurgical coal miner. In addition, International Coal Group (ICO), which did an impressive job of turning around its operations in the last three years, had been rumored to be up for grabs.
Forest Products and Packaging
During the first two months of 2011, uncoated free sheet (UFS) paper shipments in the U.S. were down 5% from the same period in 2010. We believe that the persistently high levels of unemployment coupled with the increasing mix of digital media consumption will result in a continuation of this trend. During the past decade the amount of uncoated free-sheet paper produced per U.S. worker per year has fallen from around 210 pounds in 2000 to about 145 pounds today. We believe that as more workers continue to use e-mail instead of fax, e-readers instead of paper, and duplex printing whenever possible, UFS will continue its secular decline for the foreseeable future.
Silgan (SLGN), North America's largest provider of metal food cans, recently acquired European can company Vogel & Noot. The North American food can market is already highly concentrated, with Silgan controlling roughly half of the overall market. However, the food can industry in the United States is in a state of secular decline as consumers have consistently reduced their tendency to purchase canned foods during the last 40 years. Consequently, Silgan is embarking on its first food can foray on the European continent, which we suspect will be part of a multi-year consolidation strategy.
On Mar. 8, Ball (BLL) corporation announced that it will build a beverage can line in Vietnam as part of a joint venture with Thai Beverage Can Limited. This can expansion should be completed during the first half of 2012 and is in-line with other beverage can makers' growth aspirations by targeting the faster-growing Asian and South American markets.
Metals & Mining: Aluminum
Aluminum prices have trended slightly higher in the first quarter compared with the final months of 2010, breaking $2,600 per metric ton in early March, the highest since 2008. This should help offset higher energy and raw material costs for most producers of the metal while global demand for aluminum is rising, with China continuing to lead the pack.
However, the fundamentals driving the current trend in aluminum prices are different from just a couple months ago. We attribute much of the strong performance of aluminum prices over the latter half of 2010 to output curtailments in China. The government-mandated output cuts of late 2010 continued into the early weeks of 2011 as the cold weather prompted Beijing to divert more power away from energy intensive sectors to satisfy the needs of residential areas. However, smelters are already ramping back up, with February Chinese aluminum output climbing 11% from January, and capacity ramp-ups and restarts are continuing outside China, including restarts by Alcoa (AA) and Century Aluminum (CENX).
Yet the metal price has actually moved higher into March. We believe political turmoil in the Middle East is providing a temporary boost, as the region holds about 10% of global aluminum capacity and is growing in importance as it is expected to be one of the fastest-growing regions in terms of supply for the next couple of years. We think this effect is temporary, and the larger driver of where the metal price heads in the second quarter will be back to the supply equation. Rising input costs, particularly energy prices, can provide some support, but ultimately aluminum prices should be stagnant if an oversupplied market continues.
Metals & Mining: Mining
Mining shares exhibited significant volatility in the first quarter, a roller-coaster ride that we expect to persist into the second quarter. Can China's heady fixed asset investment growth (a key driver of copper, iron ore, and metallurgical coal prices) sustain further tightening by an increasingly hawkish People's Bank of China? Is the recovery in the U.S. and Europe getting weak in the legs? What are the ultimate consequences of the human and economic tragedy that befell Japan? Shifts in investor sentiment on any of these issues are sure to generate significant swings in mining share prices. In the event we see some sizable dips, investors could be afforded the opportunity to snap up shares of some quality businesses that in recent months have traded well-above what we consider to be their intrinsic value.
Macroeconomic variables aside, no name on our list faces more questions than Cameco (CCJ), the world's largest uranium producer. In the days following the Japanese disaster, Cameco's shares suffered terribly. And rightly so, in our mind: The events at Fukushima Daiichi may deal a serious blow to the prospects of a Nuclear Renaissance, having reminded political leaders and regulators (not to mention a shaken public) around the world that, for all its green credentials, nuclear power carries a dangerous tail risk.
If events in Japan mean more circumspect political leaders and tougher regulators, uranium demand will suffer in two ways: fewer new builds and shorter operating lives for existing reactors. As far as new builds are concerned, Asia represents the largest share of anticipated growth, led by China. In recent months, promulgations of evermore ambitious new-build targets by Chinese officials had bolstered the Nuclear Renaissance case, sending spot uranium prices surging more than 50% since mid-2010, and Cameco's share price to levels not seen since the onset of the global financial crisis. Now, to the extent we see officials in Beijing and, to a lesser degree, their peers in Moscow, Seoul, New Delhi, and Tokyo (all countries with large expansion plans) adopt a more circumspect approach, the long-term growth outlook for uranium demand will weaken materially.
The second question is, what do these events mean for the existing reactor fleet around the globe, particularly older operations often built to less exacting standards than the advanced models of today? In recent years, we have seen political and regulatory leaders agree to extend the operating lives of the nuclear industry's old mares. Electorates have been largely accommodating to such moves, with memories of Three Mile Island and Chernobyl having faded and the impetus for low-carbon power generation strengthening nuclear's hand versus fossil fuel alternatives. Looking ahead, operating life extensions, particularly at older facilities, seem less likely, given the hit that events in Japan are likely to deal to nuclear power's popularity among voters in countries with a large installed nuclear base (U.S., Japan, France, and Germany).
The bull run in steel prices that began in November quickly extended into the second quarter of 2011 as some mills opened their order books for April only a few weeks into the year. With lead times stretched out that far and the price of hot-rolled coil currently at $950 per ton, the first half of the year is looking pretty rosy for U.S. steelmakers. While raw material costs have also increased, the impact is more modest. With operating rates back up to 75%, all U.S. steel producers should experience healthy margin expansion in the first quarter with the second quarter faring at least as well, assuming we don't see a drastic reversal in the next couple months.
As for the latter half of the year, the downside risk looks greater than the upside risk. We certainly think the year-over-year comparison will be favorable for every quarter, but much of the strength will be weighted in the first half of 2011. We don't think demand will be strong enough to maintain the magnitude of the price hikes, as some order rate improvement is attributed to restocking and pre-buying in anticipation of higher prices. Further, steel prices outside the U.S. did not have the same surge and have already shown signs of faltering. We don't think a sustained disconnect between steel prices in the U.S. and other parts of the world is likely. Unless iron ore, coal, and scrap prices provide much relief, a doubtful scenario in our view, 2011 will be another year of depressed margins for the industry as a whole.
Our Top Basic Materials Picks
|Top Basic Materials Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
|Xstrata||GBX 1300||None||Very High||GBX 650|
|Data as of 03-24-11.|
Considering current valuations and secular trends, we would rather be a buyer of flexible packaging maker Bemis than North America's largest food can producer Silgan. Given the secular challenges and 2013 contract renegotiations, we believe that Silgan shares are currently overvalued. On the other hand, shares of Bemis currently trade at 90% of our fair value estimate, and we believe provide investors with a larger margin of safety than Silgan shares. Approximately 70% of Bemis' revenues are related to food packaging, 20% to other packaging, and about 10% to pressure-sensitive materials. While the largest part of Bemis' food packaging business is related to meats and cheeses, the company also provides an array of highly convenient retort pouches, CPET trays (for the microwave and oven), and self-venting microwavable bags for frozen vegetables. Bemis is also well positioned to further expand in Brazil, Mexico, and Argentina, where it has significant operations and where the populations have significant capacity to increase their per-capita incomes and per-capita packaged food consumption.
Sigma-Aldrich is a leading provider of research consumables and fine chemicals to a variety of players in the life sciences and technology industries. We think Sigma is well positioned to benefit from improving conditions in early-stage drug spending. Following a period of recent weakness, early-stage R&D is returning to more normal levels. With solid pricing power and a steady revenue stream created by recurring consumables purchases, we think Sigma's 20%-plus operating margin will continue like clockwork. Although shares look fairly valued at the moment, Sigma is a solid narrow-moat operator with compelling growth opportunities in biologics, analytical chemistry, and high-tech manufacturing.
Ternium is a Latin American steel company that flies under the radar among its peers, in our view. The company's diversified exposure in Mexico, Argentina, and Colombia keeps it isolated from the more competitive Brazilian market that is attracting new entrants and import pressures, while much of Latin America (including Mexico and Argentina) enjoys a similar growth profile to Brazil. Ternium had the second highest EBITDA per ton in our steel universe in 2009 and 2010 (trailing only South Korea's POSCO (PKX)), yet it currently trades two full EBITDA turns below its Latin American peers ( Gerdau (GGB), Usiminas, and CSN (SID)) compared with a historical average discount of less than one turn. The company also boasts the strongest balance sheet with near-zero net debt and has several potential growth projects in various stages of planning. While Ternium's equity float is still small (only 24% of shares) it increased 70% in February following the exit of Usiminas' ownership holding. We think this new liquidity and additional power given to minority shareholders should be a positive for the stock. Finally, we believe the downside risks of operating in less stable Argentina are overplayed and don't justify the significant valuation divergence, as Ternium has experience operating in similar jurisdictions (its Venezuelan mill was nationalized in 2008), lower relative pricing in Argentina makes exports an attractive alternative, and the company is well diversified with significant NAFTA exposure from its two Mexican mills.
Xstrata (GBR: XTA)
One of our favorite mining names on a relative value basis is Xstrata, largely because we have a more favorable long-term view on thermal coal prices, in contrast to, say, our view on copper, where we expect supply additions coming in 2012-2015 to push prices well below today's heady $4-per-pound-plus levels. That said, Xstrata isn't a stock for the faint of heart. In the event privately held commodity trading giant Glencore's IPO is a prelude to an eventual tie-up with Xstrata, it's possible things may shake out in a way contrary to the wishes of Xstrata's minority shareholders.
Yamana is a midtier gold producer that operates a portfolio of six mines in Central and South America. The firm is one of the lowest-cost producers in the gold mining space and has a quartet of near-term projects that is scheduled to start gold production over the next few years. Yamana is currently trading at one of the lowest enterprise value-to-reserves ratios among the major gold miners, which we believe is unwarranted given the firm's low-cost profile and promising growth trajectory. We think a major overhang on the stock is the market's misgivings about Yamana's ability to execute on its growth projects. However, we believe that Yamana is putting its past missteps in the rearview mirror as the company has largely digested its major acquisitions from 2006 and 2007. Three out of Yamana's four near-term projects (Mercedes, C1 Santa Luz, and Ernesto) have passed the permitting process with flying colors and have already broken ground, and we don't see the market giving the company enough credit for the explosive gold production growth that these projects should drive starting from 2012. We also believe that Yamana's sale of a majority stake in its Agua Rica copper-gold deposit to Goldcorp (GG) and Xstrata, which was announced in March 2011, will prove beneficial to the stock price. We think the transaction has lifted much of the uncertainty surrounding Agua Rica and also helps to address investor concerns about the company's high weighting of copper production relative to other gold miners.
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Elizabeth Collins has a position in the following securities mentioned above: TX, CCJ. Find out about Morningstar’s editorial policies.