Chemicals Monthly – A Richer Sector With Limited Upside

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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

September 16th, 2013

Chemicals Monthly A Richer Sector With Limited Upside

  • A mainly positive month for the Chemicals subsectors from a performance perspective, as only Diversified trailed the S&P. Where there were revisions they were negative, and they were most pronounced for Coatings.
  • As indicated in our piece last month on transformational change we have adjusted the group composition, changing EMN from a Diversified to a Specialty chemical company. Reweighting has changed the shape of the normal value analysis meaningfully and today only the Ag sector looks undervalued, in part dragged down by MOS.
  • This month we have written on misvaluation, as picked up by our Skepticism analysis and implications for chemicals are contained in this report. This week we wrote about the impact of absolute pricing on basic chemical demand growth.
  • We would still focus on DD as we still see upside without a transaction and greater upside with one. MON looks interesting, but we would not chase the cheaper potash related stocks and we are more concerned about a valuation peak in RPM, though it did not screen expensive in the SI work, only because revisions have stabilized.

Exhibit 1

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

Overview

It was a mostly positive month for the Chemicals space. All subsectors, save Diversified Chemicals, outperformed the S&P, which itself gained 1.6% since our last monthly report.

It is hard to find cheap stocks and without negative revisions and most with positive revisions are trading well above what we would consider to be fair value. In work this month we looked at the relationship between valuation, earnings expectations and revisions and identified only a few names that looked interesting. There are few cheap companies with strong positive revisions but there are a few where estimates have stopped falling – DD for example. The same analysis identified LYB and AXLL as expensive and likely to fall. The reality is that these stocks are at all time high relative multiples, despite very strong earnings and earnings estimates are now driven more by fluctuations in energy prices than anything company specific.

As published in research this week
, we see little if any volume story for the US chemical producers as any small increase in demand is likely to be more than offset by incremental additions in capacity. Our view is that demand growth is constrained by high pricing.

We continue to see value in DD, but other Ag names now look very cheap also, though we would not chase the potash names as we think there is likely further downside as a real global clearing price is established. Ag remains the cheapest sub-sector, and the only one trading below its normal value.

Valuation

Exhibit 2 summarizes our valuation work.

The Coatings group,
as anticipated
, continues to see negative revisions to earnings estimates. Valuation here is still discounting a great degree of optimism, and the subsector remains well above normal value.

Exhibit 2

Exhibit 3 shows subsector discount from normal value in standard deviations.

Exhibit 3

Source: Capital IQ and SSR Analysis

The group composition is summarized below. As
noted in our piece on transformational change from last month
, we have adjusted the group constituents, changing EMN from a Diversified to a Specialty company.

Exhibit 4

Exhibits 5 and 6 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our August Chemicals Monthly. It was a strong month for the group, with only Diversified trailing the S&P.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Monthly Topics: Skepticism Index Update

Earlier this month
we published a comprehensive update of our work on Skepticism
. The underlying focus on this work is to measure the discrepancy in both the valuation (as measured by deviation from normal value) and the expected return on capital (as measured by the deviation from the long term trajectory). We appreciate that the equity market has a tendency to anticipate future trends and so we account for this by looking at valuation today versus the earnings potential one year out. Of course the lead/lag relationship may be different for some specific companies at specific times but we feel this captures the essence of the markets behavior.

In the original analysis we attempted to quantify how much of any company (as well as any sector’s) current valuation is explained by current return on capital. Otherwise put; is a company’s current deviation from “normal” value explained by an equal deviation in return on capital. Where current returns suggest that valuation should be higher we have labeled it “Skepticism”. The analysis is a simple sum of the number of standard deviations that a company is trading BELOW its normal value and the number of standard deviations above the return on capital (ROC) trend. There of course are two ways for this apparent anomaly to close – either the stock price (and hence valuation) can move in line or the earnings expectations can change (up or down) to close the gap.

  • A company trading at one standard deviation below normal value (+1) and with ROC half a standard deviation below normal (-0.5) has a skepticism index (SI) of 0.5. Negative skepticism is otherwise labeled as optimism.
  • If a company has a positive SI, either the relative share price is too low or the ROC is going to fall. If a company has a negative SI either stock price will fall or returns will rise to get back to normal.
  • Almost every stock in our universe oscillates regularly around the zero line – Exhibit 7 shows the time series for PX, and PPG as examples

Exhibit 7

Source: Capital IQ and SSR Analysis

In Exhibit 8 we show the aggregate data across the Chemicals sectors. This shows the equally weighted 6-month forward returns for stocks in each of the Skepticism Index categories. The result is interesting in that it shows a clear downward trend in forward returns as the SI level falls. The results for each of the sub-segments are shown in the exhibits which follow. Where we only have a few companies in each group or shorter histories we do not necessarily have a significant sample size and this causes some of the inconsistencies in Industrial Gas and Coatings, but for the most part the patterns are similar.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

We refined the analysis further to look for companies with a high SI index and either positive forward revisions or revisions that appear to be turning from positive to negative, on the assumption that more stable or positive revisions would suggest that the SI corrects through a movement in share price rather than a negative movement in earnings. We looked for the converse to suggest stocks with downside. This analysis resulted in better selectivity and better returns when back tested. The analysis for the Chemical sector yields only a few names as very few have extreme SI values today. The more interesting ideas are summarized in Exhibit 10 and the full list is shown in Exhibit 11.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Portfolio Performance

The August selections are shown in Exhibit 12. DD remains attractive despite its recent performance, but this partly because it is hard to find a cheap stock anywhere in the sector today.

Exhibit 12

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April 2012; we show the results for the current year in Exhibit 13. Results have been mixed in recent months. We should note that where the portfolios have outperformed they have outperformed considerably and in months they have lagged, the underperformance has been far less severe. We highlight the hedged overlap portfolio which has tended to produce the best return.

Exhibit 13

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • April, May and June consumer spending numbers were revised negligibly, and the preliminary July reading showed virtually no increase.
  • The short term trend remains upward, but appears to be flattening out. Spending has already far surpassed pre-crisis levels – Exhibit 15.

Exhibit 14

Exhibit 15

Source: BEA

Construction

  • Preliminary construction spending data for July showed the seasonally adjusted annual rate of expenditures exceeding $900B for the first time since June of 2009.
  • Figures for May and June were each revised up 1% and the long term trend shows quite a bit of slack for further improvements – Exhibit 17.

Exhibit 16

Exhibit 17

Source: US Census Bureau

Agriculture

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • The PMI held strong in the August reading as industrial activity appears to be gaining momentum.
  • The production sub component fell slightly, but remains well above the inventory index, which was little changed on the month.

Exhibit 19

Expansion

Contraction

Source: ISM

Exhibit 20

Source: ISM

Trade

  • A month after hitting a multiyear high, chemical trade volumes plummeted in the latest data. The balance has been spiking above and below a middling 12 month rolling average trend line – Exhibit 21.
  • The Indian Rupee continues to get hit hard and has depreciated 21% since January – Exhibit 22. Thus far, Q3 has seen the dollar weaker versus the Euro by over 5% year over year – Exhibit 23.

Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: IMF

Exhibit 23

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our recent piece on US ethylene demand for our current perspective. We remain concerned that high absolute pricing for chemicals are constraining growth.

In both of the charts that follow we include HIS’ forecaster for the balance of 2013, and it is interesting to note that while production has picked up this year, operating rates are beginning to trend downwards, reflecting the capacity additions at the beginning of the year from DOW and WLK. We would not expect production in Q3 and Q4 2013 to be meaningfully impacted by Williams as the whole system has room to make up the gap – Exhibit 24. Given the better consumer spending numbers and the better housing numbers in the US we do see some support for the better production levels and without this spending increase we would be concerned that the extra production is going into inventory.

Operating rates are summarized in Exhibit 25.

While the current significant discount in NGL pricing in the US relative to crude oil gives a subset of US producers a meaningful cost advantage over any producer globally using an oil fraction as an ethylene feed, the higher cost producers in the US do not have costs materially lower than the higher cost producers in Europe, Latin America and Asia, at this time. While the plans to add NGL based capacity in the US is predicated on the idea that it should displace crude oil fraction based production outside the US, there is a risk that some of the early victims will be crude oil based producers locally. Looking back at the trade figures above – Exhibit 21 – until the last data point (which is only one month), we have not seen the lower cost base in the US turn into a meaningful improvement in exports. The trade data is volatile but it is hard to see a positive trend and if we do a 12 month rolling average the line trend is not compelling.

Exhibit 24

Source: IHS and SSR Analysis

Exhibit 25

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 26

The Middle East continues to dominate the crude oil story and we have seen prices above $110 per BBL for Brent through September so far. Natural gas remains quite cheap – but is around 50 cents higher than it was in the first half of August.

Exhibit 26

Source: Capital IQ and SSR Analysis

NGL pricing continues to track natural gas, at economics that cover variable costs for extraction facilities but do not cover cash costs. Ethane margins remain below break-even extraction costs for the average producer. Margins have now been negative for 10 months in a row – Exhibit 27.

Exhibit 27

Source: IHS and SSR Analysis

Butane and propane pricing have turned more positive reflecting the expected heating and winter blending season for butane. Ethane is now by far the most attractive feedstock for ethylene production. Ethane has not weakened further relative to natural gas. The longer-term trend relative to crude remains negative – Exhibit 28.

Exhibit 28

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is stable in the US, with producers looking for increases in September, probably with the goal of holding prices steady. Markets are not significantly oversupplied, but there is no shortage of product and the overall demand picture remains weak, more so overseas than domestically. Unless we see some sort of pick up in global demand we would expect the price and margin lines in Exhibit 29 to start moving down more quickly from the relative stability so far this year.

Exhibit 29

Source: IHS and SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (30) summarizes the results and is a repeat of Exhibit 1.
Exhibit 30

Valuation Charts – Exhibits 3133

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see
our past research for more detail
. The primary conclusions are:

  • Specialty and Coatings continue to have valuations that discount an increase in return on capital from current levels. The Commodity and Ag Chem subgroups both have values that anticipate a fall in returns on capital, while valuation and ROC seem to be fairly aligned for the Industrial Gas and Diversified Chemical companies – Exhibit 34.

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

September 15, 2013 – Optimism and Forecasting in the Chemical Industry

August 5, 2013 – Understanding Transformational Change: The Eastman Example

August 5, 2013 – Potash: Breaking Up Apparently Isn’t That Hard to Do (Blog)

July 25, 2013 – DuPont: Getting Appropriate Value for the Growth Engine

June 19, 2013 – Complexity, Volatility, and a Market Where Neither Extremes Work Well

June 14, 2013 – Ethylene: Unlikely to Be a Quick Fix for Williams

May 13, 2013 – DuPont: Betting the Farm – But Perhaps a Need to Crop the Portfolio?

April 10, 2013 – US Energy Advantage – Unintended Consequence; Global Overbuilding of Petrochemicals

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 36 to 40.

Exhibit 36


Source: Company Reports and SSR Analysis

Exhibit 37

Source: Company Reports and SSR Analysis

Exhibit 38

Source: Company Reports and SSR Analysis

Exhibit 39

Source: Company Reports and SSR Analysis

Exhibit 40

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 41 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 1.

Exhibit 41A

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 41B

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. We will test this more empirically in the coming months.

Appendix 2

©2013, 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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