Chemicals Monthly – Agricultural Action

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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 17th, 2016

Chemicals Monthly – Agricultural Action

  • Thirst for deals in the sector remains strong, and Ag Chemicals continues to be a focal point – MON now the hunted after a failed stab at hunting (Syngenta)
  • Ag was easily the best performing subsector over the past month due to MON’s gains on the Bayer news
    • Countered continued weakness in fertilizer stocks, though the risk-reward looks increasingly favorable in our opinion (see research referenced below)
  • Q1 earnings roundup:
    • Nearly all of our Chemical stocks beat on the bottom line in Q1, and revenue surprises were far more prevalent than in prior quarters
    • DD a standout – results indicate proactivity leading up to DOW merger – DOW results showing less urgency
  • Energy pricing continued to trend higher, posting modest gains, but US inventories of crude and natural gas are well above historical norms
  • Chemicals research published since our last monthly:
    • Global chemicals – we see more risk than reward in BASF
    • Dow/DuPont – abundant optionality
    • Fertilizers
      • Potential green shoots for MOS?
      • Nitrogen analysis – recent weakness presents interesting entry point for CF
  • Our preferences in the sector are summarized in Exhibit 1
    • We are underweight the sector given the macro challenges facing the industry, but see pockets of opportunity
    • Ethylene and polyethylene remain strong but we still believe that Q2 will be the peak

Exhibit 1

Exhibit 2

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

Overview

A year after the start of its failed pursuit of Syngenta, Monsanto finds itself in the crosshairs of a potential acquirer (or two). News of Bayer’s interest in MON, coupled with prior overtures from BASF, makes a further shakeup in the Ag chemicals space a seeming inevitability. We explored the various possibilities for MON in recent research – taken together we would own the stock. FMC also looks intriguing as a likely takeout candidate by the odd man out in the MON/BASF/Bayer development.

Elsewhere in the Ag market – fertilizer stocks remain under pressure but the tide may be turning. This was an area of focus for us over the past month – recent negative revisions and poor stock performance likely offer some intriguing entry points. MOS looks best positioned on valuation and balance sheet strength. CF may be doubly discounted for weak urea pricing and the complexity of its recent deals – we think urea prices may have bottomed in Q1, driven not by cost curve dynamics, but by the sentiment surrounding the lows in crude pricing earlier in the year (with crude driving the price of natural gas-based urea production in several key geographies) and the OCI deal in particular should be positive for CF by virtue of expanded international distribution.

These stocks were outliers in the Chemicals Q1 earnings results – Exhibit 3. CF and MOS posted the largest revenue surprises in the sector, but EPS results lagged, indicating the current low utilization rates.

DD is also a standout in the scatter below, but for more positive reasons, posting a strong EPS surprise to the upside while the top line came in above expectations as well. Management is clearly being very proactive leading up to the DOW merger – less so for its partner to be. DOW’s results were far from terrible but do not suggest the same type of urgency.

Exhibit 3

Source: Capital IQ, SSR Analysis

Valuation

Exhibit 4 summarizes our valuation work and the subsector classifications are summarized in Exhibit 5. Another round of negative revisions for fertilizer stocks (CF and MOS) makes for a favorable risk-reward proposition – downside is limited in our view while leverage to a recovery is high. Positive revisions have been rare in the Chemical space of late, but both Diversified and Commodity groups saw significant momentum here. DD (+4%) and ALB (+12%) were most responsible for the positive revisions in the Diversified subsector. DOW (+1.8%) contributed to the cap weighted Commodity revision but AXLL (+27%) was the big mover.

Exhibit 4

Exhibit 5

In Exhibit 6 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 7 we show discount by company. The Ag group continues to look cheap in aggregate despite MON’s pop on the Bayer news, which was offset by weakness in the fertilizer stocks. Coatings remains as expensive as it has looked in some time.

Exhibit 6

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 7 – MOS and CF, focus stocks for our recent work on fertilizers, both screen at all-time valuation lows on normalized earnings. SHW is driving the premium valuation in the aggregate Coatings space, though RPM is also at its own valuation extreme (note the buyout premium reflected in VAL). PPG’s valuation looks much more reasonable and this is our preferred play in Coatings.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 shows absolute and relative performance by subsector since our last monthly report. The Ag group was boosted singularly by MON – fertilizer stocks have been weak and are hovering near 52 week lows.

 

Exhibit 8

Source: Capital IQ and SSR Analysis

 

Profitability

 

Exhibits 9 through 11 show profitability at the sector, subsector, and stock level. All of the Coatings stocks with the exception of RPM are at 10 year earnings extremes. APD continues to earn well above its long term return on capital trend – this extreme figure is partly explained by the historical stability of the industrial gas industry, which for APD results in one standard deviation in ROC being small in absolute terms compared to more volatile industries (i.e. Commodity Chemicals). On the opposite end of the spectrum, ALB’s ROC is depressed from the Rockwood acquisition, but the stock has performed well on strong Lithium results.

Exhibit 9

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. Net income margin for the group in aggregate remains historically elevated and continues to trend higher driven by the Diversified group’s sharp turn off recent lows and continued gains in Industrial Gas. Coatings margins also are trending higher though at a slower pace of expansion than seen recently. Commodity margins appear to be turning over near historical peak levels and Ag margins have room to come down further to prior troughs.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 12 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 – OLN, for example, screens as cheap but we see good reason for this and have long been concerned about the stock (see Exhibit 1 for our preferences by Chemicals subsector).

2015 was not a successful year for these selections across the board, though results for the skepticism and overlap portfolios had been robust in 2013 and 2014 – Exhibit 13. Cheap commodity stocks AXLL, OLN, and HUN were mainstays on the long screens in 2015 and this was a yearlong headwind for the selections. These stocks have enjoyed a bounce off the lows, and the short stocks have capitulated somewhat, and the results in 2016 thus far are accordingly more positive than in ’15, though May’s results two weeks in are mostly negative.

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. When revisions are positive while the valuation and skepticism components are also positive, the risk-reward profile is very attractive, and improves at greater levels of discount and skepticism. Negative revisions have limited this list in recent months and no stocks had met the criteria for the past two months – currently we have a group of five stocks including OLN, EMN, HUN, LYB, and POL – Exhibit 14.

Exhibit 12

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures were virtually flat in the latest data through March – services down modestly, goods up modestly
  • Yaer over year growth in goods (~34% of spending – Exhibit 15) trailed the growth in services (~66% – Exhibit 16) for the first time since January 2014

Exhibit 15 Exhibit 16
Source: BEA

Construction

  • Construction spending saw a slight sequential uptick – year over year growth is 8%, but decelerating from the 10-13% growth seen in the middle of 2015
  • Seasonality suggests we should see the upward trend resume as we move into the warmer months
  • Exhibit 17 shows the long term trend in US construction spending and Exhibit 18 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period

Exhibit 17 Exhibit 18

Source: US Census Bureau

Agriculture

  • Soybean pricing has continued to trend higher on a combination of relative strength in the export market and potential summer drought conditions in the US – prices are up another 3.5% midway through May and have risen nearly 25% on the year
  • Corn pricing has been less responsive given strong estimates of planted acres

Exhibit 19

Source: Capital IQ, SSR Analysis

ISM

  • The PMI fell in the latest reading but managed to hold in the expansion range
  • Inventories appear to be in a healthy position and there is plenty of slack in productive capacity

Exhibit 20 Exhibit 21


Source: ISM

Trade

  • Our trade balance exhibit excludes medicinal and pharmaceutical products to more accurately reflect the composition of our chemical index
  • The 12 month rolling average (dotted green line) in Exhibit 22 is taking on a more pronounced downslope – sustained lower oil prices are not helping the case for US chemical exports, but given that the measure is in $ rather than volumes (pounds or tons), lower energy pricing (and therefore product pricing) may account for the declining trend

Exhibit 22

Source: US Census Bureau

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Delays or postponements of scheduled turnarounds have provided a boost to supply. Demand has been solid, particularly for ethylene into polyethylene. Ethylene production is summarized in Exhibit 25 and operating rates are summarized in Exhibit 26. Capacity increases are set to vastly outpace demand growth over the next three years – see our recent research on this topic and its implications.

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Exhibits 27-29 highlight the record energy stockpiles in the US – yet despite elevated domestic supply levels, energy pricing has rebounded off the lows driven partly by sentiment and planned production freezes – Exhibit 30. Ethane pricing has continued to trend higher in May – Exhibit 31.

Exhibit 27 Exhibit 28


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

Exhibit 29

Source: EIA, SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31


Source: Midstream Business and SSR Analysis

Exhibit 32


Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 33


Source: IHS and SSR Analysis

Basic Plastics

Domestic polyethylene demand growth was about in line with GDP estimates for Q1, but the export market has been notably strong (+30% YTD through April). We remain skeptical that there is sufficient demand for a polyethylene price increase to take hold beyond Q2 2016 (and only in Q2 because of support from planned plant shutdowns) and believe a further margin decline of 10-15 cents per pound is likely over the course of the next 12-18 months.

Exhibit 34

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 (35) summarizes the results and is a repeat of Exhibit 4.

Exhibit 35

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37


Source: Capital IQ and SSR Analysis

Exhibit 38

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 39 summarizes Skepticism Index values by subsector, Exhibit 40 shows the extent to which valuation is historically explained by returns, and Exhibit 41 plots the individual SI components, valuation discount and deviation from return on capital trend:

  • Industrial Gas was a big mover over the past month – Praxair’s returns have risen strongly off the trough, and are now more in line with valuations
  • SHW again drives the Coatings result and this subsector now shows the greatest degree of skepticism – returns may be stretched at SHW but we think PPG has a clear path for returns to continue higher
  • The Ag group may have some further downside to returns, but this is already priced in
  • Elsewhere the SI values show valuations and returns are largely aligned

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42 shows SI by company. Only IFF is at a skepticism extreme, currently at its all-time SI low, indicating market optimism that returns can be maintained.

Exhibit 42

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

May 16, 2016 – Monsanto Multiple Choice: Going it Alone, Merging, Selling, Spoiling?

May 16, 2015 – Nitrogen Fertilizer: Just Like Ethylene, but Different

May 5, 2016 – Fertilizer: Looking for Green Shoots

April 26, 2016 – Dow DuPont: So Many Scenarios, Few Companies Unaffected

April 19, 2016 – BASF: Trapped from the Inside and the Outside?

April 11, 2016 – PPG: Historical Anchors Away

March 29, 2016 – Lyondell: Over-Optimistic on Ethylene Means Over-

March 29, 2016 – Ethylene: Rewind to the 90s

March 15, 2016 – Sasol Delays Ethylene Plant: Axiall, Westlake and Eastman Should Be Paying Attention (blog)

March 14, 2016 – Monsanto: A Round-Up of Opportunities

March 6, 2016 – Enter BASF! Spoiler or Another Consolidator? We Think the Latter More Likely

March 2, 2016 – DowDuPont Trough Earnings: Risk/Reward Stacked to the Upside

February 25, 2016 – WLK + AXLL: A Deal Makes Sense – WLK Attractive Regardles

February 22, 2016 – Eastman: Should You Try for 2nd Base?

February 9, 2016 – Polyethylene: The Fragile Last Line of Defense!

January 27, 2016 – Coatings (PPG) A Safer Bet than Industrial Gas

January 13, 2016 – Dow/DuPont: So Far Not So Good – But Now More Compelling

January 6, 2016 – PPG: The Best of the Bunch (McGarry) for 2016

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 42 to 46.

Exhibit 43

Source: Company Reports and SSR Analysis

Exhibit 44

Source: Company Reports and SSR Analysis

Exhibit 45

Source: Company Reports and SSR Analysis

Exhibit 46

Source: Company Reports and SSR Analysis

Exhibit 47

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 48 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 48A

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 48B

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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