Chemicals December: Commodity Charge Caps a Strong Year

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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

December 15th, 2017

Chemicals December: Commodity Charge Caps a Strong Year

  • In January we wrote that commodity chemicals were in for a year of outperformance – with two weeks left in the year, this has proved prescient as gains have been widespread:
    • HUN and WLK are the top year to date performers in our long-term-history coverage (does not include CC and TROX, which have seen even more significant gains)
    • OLN and CF also above the sector average and the S&P
    • DWDP has outperformed the market by a few percentage points but the recent lack of news flow and investor/analyst inertia with respect to the modelling of the company have in our view held back estimates and in effect the stock (see below)
    • PX has also performed well and remains our top pick
  • These stocks are maintaining the momentum as we approach year’s end – only the Commodity group has stayed ahead of the S&P since our last monthly report (WLK in particular – see ethylene research referenced below)
  • Since our last Chemicals monthly we have published on:
    • Ethylene – we expect some volatility around unit startups in 2018 but see the positive December fundamentals as generally boding well for producers in the new year
    • DWDP – current estimates look conservative to us based on the combined company analysis we published in September
    • Coatings – we examined strategic options for the major players amidst a flurry of speculated deals regarding AXTA (which have subsequently fell through)
  • Our preferences in the Chemical sector are summarized in Exhibit 1
    • We are positive on most of the large cap names in the space – DWDPLYB, PX
    • At the subsector level, we are overweight the Diversified group given the large weight of DWDP, in addition to our continued overweight positions in Commodities and Industrial Gas
      • In part because of valuations, in part because of improving fundamentals or mergers – for commodities we are assuming that oil stays around $60
      • Order of preference within Industrial gas is PX/LIN over Air Liquide
    • We remain underweight on Coatings; our Akzo concern is tempered by Elliott’s continued (increased) presence; SHW continues to look stretched in our view
      • We would be underweighting the coatings group (US and Europe) and underweight Ag, at least through the end of the year – otherwise the broad picture is quite positive

Exhibit 1


Exhibit 2

Source: SSR Analysis – See Appendix 1 for background and see Appendix 2 for a larger version of this table.

Overview

Exhibit 3 shows the performance of chemical stocks year to date – aside from the commodity winners detailed above, SHW has again been a notable outperformer particularly relative to the lackluster performance of other Coatings stocks. We see risks here, both for SHW with respect to the VAL integration, and for the industry at large. While SHW has been quietly outperforming, the other major players have very publicly failed in several M&A attempts that underscore the headwinds facing the sector. Most recently AXTA (a 3% underperformer on the year versus the S&P) has been in focus – the volume and price trends shown in Exhibit 4 show why AXTA may be eager to sell itself or merge. The failure of major M&A in the Coatings industry contrasts with the situation in Industrial Gas, a similarly adrift industry where business combinations have now provided a multiyear runway for growth (Air Liquide’s acquisition of Airgas, the ongoing merger of PX and Linde). The backdrop of an improving industrial economy is an added tailwind but the real upside is driven by significant, and we believe unrecognized, synergy potential that makes PX/Linde our top idea for 2018. We will publish a more formal investment outlook for 2018 in the weeks to come.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Valuation

Exhibit 5 plots return on tangible capital versus enterprise value. This is a valuation plot we have used in the past for our SMID work to overcome the limitations of historical data and lack of proxies. We will be using this plot regularly as part of what will be more frequent SMID chemicals coverage in 2018.

Exhibit 5

Source: Capital IQ and SSR Analysis

In Exhibit 6 we detail our Chemical subsector composition, and our usual valuation summary is shown in Exhibit 7.

Exhibit 6

Exhibit 7

Exhibit 8 summarizes discount from normal value at the sector level, and Exhibit 9 shows a stock level view. Coatings remains the valuation concern – the premium for the Diversified group is not inclusive of the DWDP synergy upside. Only Ag screens cheap at the sector level but we are cautious on the fundamentals in this space – CF the possible exception as evidenced in the year to date performance data.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 10 we show performance by Chemical subsector over the past month. WLK was the big winner in the Commodity group, though LYB was also ahead of the S&P.

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 12 and 13 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. The new subsector classification demonstrates the recent strength in the combined DWDP and also highlights a flat to declining trend in commodity chemicals net income margins over the past several years.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 14 summarizes the 5 most attractive and unattractive stocks on our normalized earnings valuation and skepticism index frameworks as of the start of the month. We note that these are based solely on our valuation models and we do not make any judgment calls to adjust these selections (see Exhibit 1 for our preferences by Chemicals subsector).

It has been another solid year for our selection methodology, particularly in the overlap group which continues to produce the most robust returns – Exhibit 15 shows cumulative monthly returns for 2017 and prior years.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions – Exhibit 16. The same four stocks appear on this screen as last month – MOS, MON, WLK, and LYB. Exhibit 17 frames the historical performance results that inform this portfolio selection methodology.

Exhibit 14

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17