“Can We Talk” – Action Is Imperative… and an Opportunity

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 4th, 2016

“Can We Talk” – Action Is Imperative… and an Opportunity

There are a number of coincident distinct macro and micro issues impacting the Chemicals Industry today and in our opinion every company is impacted by at least one. In Exhibit 1 we summarize how each factor is impacting at the sector level. The winners will be those that identify the opportunities from here.

  1. This cycle is different – massive central bank liquidity has led to misallocation of capital in commodities – this has led to commodities being deflationary rather than inflationary
    1. We have unprecedented levels of overcapacity relative to demand growth rates
    2. The world has limited levers left to pull to stimulate growth
    3. Problems for most companies – negative revisions will likely continue
  2. Massive growth of new capacity in areas of the world that look at economics differently than those in the US and Europe
    1. New players looking to gain market share at marginal economics based on either cheap raw materials or cheap energy – at risk: CC, TROX, AXLL, OLN, maybe polyethylene
    2. In many cases they expect to be rescued by demand growth, which may not come
  3. Competition rising across the board
    1. New producers in Asia and the Middle East outpace the rate at which producers in the developed World consolidate – WLK/AXLL and DOW/DD are good moves
    2. Regulators continue to think about regional competition in markets that are increasingly global – a problem for TiO2, epoxies, polyurethanes and others
  4. Business models have changed
    1. In Agriculture it has moved to a solutions platform rather than just seed innovation – DOW/DD is a strong leadership move here – MON may continue to struggle
    2. In PVC the level of integration into ethylene has meant that producers of PVC without ethylene are being squeezed and are reacting by investing to integrate
    3. Long term, well established trade flows are shifting, impacting relative regional pricing
  5. Companies that have been thoughtful about building a portfolio of more “protected” products have often not managed to get understood – complexity
    1. The lack of overall confidence in the market has made investors even more cautious with regard to portfolios they do not fully understand – EMN best example – DOW/DD plan begins to address this issue

Exhibit 1

Source: SSR Analysis

Overview

In the 1990s, coming on the heels of a 4-5 year period of significant investment to chase stronger growth and fueled by optimism that high oil prices and high interest rates were behind us, the economic slowdown caused a period of widespread sentiment depression and consolidation, particularly in the chemical space. The developed market sought to deal with overcapacity and a developing world which was not growing quickly enough to absorb the surpluses. The Asia financial crisis was the final nail in the coffin and was the beginning of the end for confidence in energy, which resulted in all the big oil (and associated chemical) mergers in the late 1990s. These consolidation moves helped to improve market structure in the West, caused some capacity closures and things got better for a while.

But, the business world shrank every day during that period and has shrunk every day since as trade barriers come down with developed nations trying to build bridges to the developing world, looking to increase markets for their own goods and services. The fact that developing nations would want to build their own basic and downstream industries as quickly as was practical has not been a surprise to anyone but was almost irrelevant in the 90s when those developing nations were a fraction of global GDP, but huge potential consumers.

Today we are back to where we were in the early 1990s – slow growth (slower than the 90s), significant overcapacity and not a particularly rosy view of the future. The difference now is that the then developing world is now a power house and while we may have made some structural improvements in the US and Europe, markets have become much more competitive globally. Exhibit 2 shows the Herfindahl Index for the US, for Western Europe and for the World for ethylene in 1993 and 2015. For reference the index is interpreted such that an index of 1500 begins to suggest a concentrated market and 2500 is a red flag. An index of 100 is “highly competitive”.

Exhibit 2

Source: HIS, Wood Makenzie, Company Reports and SSR Analysis

We have more data for ethylene than for any other material or industrial product, but we would assert that while the numbers will not likely be the same, almost any other industrial product or material will have a chart that has the same shape as the one above – or is heading in that direction. Most of the new players are in China, with some in India and the Middle East, but we see countless products today where the emergence of China as an exporter has caused real problems.

Of course, as long as markets are growing, and especially where capacity is struggling to keep pace with demand, no one gives a thought to the Herfindahl Index or other measures of market concentration. But that is not the case today and as we have indicated in research many times – “hope” is not a strategy.

In almost every sub-industry we have overcapacity – or looming overcapacity – and global market structures that are deteriorating. The natural reaction is pessimism and underweight investment strategies, but there are a couple of tested value creating strategies in such a scenario – the more obvious being sell, or consolidate and drive costs lower. A possible third option, if you have a cost advantage which drives positive free cash is simply to buy back shares in a meaningful and consistent manner.

  • Westlake/Axiall is a true consolidation move, as was Westlake’s acquisition of Vinnolit in 2014 and the formation of Axiall through the combination of PPG and Georgia Gulf’s businesses in 2013
  • Dow/Olin was almost a consolidation move – it was in the US, but Dow kept the chlor-alkali in Europe
  • Dow/DuPont is not a consolidation to change market structures (except in Ag) – the combined company will, in many areas, be able to sell more distinct products to the same customers but the deal does not reduce the number of sellers in any given product
    • Ethylene is a possible exception, though DuPont’s position is very small
    • The deal will allow the companies to cut substantial costs and will not likely constrain the surviving materials and specialty companies from real consolidation moves going forward
  • Dow/DuPont, Westlake (if successful) and Olin all have cost reduction opportunities to increase cash flows over the next couple of years that will not be available to those not involved in consolidation – EMN has managed to grow EBITDA through acquisition for the last several years – it has not seen the value in the market because of the complexity of its portfolio and its message in our view

We expect to see many more proposed deals and many completed deals as the next two years unfold. As a management team and as a board of directors, an open mind is needed. There is likely a lot of money to be made for shareholders by looking at the current market as an opportunity – either to sell into a consolidation – or participate otherwise, without overpaying.

Those who are proactive, creative and move first will likely outperform the rest – we like the Dow/DuPont deal, we like the proposed Westlake/Axiall deal. We think that Syngenta management will ultimately regret not dealing with MON, even if the shareholders are happy today. In short – everyone in every U.S. and European Chemicals Industry should be looking for someone to talk to and this should be a much higher priority than building anything right now.

Different Cycle

In the broader commodity material space there is lots of talk about a “different cycle”. We believe that it is only different in that it could well be longer than prior cycles. The length of the cycle will come from a combination of both rapid capacity expansion and slower growth – here interest rates are part of the problem with the capacity issue and also present a major challenge with the demand issue. In Exhibit 3 we show the 10 year US treasury yield from 1965. The very low rates we have seen for the last 5 years have stimulated spending – money has been available and cheap and this has encouraged over-investment.

The issue with demand is that, unlike in the 1990s, the world cannot decrease interest rates in order to stimulate demand – we have already tried that and it has not worked. There is likely a much lower aggregate consumer confidence globally than there was in the 1990s and we are not seeing either low rates or much lower energy costs stimulate stronger demand growth. The commodity chemical markets need a couple of years of very strong demand growth to correct some of the imbalances and we struggle to see where that comes from.

Exhibit 3

Source: Bloomberg

As a levered producer, a longer down cycle presents a real problem – for example, without some sort of recovery in TiO2 margins over the next couple of years, both TROX and CC will have debt financing problems. OLN is more at risk than AXLL in the chlor-alkali space – particularly if AXLL combines with WLK (which has net cash today).

New Capacity

The collapse in global PVC and caustic soda global operating rates since 2007 are a function of massive over-building – principally in China – rather than a collapse in demand – Exhibits 4 and 5. TiO2 and aluminum look similar (though aluminum is several years ahead of the other commodities in our view), and we are concerned that the wave of polyethylene capacity coming on line over the next three years will create the same oversupply.

Exhibit 4

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 5

Source: IHS, Wood Mackenzie and SSR Analysis

 

The slowing nature of the China economy has curtailed the level of investment over the last 12-24 months, but there is a tail to the previous strong investment cycle and new capacity is still expected this year and next for most products. The exception is polyethylene and polypropylene where the country is still very net short and investments – mainly coal based – continue.

If we look to India as the possible savior – i.e. the country that could absorb the surpluses, we are likely to be disappointed; not because of slow growth, but because of a determination to become self-sufficient and continuous investment. In the meantime the Middle East keeps building and now we have to think about the impact of Iran – probably a net importer for a while – but likely a significant exporter longer-term.

Competition

Assuming that we will see widespread consolidation in Asia is likely too optimistic – we may see further moves in Korea and Southeast Asia, but China and India will continue to expand, as will the Middle East.

Further large sale consolidation in the US and Europe is inevitable, especially in a sub $40 crude environment where the US does not have the competitive edge needed to export unless natural gas prices stay below $2.00 per MMBTU.

  • The smart “bottom fishers” will look for the next trough to bulk up and the moves will likely be trans-Atlantic and possibly more global than that – watch Ineos and Westlake for more interesting moves – Westlake globally, Ineos to bulk up in the US
  • Lyondell should be buying rather than building
  • DowDuPont Materials should target separation in time to exploit possible opportunities caused by ethylene oversupply in 2018 and 2019 – Dow and DuPont should keep this balance sheet as clean as possible relative to the Ag and Specialty businesses
  • Do OxyChem and CPChem’s parents look to sell, in part to fund upstream or simply to get away from a smaller distracting business?

In Exhibit 6 we show the Herfindahl Index for PVC and compare 2009 with 2015 – a short timeline. The consolidation in Europe and the US has not been enough (despite the significance of the European moves) to stop the global picture from deteriorating.

Exhibit 6

Source: IHS, Wood Mackenzie and SSR Analysis

Changing Business Models

There appear to be a number of meaningful business model/industry model transformations taking place today, and while we use Chemical Industry examples below, we can see similar trends in other industries.

  • Solution based sales and marketing rather than product based marketing. A number of companies talk about this, but Dow Chemical likely practices it best – albeit with not much margin expansion to show for it yet!
    • This is a real trend in agriculture with “seed or chemicals” migrating to “seed and chemicals” – it was behind the MON bid for Syngenta and is behind the DOW/DD merger.
      • We think there is likely a buyer for FMC eventually, but FMC may need to separate its lithium business first – similar to Rockwood needing to sell TiO2 in order to find a buyer for the rest of the company
    • The rest of the DOW/DD portfolio (ex Ag) will end up selling more products to the same customers – increasing the opportunity to address a customer’s entire solution requirement rather than just parts of it
      • The Specialty carve out may either consolidate business lines itself or divest pieces to others who value businesses more highly – here the commercial logic is likely to be more driven by the solution focus
      • Standalone smaller focused specialty businesses may get absorbed as a consequence
        • Targets might include, ALB, CBT, and even EMN
  • Integration – already driving strategy in the PVC chain – what happens to the styrene chain and the independents?
    • Westlake/Axiall is partly about integration
    • Westlake is the only logical bidder for EMN’s ethylene units – no-one without demand would buy the units in the face of the new ethylene capacity coming on line in 2017/2018
    • Trinseo is likely a takeout target at some point, when the price/timing is right – recent strong results put TSE in a stronger position to negotiate
    • Oxy sells is chemical business or JV’s with more ethylene supply
  • Commoditization – What is next?
    • Epoxies – already there for liquids? Hard to consolidate – too few players
    • Polyurethanes and other insulation products? Also hard to consolidate
    • Paints? Paint ingredients certainly

Complexity

We have written on the issue of complexity a number of times and we reference the most recent report here.

The market is increasingly skeptical of complex stories, especialy those with earnings uncertainty. EMN is the best example we have today of a company penalized by its complexity but both Dow and DuPont have had issues with explaining business mix and strategy in the past. The merger-split process should create three strong companies that are easier to understand.

In Exhibit 7 we show where our Chemical companies sit on our Complexity Index – the calculation is rudimentary but directionally useful – we view complexity as increasing in the number of reportable segments and non-US sales.

Exhibit 7

Source: SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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.

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