Chemicals August Monthly – Summary – Deals Leading Performance

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

August 27th 2018

Chemicals Monthly – Summary – Deals Leading Performance

  • We are late with this publication in August – but are pleased to announce that Anthony Salzillo has joined the team, which should get us back on track!
    • This report contains a summary for the month, recommendation changes etc., and the accompanying two PowerPoints focus on the large cap and SMID data respectfully.
    • There are changes to the data in the large-cap piece as we account for the loss of Monsanto and reweight the Diversified group based on the combination of Dow and DuPont – the second change has been forced upon us based on changes at our data provider.
  • Earnings were generally strong, but guidance was mixed and consequently August has not been the best month for the group – every subsector underperformed.
    • Among Industrials and Materials only CF makes it into the top five performers for the month, while chemical companies occupy 3 of the bottom 5 spots VNTR, TROX and ASIX
    • The market is particularly unhappy with TiO2 – CC also underperformed – despite stable TiO2 pricing. It is possible that there may be too many TiO2 centric stocks to look at. CC offers a more diverse portfolio – very strong growth in other businesses and attractive value.
  • US ethylene remains a problem. Margins are lower in August than in July because of higher ethane pricing and incrementally lower polyethylene pricing. We remain concerned about Q3 and 2H estimates for LYB and DWDP (more so for LYB).
    • None of the ethylene exposed names looks expensive today – but we have never seen meaningful negative revisions because of ethylene margins without stock price erosion.
  • Better performers for the month are deal driven or expected deal driven names – KMG, RPM and PAH, although LYB has had a good run, as has ECL.
    • FULL continues to outperform and remains on our preferred list
    • EMN remains positive for the year despite another poor month – which continues to create an entry point – which we also see for HUN. WLK, and CF also look interesting
  • SMID ideas unchanged – Electronics, TSE, VNTR, IPHS, KRA, KWR, VHI

Exhibit 1.

Source: Capital IQ and SSR Analysis

Fundamentals – US Ethylene Still Terrible and only Deals appear to be of interest.

The economic backdrop remains strong, but the foreboding of trade wars is keeping investors leery of the chemical space in general. The general view is likely justified, but we see some specific pockets of opportunity and risk.

The main risk is in US ethylene – which we have covered at length. Ethane pricing remains a problem in the US Gulf – hovering around 39 cents per gallon in August. From a raw material cost alone, this is more than 16 cents per pound for ethylene – the most recent spot price is 15.75 cents! The economics make no sense, but the spot price is being fed into formulae for the sale of ethylene and for the sale of polyethylene for much of the market.

Ethane is steeply higher relative to Brent crude – Exhibit 2 – and while still much lower than history, this directly impacts the economics of exporting US produced ethylene-based derivatives. Polyethylene pricing is sliding – as shown in Exhibit 3 – but margins are collapsing on an integrated basis because of the increase in ethane – all US polyethylene producers have integration back through ethylene.

We have discussed in prior work the challenges of investing in ethylene and we expect that there are some tense meeting going on between potential JV partners for new US facilities, and that both Shintech and Formosa are regrouping, as it is almost impossible to ignore the current situation when looking at a long-term investment.

Near-term we still think that Q3 estimates do not reflect the turndown in margins – especially for LYB. DWDP had some implicit negative guidance its Q3 and full year forecast if you believe that the synergy numbers that the company discussed are possible for Q3 and Q4. However, the reduction in estimates may not be enough. The same is probably not true for WLK – strong PVC and significant spot ethylene purchases could help WLK in Q3.

Exhibit 2

Source: Bloomberg, Capital IQ and SSR Analysis

Exhibit 3

Source: Bloomberg, Capital IQ and SSR Analysis

Outside (US) ethylene the industry appears to be in good shape still although there some inflationary pressures – if you are an ethylene buyer based on a cost formula – as well as high crude prices and some logistic and wage inflation.

With the exception of the trade issues and one or two specific geopolitical issues (such as Turkey), the backdrop for the industry still looks good, and for the most part earnings were strong in the second quarter with the majority of companies beating expectations – Exhibit 4 (we have not labeled the cluster grouped around the mid-point). However, performance was poor for the group in August, with every sector underperforming a stronger S&P – Exhibit 5.

We would maintain our focus on WLK and the intermediate names – TSE, FUL, HUN, EMN, 1COV and also now SMG because of valuation and relative insulation from trade issues. WLK has pulled back because of its earnings miss and provides an entry point. Otherwise we continue to like the fertilizer names, both CF and MOS

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Within our core coverage group many of the stocks look cheap but note that this is a relative metric and the very strong broader market is biasing the data – Exhibit 6. As shown in Exhibit 7, we are a long way from a cyclical relative low – like the one seen in the last tech bubble.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

SMID Summary

Our recommendations are unchanged from last month – although some are working far better than others! – Exhibit 9.

Exhibit 9

Monthly performance is summarized in Exhibit 10:

  • Generally, not a great month for the group with the best performance generally correlating with the best earnings results and vice versa. The exception would be KMG – reacting to the offer from CCMP
  • RPM’s quick and successful activist move in July was followed by the removal of the company’s poison pill in August – likely setting the company up for sale.
    • We see as much as 20% further upside here.
    • At the other end of the coating spectrum, the loss of the CEO at AXTA hurt the stock – he is leaving to run Akzo Specialties once it has been acquired by private equity.
  • The electronics group has pulled back over the last few months (with the exception of KMG this month) and we see this as an entry point – chip demand remains very strong and as long as production remains high suppliers will get paid, regardless of how much money the semiconductor producers make.
  • Lastly – Exhibit 11– BCPC continues to defy gravity – we do not understand the logic of owning this name. The company needs a large acquisition to keep the momentum going and market values are high suggesting that there are no bargains out there.
    • There is a major pairs trade opportunity in our view – long IPHS and short BCPC
    • The general dislike for TiO2 is also evident in Exhibit 11

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

©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.

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