Chemicals June – Not All Mergers Are Created Equal

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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

June 19th, 2017

Chemicals June – Not All Mergers Are Created Equal

  • While one potential cross-border Chemical merger has failed (PPG/Akzo) since our last monthly report, two have been announced (HUN/Clariant and Linde/PX)), one has been completed (ChemChina/Syngenta) and another appears to be moving ahead (Bayer/Monsanto)
    • We worry about the HUN deal, given the significant complexity of the prospective Huntsman/Clariant portfolio, and what are likely overestimated synergies
  • Ineos’ announced basic chemical (ethylene, propylene) capacity expansions/additions in Europe speak, in our view, to an expectation that UK shale resources will be developed
    • While portrayed as an exploitation of trans-Atlantic feedstocks, our historical return analysis of basic chemical new builds highlighted the forecasting and timing challenges for these projects; though this analysis focused on the US, it is illustrative support for the expansion (vs. new build) strategy – see prior research
  • Revisions have stabilized in the Ag and Coatings space but performance remains divergent for the cheapest and most expensive Chemicals sectors, respectively
    • SHW continues to set new highs as the VAL deal has finally closed and PPG has retained much of the share price gain it accrued during its Akzo pursuit
    • CF and MOS meanwhile continue to hover near trough valuations – driven by trough pricing
  • Since our last monthly we have written on:
    • Akzo – while we are unsure of what Elliott’s end game is, their recently increased position in Akzo makes us less negative on the stock
    • LYB/WLK – disputes in the Middle East present a potential upside tail risk for these stocks, which we continue to see as extremely cheap
    • PX/LIN – with the deal terms finalized, we would be buyers of both stocks as synergies, in our view, are likely to greatly exceed what has been announced
    • Huntsman – see research referenced above
  • Our preferences in the Chemical sector are summarized in Exhibit 1
    • We are positive on most of the large cap names in the space (DOW, DD, LYB) but have concerns in most subsectors, and at the subsector level would only be overweight Commodities and Ag Chemicals – in part because of valuations, in part because of improving fundamentals – for commodities we are assuming that oil stays around $50
    • We had been underweight Industrial Gas for general industry stagnation and lack of strategic options, with relative preference for Air Liquide on Airgas integration and US expansion – we change this to neutral given our above views on PX/LIN and continued concern about APD
    • We remain underweight on Coatings – our underweight on Akzo is tempered by Elliott’s continued (increased) presence; SHW continues to look stretched in our view

Exhibit 1


Exhibit 2

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

Overview

Huntsman/Clariant replaces PPG/Akzo in the list of pending Chemicals deals, but significant progress was made in a couple of cases over the last few weeks:

  • Dow/DuPont received US regulatory approval – paving the way for the expected August closure
  • ChemChina closed its acquisition of Syngenta
  • Praxair and Linde announced the structure of their proposed merger of equals
  • Significant increase in the amount of noise around the likely divestitures needed to get the Bayer/Monsanto deal approved

In the light of the increasing number of cross border mergers, we are working on increasing our coverage of the non-US industry and have written about both Braskem and Ineos in recent Friday emails.

Exhibit 3


Source: Capital IQ and SSR Analysis

In Exhibit 4 we look at the elective cash spend of the US chemical industry over the last 7 years and make the following observations:

  • The deal flow has reduced the share buybacks (both Dow and DD were very active and LYB has cut back in 2017 in part because of potential M&A opportunity).
  • The M&S spend is deceptive, but US companies are not paying up for businesses (the exception would be Nova with the Williams deal).
    • DOW/DD is a merger.
    • PX/Linde is a merger.
    • Bayer is buying Monsanto – not a US deal.

Both 2016 and 2017 YTD have been quite profitable for the industry so cash is building! We expect a big step up in share buybacks and further M&A.

Exhibit 4


Source: Capital IQ and SSR Analysis

Valuation

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6.

Exhibit 5

Exhibit 6

In Exhibit 7 we show subsector discount from normal value as measured by our valuation framework, and in Exhibit 8 we show discount by company. The sector order in Exhibit 7 is unchanged from the last two months as performance continues to diverge at the extremes. Sector performance over the past month is summarized in Exhibit 9 and we see Ag has continued to lag while Coatings produced another strong relative gain.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – the story is little changed from recent months. Fertilizer names remain near extreme discounts. Eastman is no longer a 10% outlier but continues to stand out in Exhibit 8 – at an extreme valuation low while US economic growth is improving. We still believe that there is significant value to unlock at Eastman but are unconvinced that the current management team is focused on the right things – in other words we struggle to see a catalyst. The other stand-out in Exhibit 8 is WLK, where despite the improved stock price the market is not giving the company the benefit of the doubt regarding its ability to integrate and extract value from the Axiall acquisition. Betting against WLK in these situations in the past has generally been the wrong move. Note also that neither Dow nor DuPont looks expensive in the analysis below if you give the companies the benefit of the expected merger synergies.

CF is the stock that everyone appears to be watching with a view to timing an entry point. Leverage to the nitrogen market is extreme, following new capacity additions in the US, but there is a significant global and US oversupply today and US pricing is at levels needed to push out importers and create some marginal exports. Our “Normal Value” for CF based on normal (mid-cycle) return on capital is around $65 per share based on the increased capital base following the expansion. How clever on timing do you need to try be with this level of upside?

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. Both PPG and SHW are now at 10 year return peaks, suggesting why mergers are currently in focus in the Coatings space. On the under-earning side, sub-trend returns help explain the valuation discounts seen in the fertilizer stocks.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibits 11 and 12 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. Net income margin for the group in aggregate remains historically elevated. Coatings margins continue to stretch higher, along with Diversified. Ag margins are off the recent lows but appear to have stalled, while commodity and gas margins are rolling over from recent peaks.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 13 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).

The commodity and agriculture stocks had boosted these portfolios in 2016 and the early part of this year, but the rally has begun to stall. Weakness in the short side overlap selections has helped the hedged results.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions – the addition of the revisions metric provides a momentum style factor. This month we have the same group of six as we did in our May report – Exhibit 15 – including two stocks where we see considerable upside potential, LYB and EMN. Exhibit 16 shows the recently updated performance results for companies meeting these conditions at various ranges.

Exhibit 13

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Spend on services was virtually flat month over month and +2% year over year
  • Goods spending was up nearly 1% sequentially and up 3.6% versus the prior year
  • Growth in durable goods spend is tempering but the latest data (caputring spending through April) marked the seventh consecutive month of 7% year over year growth

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • Significant positive revisions to March construction spending estimates (+1.4%) were offset by a sequential decline for April, though year over year growth accelerated – Exhibit 21
  • Exhibit 19 shows the long-term trend in US construction spending and Exhibit 20 shows the trend over the past several years

Exhibit 19 Exhibit 20


Source: US Census Bureau

Exhibit 21

Source: US Census Bureau

Agriculture

  • June to date has seen modest price gains for soybeans (+1.7%), corn (+1.3%), and wheat (+3.2%)
  • An expected significant soybean harvest in Brazil is poised to weigh on prices throughout the summer
  • Corn pricing is seen as likely to be firmer in the coming months, with potential for lower yields than in recent years

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • The US manufacturing PMI ticked slightly higher in the May reading and remains at solid expansion levels
  • Inventories are trending higher and production is coming off its recent peaks
  • New orders were strongly higher – Exhibit 25

Exhibit 23 Exhibit 24

Source: ISM

Exhibit 25

Source: ISM

Trade

  • Our trade balance exhibit excludes medicinal and pharmaceutical products to more accurately reflect the composition of our chemical index
  • We see trade risk from a Trump presidency as a potentially significant headwind for the US Chemicals space
  • The trade balance has come off its recent highs (levels not seen since 2013) in the latest data through April. As all of the new capacity scheduled for this year in the US comes on line in basic chemicals and plastics we would expect a significant upward trend in the data from here, and the 12 month rolling average (dotted green line) is trending higher quickly.

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Q2 ’17 ethylene production is on track to break Q4 ’15’s record as outages have been minimal (lowest since 2011). High inventories further down the chain are dampening current ethylene demand, which is expected to rise in 2H with the startup of polyethylene capacity.

Production and operating rates are summarized in Exhibits 29 and 30.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Output reductions have not broken the downward trend in crude pricing – Exhibit 33 – and US crude stockpiles, while off recent all-time highs, are still elevated – Exhibits 31 and 32. Natural gas is back round $3.00 per MMBTU after approaching $3.50 last month, driven by expectations of an export pull – net long natural gas positions have been trending higher and are currently at the highest level since 2014. Gas in storage remains above the seasonal norm of the past five years but could be drawn down quickly as the weather heats up.

Exhibit 31 Exhibit 32

Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Exhibit 33

Source: EIA, SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Midstream Business and SSR Analysis

Exhibit 36

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 37

Source: IHS and SSR Analysis

Basic Plastics

Total PE demand in April was at its lowest level since early 2014, and lackluster demand continued in May, but is expected to turn around as we move through the year. Inventories remain elevated, contributing to pricing pressure.

Exhibit 38

Source: Wood Mackenzie, Midstream Business, Industry Sources, SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical subsectors. The first exhibit (39) summarizes the results and is a repeat of Exhibit 5.

Exhibit 39

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41



Source: Capital IQ and SSR Analysis

Exhibit 42



Source: Capital IQ and SSR Analysis

Skepticism Analysis

Here we apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see past research for more detail. Exhibit 43 summarizes Skepticism Index values by subsector, Exhibit 44 shows the extent to which valuation is historically explained by returns, and Exhibit 45 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46 shows SI by company. No company currently sits at a skepticism extreme.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

June 13, 2017 – Akzo: Time for a New Game! Problem or Opportunity for PPG?

June 7, 2017 – LYB, WLK: A Risk to the Upside – Albeit Remote – Qatar

June 5, 2017 – Akzo/PPG: Maybe the DEVIL is in the Details – Did PPG Dodge a Bullet?

June 2, 2017 – PX/LIN: Buy Both – Now We Have the Deal Terms Out of the Way

June 1, 2017 – PPG/Akzo: Probably the Right Move for PPG but Disappointing – Unanswered Questions for Akzo

May 24, 2017 – The Cheapest Pound of Ethylene: Why LYB Should Buy LYB – or WLK!

May 23, 2017 – HuntsmanClariant: Could Two Poorly Understood Businesses Combine to Make Matters Worse

May 22, 2017 – Huntsman: Another Cross Border Deal – Another Reaction to Slow Growth, but a Good Idea

May 9, 2017 – Akzo: Arrogance and Optimism: Likely to Hurt Every Stakeholder

May 5, 2017 – Lyondell: Dip = Opportunity? Harder to a Deal – Bring Back the Buy Back

May 2, 2017 – Air Products: Back Down the Rabbit Hole?

May 1, 2017 – Making Money in Ethylene: Much Harder Than it Looks

April 24, 2017 – PPG/Akzo: Is the Negotiation Over?

April 17, 2017 – Nova: Flexing Its Financial Muscles – Changing the Shape of US Ethylene

April 17, 2017 – Industrial Gases: “Multiple” Risks – Driving the Attempted M&A

April 7, 2017 – Lyondell M&A: Triangulating to the Best Idea – WLK?

March 29, 2017 – “What’s Wrong with Eastman?” – A Common Question

March 27, 2017 – More Constructively Bullish on Ethylene: Takeaways from the IHS Conference

March 23, 2017 – Akzo: An Opportunity for Active Managers to Manage Actively

March 21, 2017 – Dow/DuPont: The Last Stretch of the First Step

January 5, 2017 – Dow/DuPont: Again in 2017!

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 47 to 51.

Exhibit 47



Source: Company Reports and SSR Analysis

Exhibit 48

Source: Company Reports and SSR Analysis

Exhibit 49

Source: Company Reports and SSR Analysis

Exhibit 50

Source: Company Reports and SSR Analysis

Exhibit 51

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 52 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 2.

Exhibit 52A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 52B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment – assumed that valuation is 60% of the story and revisions is 40% for each sector.

Appendix 2

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