Chemicals Monthly – Beating Lower Guidance is Not Really a Victory

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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

February 16th, 2016

Chemicals Monthly – Beating Lower Guidance is Not Really a Victory 

  • Most of the major companies have reported Q4 ’15 results and earnings in the Chemical space have beaten estimates by 11% on average on 2% lower revenues year over year
    • Continuing a recent trend that should prove difficult to sustain
    • The Q4 beat followed a year of negative revisions
  • We expect global polyethylene margins to contract in 2016 – see recent research
    • Valuations appear to be pricing in this risk but we think estimates will continue to come down and provide better entry points for LYB and WLK
  • Chemical stocks have seen significant volatility already in 2016, highlighted by DOW/DD, which largely influence the valuations of the Commodity and Diversified subsectors, respectively
    • Both groups are looking closer to fair value after rebounding in the first two weeks of February – DOW and DD continue to look attractive in our view
  • Energy pricing continues to trend downward, tightening the gas/oil spread and pressuring US Gulf relative basic chemicals and plastics economics
    • Natural gas the bigger move over the past month, down 12% sequentially (25% year over year), compared to a 5% sequential decline in crude pricing (down 45% year over year)
  • Over the past month we have written about:
    • The fragility of polyethylene margins
    • Our belief that Coatings (PPG specifically) should be a safer play in the current environment than the typical defensive Chemical plays in Industrial Gas
  • Our favorites in the sector are shown in Exhibit 1
    • Remain concerned about OLN despite investor day optimism – stock was an earnings outlier missing on revenues and EPS
    • Still positive on DOW/DD – solid rebound thus far in February after January weakness
    • PPG a standout in our view – see recent research

Exhibit 1

Exhibit 2

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

Overview

Q4 results in the Chemical space again showed bottom line beats on top line misses – Exhibit 3 – a trend reflected in the broader Industrials & Materials space as well, and one that will be difficult to sustain through the course of the year in the absence of an upside demand surprise. Positive EPS surprises were only associated with significant revenue growth in the case of MOS, potentially a bellwether of improvement in the fertilizer market. Results were more mixed for the Canadian players (earnings beat for AGU on lower revenues, misses on both for POT which also trimmed its dividend). CF reports this week.

At the other extreme, OLN was an outlier with a large earnings miss on significantly lower revenues than expected. We are skeptical of management optimism at the recent investor day and remain concerned about the stock – we think it could break single digits before we see any upside.

Exhibit 3 also highlights the weakness in the Specialty space, with IFF and CBT missing on both the top and bottom line. In this light, EMN’s results look impressive but the stock continues to be plagued by (in our view) poor corporate messaging and limited investor interest (possibly related).

The macro outlook has not changed materially and remains challenging, and energy pricing is under perpetual pressure amidst substantial oversupply and lackluster global demand. Despite a recent cold spell, natural gas inventories continue to track above the high end of the five year range – Exhibit 4. Crude inventories continue to reach new record highs – Exhibit 5. All told, gas pricing is down 25% from this time last year, but crude has fallen more than 45%. This is a rather quick and sharp contraction in the gas/oil spread, which should test the feasibility economics of the basic chemical investment wave in the US Gulf.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: EIA, SSR Analysis

Exhibit 5

Source: EIA, SSR Analysis

Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. The trend of negative revisions has continued in full force halfway through February, with Commodity and Ag chemicals seeing the largest cuts. Estimates in the Coatings space have been the best insulated but even these have turned negative over the past six months.

Exhibit 6

Exhibit 7

In Exhibit 8 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 9 we show discount by company. Industrial Gases are looking more expensive after strong starts to the year for APD and PX. Valuations in the Commodity group moved closer to fair value following a month of strong outperformance highlighted by DOW. Similarly, DD continues to drive valuations in the Diversified space, which itself was considerably cheaper last month. At the extremes Ag is cheap and still waiting for a bottom while Coatings remains relatively strong.

Exhibit 8

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 9 – MOS and OLN remain at 10 year lows, and EMN is also within 5% of its low. ARG (with its buyout premium) is at a 10 year valuation high – SHW is within 10% of its high, slightly off the peaks of 2015.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 shows absolute and relative performance by subsector since our last monthly report. All of the Chemical subsectors, save Ag, have meaningfully outperformed the market, highlighted by Industrial Gases. DOW/DD drove the Commodity and Diversified results, respectively.

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level. Praxair’s return on capital is off the lows seen a month ago. The divergence with peer APD, at the other end of the return spectrum in Exhibit 11, is the result of catch-up cost opportunities than Air Products has been effectively exploiting for the past several years. Coatings companies PPG and SHW are at 10 year earnings highs – the lower absolute level for PPG underscores its greater diversification and associated lower volatility compared to SHW. Ecolab (ECL) is also at its highest point of over-earning in a decade. ARG was bought out at peak return levels.

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. Net income margin for the group in aggregate has been in a tight range over the past several months and returns remain historically elevated. Margins are trending higher for Specialty Chemicals, Industrial Gas and Coatings, lower for Ag Chem. Commodity margins appear to be flattening near peak levels and Diversified margins appear to be rising off the trough.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 14 summarizes the top five 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 15. 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 remain in the screen below, and continue to be weak. The shorts screens, however, capitulated more through the first weeks of 2016, giving us mostly positive results for January. Two weeks into February, results are mixed for the month so far.

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. Chemical stocks that meet these criteria are shown in Exhibit 16 – the negative revisions picture continues to shorten this list and this month only Monsanto (MON) qualifies.

Exhibit 14

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

  • Personal consumption expenditures remain strong and on a solid upward trend, but the Q4 figures showed a slight slow down in year over year growth
  • Through the first nine months of 2015, expenditures were up 3.2% year over year (+3% in every month) but this slowed to 2.6% in Q4
  • Growth in goods (~35% of spending) continues to outpace growth in services (~65%) – 12 month average year over year growth has been 3.8% for goods and 2.8% for services
  • However, in the most recent month’s data (December) spending on goods (both durable and non-durable) showed a sequential decline while services continued to trend higher
  • Further segmenting the goods component, durable goods have averaged 6% year over year growth during the past year, compared to 2.7% average growth for non-durables
  • Exhibit 17 summarizes personal consumption expenditures for goods and Exhibit 18 shows expenditures for services

Exhibit 17                                                                                              Exhibit 18

Source: BEA

Construction

  • November construction spending was revised down and marked the first month since April 2015 that year over year growth in spending was below 10% (a still robust 9.8%)
  • The latest data point (December) showed a small sequential improvement but a year over year slowdown – growth of “just” 8.2% in a seasonally slower construction month
  • Most of the remaining slack in construction markets is in the residential sector – nonresidential spending is nearly back at pre-crisis levels
  • Exhibit 19 shows the long term trend in US construction spending and Exhibit 20 shows the trend over the past several years and highlights the lack of recent momentum compares with the 2012-2014 period.

Exhibit 19                                                                                             Exhibit 20

Source: US Census Bureau

Agriculture

  • Agricultural commodity pricing appears to be stabilizing – Exhibit 21 – but the year over year price differentials are still significant – Soybeans down 15%, corn down 8%, and wheat down 10%
  • Prices have seen minimal sequential movement since the start of the year, but remain depressed relative to the 2012 peaks – all down at least 50% from those highs

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • The third consecutive month of sub-50 readings on the US PMI have sparked recession fears but these may be overblown
  • Inventories appear to be at trough levels, and consumer spending remains strong as seen above
  • New orders improved and rose above 50 in January, and production ticker higher as well

Exhibit 22                                                                                              Exhibit 23

Source: ISM

Trade

  • The US Chemicals trade balance (ex. Medicinal & Pharma) continued a pattern of up and down months, but volatility has been muted over the past several months compared to history
  • The 12 month rolling average (dotted green line) is taking on a more pronounced downslope – sustained lower oil prices is not helping the case for US chemical exports, but given that the measure is in $ rather than pounds or tons, lower energy pricing (and therefore product pricing) may account for the declining trend.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28. We see the market moving to surplus in 2016, driven by tepid demand, capacity startups and fewer unplanned outages than in 2015, all of which should combine to pressure margins and estimates. See recent research on the polyethylene market for greater detail.

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Stocks of crude oil breezed past the two billion barrel mark several months ago and have trended strongly higher – Exhibits 29 and 30 – contributing to steady declines in crude pricing. Natural gas inventories remain above the high end of the five year range – Exhibit 3. Gas pricing is just above $2.00 per mmbtu and continues to test the 2012 lows. Ethane pricing is down more than 20% versus the prior year, propane even more so, down more than 30%.

Exhibit 29 Exhibit 30

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

Exhibit 31

Source: EIA, SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 34

Source: IHS and SSR Analysis

Basic Plastics

Margins held in with prices for much of 2015, as costs fell more quickly and significantly. HDPE prices and margins are still above the longer term averages but we see the potential for continued erosion in 2016 given the tightening of the gas/oil spread.

Exhibit 35

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

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (36) summarizes the results and is a repeat of Exhibit 6.

Exhibit 36

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38



Source: Capital IQ and SSR Analysis

Exhibit 39



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 40 summarizes Skepticism Index values by subsector, and Exhibit 41 shows the extent to which valuation is historically explained by returns:

  • Most subsectors are showing positive values on the SI – Diversified is the only group showing a material degree of market “optimism” as the stocks (namely DD) have preemptively priced in an improvement in returns
  • The Coatings subsector could be significantly more expensive than it already appears to be but it seems more likely that returns will normalize relative to valuations
  • Returns and valuation are more or less aligned in Industrials Gases and Specialty Chemicals
  • Ag and Commodity continue to price in return downside, and this has begun to be evident for the latter

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42 plots the individual SI components, valuation discount and deviation from return on capital trend, for each of the Chemical subsectors. The Commodity group is now slightly under-earning after a period of above trend returns on capital but there is still plenty of downside to equalization. Coatings has similar return downside, but from a much higher baseline. The Diversified group, with the only meaningfully negative SI value (implying market “optimism”) has some upside to returns, which appear to be at an inflection point.

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43 shows SI by company. Returns and valuation are better aligned at the sector level than they have been in recent months and accordingly at the stock level we see no stocks within 10% of a 10 year skepticism extreme.

Exhibit 43

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

December 14, 2015 – Dow/DuPont: The Very Best Looking Horse in the Glue Factory!!

December 9, 2015 – Dupont/Dow: The Considerable Value is All in the Execution

December 3, 2015 – Industrial Gases: Adapt to Slow Growth, or Underperform

November 17, 2015 – Monsanto: Left Out in the Cold? (blog)

November 5, 2015 – Eastman: Time to Change the Messaging (and Possibly the Strategy)

October 30, 2015 – Dow vs. DuPont: Dawn of Real Values!

October 13, 2015 – DuPont: Real Upside if New Management Brings Real Change

October 6, 2015 – DuPont: Is Some Sort of Breakup Now More Likely? We Would Own DD and DOW (blog)

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 44 to 48.

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

Exhibit 48

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 49 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 49A

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 49B

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

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