Chemicals May – Surprise! An Unexpectedly Good Q1

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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

May 16th, 2017

Chemicals May – Surprise! An Unexpectedly Good Q1

  • Q1 earnings reports in the Chemicals space mirrored what we observed in large cap Industrials & Materials – the most significant top line surprises since 2011
    • DOW and DD again were standouts, benefitting from pre-merger cost cutting and end market strength – especially in Asia
    • Coatings companies saw some of the smallest revenue beats in the group, highlighting the lack of underlying organic demand growth and perhaps the impetus for M&A
    • Commodity stocks mostly registered beats on top and bottom lines: OLN and LYB exceptions – for the latter, an apparent unpopular change is strategy has added to pressure on the stock
  • Commodity rally has stalled after a strong start to the year and despite overall positive earnings reports – group down 2% in aggregate versus the S&P since our last monthly report
    • Strong earnings (top and bottom line beats) spurred interest in Industrial Gases (APD and PX) which has been the best performing sector over the past month
    • Ag Chem (-4%) and Coatings (+2%) were other notable movers, reflecting current challenges and opportunities in the respective spaces
  • Chemicals research published over the last month has included work on:
    • Akzo – we believe the most consistently poor management team in the Coatings space is acting in self-interest rather than the interest of stakeholders by refusing to engage with PPG – see significant downside if PPG walks
    • Lyondell – we see limited downside in the stock based on trough earnings and believe investors would welcome a resumption of the buyback program after M&A rhetoric appeared toned down on the Q1 earnings call
    • Air Products – we remain concerned about underlying growth prospects in Industrial Gas and see disconcerting parallels between the strategy of cash deployment articulated on the earnings call and the strategy that dug APD into the hole from which it has been digging out for the past three years
    • Ethylene – historical analysis of IRRs for builds at varying margins and sensitivities suggest potential disappointment for recent and prospective new builds and a slowdown in investment
  • 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 are underweight Industrial Gas and Coatings – continue to prefer Akzo in Coatings on portfolio optimization (forced or otherwise) and Air Liquide in Industrial Gas on Airgas synergies and US expansion, with relative preference for Linde

Exhibit 1

 

Exhibit 2

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

Overview

It has been a predominantly positive earnings season for our US Chemicals group, with a far more significant cluster of companies in the top right quadrant of Exhibit 3 – indicating earnings and revenue have come in above expectations. Commodity stocks are the outliers on both extremes, with OLN’s disappointment countered by strong beats for TSE, CC, and WLK. DOW also continued to show strength, surprising to the upside on revenues and EPS for the sixth consecutive quarter. Pre-merger DD showed less revenue upside but considerable cost opportunity .The Coatings companies reported some of the lowest top line surprises in the group, illustrating the lack of significant demand growth that is perhaps a driving force behind recent M&A moves. Ag markets remain challenging, reflected in a disappointing quarter for MOS – urea somewhat better with CF managing to surprise on both top and bottom lines. The results for the fertilizer stocks are exaggerated by the small absolute EPS figures.

All in all, using both a simple and cap weighted average, this was the best quarter versus expectations since 2011 – Exhibit 4.

Exhibit 3

Source: Capital IQ and SSR Analysis

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. There is no change in the sector valuation rankings since last month. Strength in Industrial Gases drove the group further into the expensive side of normal value. SHW is driving the premium in the Coatings space and extended it further following earnings. Note that writhing coatings PPG remains relatively attractively valued, especially versus SHW. Ag weakness was most pronounced in MOS but SMG also contributed to an underperforming month and a more pronounced discount versus a month ago. Sector performance over the past month is summarized in Exhibit 9.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – fertilizer names remain near extreme discounts after weakness post-earnings. 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.

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, considerably 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 despite a downward trend in recent months. Margins remain elevated and upward trending in Coatings, appear to have crested in Industrial Gas, and are attempting a turn in Ag Chem.

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 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 double the stocks meeting these criteria as we did in April – 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

  • Marginally lower (-0.1% month over month) consumer spending on goods (35% of total personal consumption expenditures) was offset by 0.4% sequential growth in the larger services category
  • Growth in durable goods spend continues to temper but remains strong at 6.8% year over year in the latest data

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • Significant positive revisions to January and February construction spending estimates (+1.3% and +2.3% respectively)
  • Latest data through March showed a small sequential decline, but year over year growth remains solid – 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

  • May has been a quiet month for ag pricing – only corn (+1.3%) has seen a move of at least 1%
  • Yield efficiency continues to outpace demand growth for agricultural commodities

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • The US manufacturing PMI took a step down in April’s reading but remains strong
  • Production is off the recent peak but still elevated and the absence of a corresponding pronounced inventory build up suggests strong demand
  • New orders also declined, to a still strong 57.5 – 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 is at its highest level since 2015 in the latest data through March. 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.

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene operating rates pushed above 90% in April for the highest month of ethylene production since December 2015, +1.3% month over month. Demand, conversely, was off 1% sequentially, with elevated inventories in several downstream derivatives, but is expected to pick up in Q3 when increased polyethylene capacity is scheduled to come online.

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

After briefly dipping below $50 per barrel, crude is trending higher on reports that Russia and Saudi Arabia support output reductions through 2018. Domestic stockpiles meanwhile are rolling over from recent all-time highs – Exhibits 31 and 32. Natural gas is approaching $3.50 per MMBTU, 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

An early year proposed price increase has failed to gain traction as polyethylene pricing has been lower on soft exports, driven by elevated international inventories, and tepid domestic demand.

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 would suggest additional downside for the industrial gas companies. For Coatings, we think it more likely that returns normalize to equate current valuations, rather than valuations improving to match above-trend returns.

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. ALB and ASH are the only companies currently at skepticism extremes, influenced somewhat by recent M&A moves. Returns for these two stocks are sub-trend even with the inclusion of 2016 capital data adjusting for portfolio adjustments – valuations indicate the companies are expected to see returns move back to trend.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

March 9, 2017 – PPG/Akzo: A Smart Deal Rather Than a “Me Too” Acquisition/Merger

February 20, 2017 – Looking to Westlake for Clues

February 9, 2017 – Betting Against the Sell Side: Follow Up

February 7, 2017 – SMID Cap Chemicals: Plenty of Interesting Ideas

February 3, 2017 – Lyondell: Momentum Turning into 2017 So Far

January 31, 2017 – Chemical Commodity Rally: Just Getting Started

January 23, 2017 – Air Products: “Me Too” Folly or an Inspired Fix for a Tricky Problem

January 6, 2017 – Chemours, DuPont and Teflon: Understanding the Dimensions of the Iceberg

January 6, 2017 – Chemicals: Value and Momentum Unaligned – Limited Choices for ’17

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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