A. Schulman – A Personal Problem or A Leading Indicator

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 16th, 2016

A. Schulman – A Personal Problem or A Leading Indicator

  • The extreme nature of A. Schulman’s negative fiscal year end guidance might be a wake-up call for all with regard to the European demand environment post Brexit but is also possibly something company specific.
    • The company was explicit in June that the month was fine and in line with expectations but the update 6 weeks later tells a much more negative story for July and August
    • This dramatic change of direction either shows an abrupt change in customer purchasing trends (most likely in Europe) or a red flag on SHLM’s business management.
  • It is not a US demand problem based on comments from others, unless it is very narrow. But it is hard to draw the conclusion that it is all company specific, as SHLM’s end markets are so broad, suggesting a major decline in customer orders in many sectors.
    • In research post Brexit, we drew some general conclusions, but suggested it was highly likely that increased geopolitical uncertainty would dent both consumer and business confidence. SHLM has a significant exposure to Europe (more than 50% of sales).
    • Since June 23rd, UK consumer confidence the lowest since 2009; UK home sales dropped to the lowest levels since 2008; Weak but not negative growth in Europe
  • But is SHLM is a leading indicator for European confidence? Consumer growth not materially negative, but producers taking a more guarded view and reducing inventories – i.e. buying less with the expectation that demand will be weaker?
    • SHLM’s odd reporting year might force the company to reveal a worrying trend early.
    • SHLM European end markets include many key to other major Chemical companies:
      • Electronics – Dow/DD/BASF/APD/PX
      • Automotive – Dow/DD/BASF/EMN/PPG/AXTA
      • Food packaging – Dow/Exxon/LYB
      • Building and Construction – Dow/LYB/BASF/WLK
  • Every one of the below trend demand growth years for ethylene – shown in Exhibit 1 – started with an un-noticed inventory reduction decision somewhere in the customer chain.

Exhibit 1

Source: IHS, WoodMac and SSR Analysis

Details

We should not draw any quick dramatic conclusions from the guidance given by A. Schulman last week; this is a smaller company, with some significant recent acquisitions and a very poor return on both equity and capital. It is possible that some of the issue here is with a lack of management understanding of the portfolio, poor communication with newly acquired businesses, and it may be a simple case of overly optimistic guidance as a consequence.

But… it is a major miss in a very short period of only 6 weeks from prior guidance and so we face one of two possibilities;

  • The internal forecasting and communication mechanisms within SHLM are a real mess – or
  • There is a real demand problem – which could be
    • SHLM specific
    • Or a sign of something more broad.

Dealing with SHLM specifically, we will admit up front that we do not know the company well and it has limited sell side following – around $2.5 billion of revenue, but assets that have almost doubled in 5 years (revenues up by only 16%) – mostly intangible as the company has taken on a great deal of goodwill through a series of acquisitions. The company has taken on a great deal of debt and current tangible book value is negative – so all is not right at SHLM.

It is quite possible that the company has been struggling to keep up with earnings/synergy promises for a while and that this is the quarter it has all come to a head – we do not know enough to judge. The company has a history of optimism – Exhibit 2.

Exhibit 2

Source: Capital IQ, SSR Analysis

It is also possible that the customer demand problems discussed in the pre-announcement are specific to SHLM:

  • Either because the company has tried to push pricing (to meet targets) and customers have pushed back
  • Or because the consolidation in the sector has caused customers to diversify suppliers at the expense of SHLM. When Dow bought Union Carbide it lost polyethylene business from customers who bought from both prior to the deal. It is possible that the HGGC acquisition has created a similar problem for SHLM.
  • It is also possible that SHLM is a swing supplier for customers with their own masterbatch/compounding lines and that as demand weakens all the pain is felt by the swing supplier.

It is possible to ignore the SHLM guidance, using one of the arguments above and assume that all is right with the world otherwise. Possible, but probably not prudent!

SHLM Segments & End Markets

Exhibit 3

Source: Company Reports, SSR Analysis

Products from each of these segments are sold into a wide variety of end markets with a few exceptions. Engineered Plastics/Composites are not identified as key products in the Packaging sector (Masterbatches are); Masterbatches not sold into the Transportation sector (Engineered Plastics and Composites are). Products from each segment are identified by end-market in a slide borrowed from a recent company presentation in Exhibit 5.

Exhibit 4

Source: Company Reports, SSR Analysis

Exhibit 5

Source: Company Reports, SSR Analysis

In our Brexit piece we identified the companies in our core universe with significant business in Europe. We repeat the table here (Exhibit 6), but we highlight the companies with exposures in the segments impacted at SHLM.

Exhibit 6

Source: Capital IQ, SSR Analysis

The bigger risks are probably in the more expensive names where expectations are high and in Exhibit 7 we show valuation versus European exposure for the highlighted names – ATR, SEE, ITW and possibly DOW stand-out, though as we have seen with SHLM, which was not expensive before the guidance, earnings shocks can make cheap stocks cheaper. We have also seen this with the fertilizer names – see our accompanying monthly report.

Exhibit 7

Source: Capital IQ, SSR Analysis

SHLM – Return on Capital, Valuation, Skepticism – Probably not Cheap Enough yet.

If we look at some simple valuation metrics for SHLM we would not see the guidance driven pull back as a buying opportunity. Regardless of what its customers are doing, SHLM seems to have taken the “free money” environment a bit far – with debt per share rising so quickly that the company now has negative tangible book value per share – Exhibit 8. Not surprisingly return on capital has collapsed – Exhibit 9 – and while valuation looks attractive – Exhibit 10 – our skepticism index – Exhibits 11 and 12 – shows a mismatch and suggests that the stock could get much cheaper without a significant turnaround in results – something not supported by the recent miss, whether a company problem or a macro problem.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

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