Weekly Findings – September 30th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 30th, 2018

Weekly Findings – September 30th, 2018

Thought for the week: “Earnings Up – Stock Price Down = Frustrated Management”

  • Chart of the Week – Buy The Losers
  • Fertilizers – Time To Take Profits?
  • Basic Chemicals – THE Chart
  • FUL – Thesis Unchanged – Another Entry Point
  • Weekly Winners & Losers

Chart of the Week – Buy The Losers

  • Chart of the Week

The chart of the week is a subset of data from the first chart below which shows YDT performance versus YTD changes in 2018 estimates. We are interested in the group in the top left quadrant – those that have underperformed despite improving earnings. In the second chart below we just show that quadrant and label some of the outliers as well as outlining an area of specific interest – which is the basis for the chart of the week. These are stocks that have seen real increases to earnings (not a function of small or meaningful changes on very small initial numbers, which defines some of the outliers) but have also seen a significant pullback in valuation.

The companies in the chart of the week are summarized in the table below where we also show absolute and relative valuation metrics and some short comments. We do not have relative valuation data for CC and 1COV as we have insufficient history to create a “normal” framework. We would probably buy every company on the list today, for the following reasons:

  • Most important is likely management frustration – these companies are all performing well – driving earnings growth and better returns and not getting recognized for it. As a consequence, managements are likely more willing to explore alternative routes to unlock value – such as merger, acquisitions – strategic alignments etc. In prior work we have talked about possible combinations such as CC, either with OLN or others and we have already seen HUN thinking outside the box, quite creatively.
    • OSK looks very interesting as a possible acquisition target today.
  • Valuation – many of these companies are at low absolute values – CC, 1COV, PWR, HUN, WLK. Given the billions of dollars of PE money on the sidelines today, we could see both private and public interest in some of the very cheap cashflows available.
  • The rea other companies missing from this list that are cheap, but do not have the same level of disconnect between earnings improvements and performance:
    • In chemicals, EMN, OLN, TSE and BASF
    • Most of the Paper and Packaging sector.
    • Within capital goods, plenty of companies could afford to buy OSK today as could most Defense companies.

  • Fertilizers – Time To Take Profits?

Both CF and MOS have had very good years to date – up by 28% and 27% respectively. The question now is whether to take profits of stay with the story and there are plenty of conflicting arguments for both approaches. Corn and Soy and prices are weak – soy weaker than corn – as shown in the first chart – and the farm economy is generally a good indicator of how the overall ag chemical business fares and consequently the chart is not supportive of peak fertilizer margins without some sort of supply demand push on fertilizers themselves.

It is easier to make a case for sticking with MOS than CF today and we run through each in turn below. We would take some profit in CF today but ride MOS for a little longer.

The bull case on CF rests on the stock price still sitting well short of prior peaks – first chart below– since when the company has added significant capacity in the US as shown in the capital per share chart in the second exhibit. The opportunity is best reflected in the return on capital profile – third chart – but the more important question is whether history is our best guide when it comes to the Urea market? The peak earnings and peak values of 2014/15 were during a period when the US was significantly net short of Urea and US pricing reflected not only low costs but also tight market pricing and the added umbrella of the marginal cost of importing the marginal ton. The investments in the US from 2014 to 2017 (from several players, including CF) have pushed the domestic market into balance and marginal surplus. Consequently, even if demand in the US remains robust, the change in the net trade dynamic may make it hard for the US industry in general and CF specifically to rebound to historic returns on capital. Today, 2021 estimates for CF – the highest forward numbers – discount around 7% return on capital; well below the historic average, and the stock looks fairly valued on that basis today. If CF can get back to trend 10% return on capital the stock still has 50% upside, but it is a stretch in our view.

MOS has also seen an increase in its capital base, and lower returns on capital, but there a couple of differences with CF. First, the stock has not recovered to the same degree as CF, but also the market dynamic for much of MOS’s portfolio is not the same as it is for CF. There is a difference in the market structure for potash today than when MOS valuation last peaked, but the market is improving, and it is more likely that MOS can push returns back to trend than CF in our view.

However, even if MOS can recover to more normal levels of returns, the stock is not that inexpensive, and does not have the cyclical upside to peak that CF might have should Urea prices return to prior highs.

  • Basic Chemicals – THE Chart

Chemicals are having a bad year – and base chemicals worse than the rest. We will cover the group in more detail in our Chemical Monthly publication which will be published later today, but we thought we would share a key chart in the weekly piece as it likely is all you need to know.

The chart below shows Brent crude oil and US polyethylene pricing YTD. Crude, directionally a good proxy for costs for most producers, is going up, while polyethylene is going down. Crude rising on its own is enough drive fears of raw material escalation pressure. The collapse in US polyethylene pricing – more than 20% off its peak – is a function of the ethylene surplus in the US and the impact that lower export netbacks are having on what producers are willing to sell marginal pounds for domestically.

Stocks have underperformed gradually (a little more acceleration recently as the sell-side has begun to capitulate) but we have yet to see the sort of collapse in values that have accompanied prior cyclical meltdowns. There are a few reasons for this, in our view:

  • There have yet to be any major earnings misses or guidance announcements – we think they will probably happen – but focused in the US.
  • This margin pressure is not accompanied by an economic slowdown, which have been the driving force behind prior severe cyclical troughs – demand remains robust – polyethylene and ethylene pricing and margins outside the US remain well above normal. Within the US, economic growth is strong.
  • The crude oil price impacts costs outside the US and might help keep international pricing high – often rising costs gives chemicals producers pricing power, and if it was not for the significant US surplus it is possible that European and Asian plastics prices would be rising rather than showing a very modest weakening from quite high levels
  • As long as costs are rising we are unlikely to see a negative inventory swing – which can also cause a pricing collapse for chemicals and has in the past.

This is an unusual cycle – it does not have enough of the usual drivers to cause wholescale price and margin collapse – except in US ethylene/polyethylene. It has, however, started to drive sentiment and significant nervousness. There is likely long-term value in DWDP, WLK and probably LYB (unless the company buys Braskem at some sort of peak value), but it is generally a futile endeavor to push these names when sentiment is against you. If you are a long-term investor and you own DWDP and/or WLK, waiting it out is likely the right strategy, otherwise, wait for a better entry point.

We still prefer the intermediate group – largely covered above, but also see FUL below. This is where lack of investor interest and low valuations should drive M&A. HUN, OLN, FUL, TSE, CC, 1COV, as well as WLK and BASF.

  • FUL – Thesis Unchanged – Another Entry Point

Fuller’s earnings miss this week resulted in what is now a predictable over-reaction in the share price – and FUL is the worst performer this week. As shown in the chart below, the stock has given up much of the gains of the last few months and, in our view, represents another entry point. We have not changed our thesis and the comments below repeat what we wrote back in July.

Our interest in FUL is not based on whether the company can meet or beat near term earnings consistently – in fact that should be quite difficult to manage for a company in the process of integrating a large acquisition and facing raw material headwinds. Our interest comes from the limited benefit of the doubt given to the company with respect to the value that can be added from the recent Royal acquisition and the potential upside (100%) if the company can get it right.  We have used SWK as a possible proxy.

We also expect further consolidation moves in the chemical industry and especially in the intermediate/functional businesses and FUL would be one of our potential targets. When companies like Dow Materials Science and BASF talk about holistically solving customer problems and providing “one stop” solutions, whether it is paint, engineering plastics, advanced packaging etc., both are lacking good adhesive technology.  The FUL portfolio could be equally interesting to an intermediate/specialty company looking to add another vertical to a larger business – EMN, Clariant or Covestro might take an interest. Despite the earnings miss FUL continues to show a positive inflection point in its return on capital, which took the expected downswing with the additional capital base at a time when earnings were squeezed by rising raw materials.

There was limited investor belief in the recovery in return on capital at SWK in the initial 6 to 9 months, and it was only after consistent earnings surprises, driven by the successful integration of the Black and Decker business as well as fixing mistakes in the company’s security business, that the stock began to react.

With the benefit of hindsight, Black and Decker was a great deal for SWK and SWK management was able to manage the business to take full advantage of the opportunity. We don’t have enough data points to draw a direct comparison with FUL yet – two quarters do not make a trend. However, if FUL management is not able to get the most out of the deal, the cheap stock will attract M&A attention from those who believe they can.

  • Weekly Winners and Losers

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Sources: Capital IQ, Bloomberg, Government Publications.

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