Chemicals Monthly – Bracing For a Likely Difficult Q4

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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

October 17th, 2016

Chemicals Monthly – Bracing For a Likely Difficult Q4

  • Recent earnings pre-announcements show warning signs of a disappointing Q3 and possible negative revisions for Q4.
    • PPG indicated weakness in Europe specifically and a lethargic global economy at large
    • Weakness in the broader Industrial space (seen in similarly negative earnings guidance from HON and DOV) also portends poorly for the Chemicals space. These follow SHLM’s more dramatic negative guidance in August.
  • Natural gas rose above $3.25 as inventory additions came in lower than expected, and while high in absolute terms are less so on a days of sale basis, given demand growth.
    • Year over year price changes highlight a significant narrowing gas/oil spread – Brent crude up 5%, Henry Hub gas up 40%.
  • Year to date results highlight preference for story stocks in a flat but vacillating market.
    • ALB (+40%) – benefiting from higher lithium prices and positive sentiment for that business longer-term – also benefitting from smart portfolio moves.
    • SMG (+30%) – reaching new highs on hydroponics as well as lower raw materials.
  • M&A remains in focus but only the acquired companies’ share prices have really benefited from this year to date – and not even so in the case of MON.
    • Flat performance for SHW, WLK, DOW and DD indicates wait and see approach.
  • From a valuation perspective, most sectors have trended toward fair value recently, leaving Coatings and Ag the expensive and cheap outliers respectively.
  • Since our last monthly report, our Chemicals coverage has included work on:
    • VSM and ASIX – Chemical spin-offs looking very cheap – more positive on VSM.
    • RPM – looking more interesting after recent pull-back – place of relative safety.
    • China Coal – reasons for skepticism about the optics of higher Asian coal pricing.
    • Chemicals M&A – driven by lack of options in a slow growth, more competitive, world.
    • Akzo – we see the potential for an APD-style transformation for this underperformer.
    • Ethylene – likely a better entry point if Q4 is weaker, but a logical next area for M&A.
  • Our preferences in the sector are summarized in Exhibit 1.
    • We are positive on most of the large cap names in the space (DOW, DD, MON, PPG) but have concerns in most subsectors, and at the subsector level would only be overweight Ag Chemicals – in part because of valuations.

Exhibit 1

 

Exhibit 2

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

Overview

Negative pre-announcements and guidance has set a discouraging tone for the Q3 earnings season. PPG was the most notable chemical company to sound a warning, with particular emphasis on Europe and auto OEM, though the greater listlessness of the global economy was also cited. EMN and FUL look concerning given 25% European sales exposures. DOW/LYB face heavy Euro leverage as well while also contending with the overhang of expected weakening ethylene fundamentals that have already been weighing on valuations. Q3 results for the ethylene players could be strong, but we think longer term estimates still need to come in to reflect fundamental weakness over the next 18 months – once these are incorporated into valuations, the space looks like an interesting area for the next round of chemicals M&A.

Raw materials are ostensibly also moving against US based chemical producers. Strong pricing gains in natural gas belie rig count gains, elevated inventories, and production growth in the northeast – expectations for a cold winter apparently outweigh these factors, but in addition, given the growth in demand for natural gas, especially if we include expected LNG shipments, inventories look lower on a “days of sales” adjusted basis.

Exhibit 3

Source: Baker Hughes

With a difficult macro, story stocks have stood out in 2016, with a little over three quarters in the books. ALB has benefitted from the lithium story – prices have been rising and sentiment is positive. SMG has come into focus lately for a spat of acquisitions supplying into the burgeoning legal cannabis market, which stands to roughly triple pending voting results in California and Arizona, among others, in November. Larger scale M&A also remains in play but it is worth noting the stocks involved have generally been in holding patterns for the year – SHW, WLK, DOW, and DD all minimally divergent from the market. VAL has the buyout premium that MON is not being afforded, given a difficult path to regulatory approval.

Exhibit 4

Source: Capital IQ and SSR Analysis

Valuation

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6. Revisions were mostly negative over the past month – CBT and WLK had the rare positive revision to boost the Specialty and Commodity spaces. The pre-announced guide down from PPG weighed on Coatings and MON’s earnings release indicated weaker forthcoming results than had been expected. APD is responsible for the negative Industrial Gas revisions, largely the result of the VSM spin. HUN (-5%) was the main culprit in the Diversified group.

Exhibit 5

Exhibit 6

In Exhibit 7 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 8 we show discount by company. We see most sectors roughly at fair value, leaving Coatings and Ag notable on the expensive and cheap sides respectively. Some of the apparent value in the Ag space would be removed if the MON/Bayer deal is approved and MON rises to reflect the bid price – but the fertilizer space also remains weak, with further estimate cuts for CF indicating this is a sector still searching for an inflection point. The valuation premium in the Coatings space remains significant but has been declining in recent months as SHW and PPG have shown cracks – we are cautious about Q3 given what appears to be a heavy advertising push – see research out today.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – fertilizer stocks remain at their lows, along with EMN. OLN is up 10% since our last report and off its record discount from a month ago. On the expensive side, we think that ECL, IFF, APD and NEU are all very vulnerable to a European slowdown because of revenue exposure to Europe and the risk of translation effect if the Europe weakens. We would not own any of these names given their current premium to fair value.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 shows absolute and relative performance by subsector since our last monthly report. A second straight month for Coatings at the low end of the performance results as SHW has been trending down and PPG tumbled on the negative earnings pre-announcement. Weakness in the Industrial Gas space is primarily the result of APD’s spin out of VSM. Commodity gains were led by OLN (+10%) and WLK (+7%) while ALB (+6%) and DD (+3%) boosted Diversified Chemicals.

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. Coatings and Specialty companies mark the top end of Exhibit 9, with above trend earnings, while fertilizer producers are prominent at the back of the pack. POT/AGU is unlikely to materially affect pricing or earnings in the fertilizer space. The divergence between PX and APD perhaps suggests why PX was seeking a tie up with Linde.

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. We are seeing a possible sign of stabilization in Ag margins, while Commodity margins continue to roll over near historical peak levels and this sector is the biggest near-term risk in our view. Coatings is also a concern – margins appear to be plateauing as input costs rise and heavy discounting at the retail level suggest elevated inventories.

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 – 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).

2106 results have been generally positive (particularly in the overlap group) and more in line with what was seen in 2013 and 2014 – Exhibit 14. Cheap commodity stocks AXLL, OLN, and HUN were mainstays on the long screens in 2015 and this was a yearlong headwind for the selections – 2016 has been a different story as commodity stocks have mostly enjoyed a bounce.

We also typically 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. The negative revisions picture has resulted in none of our Chemical companies meeting all three criteria this month – LYB lost a cent off its estimate, and was closest to making the cut.

Exhibit 13

Exhibit 14


Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • US personal consumption expenditures declined slightly sequentially (latest data through August) but were 2.6% higher year over year
  • Durable goods spending was the primary driver, down more than 1% sequentially after a strong 2% gain the prior month
  • Year over year growth in goods spending remains strong (+3%) compared to services (+2.5%) but the pace has been slowing for goods and gaining speed in services

Exhibit 15 Exhibit 16

Source: BEA

Construction

  • Year over year growth in US construction spend was negative in the latest data (through August), marking the first such occurrence since July 2011
  • The comparable figures, however, are very robust – spending in August 2015 had been up 14% versus the prior year
  • Exhibit 16 shows the long term trend in US construction spending and Exhibit 16 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 been virtually flat since the end of September, while corn and wheat have shown 3% gains over this time
  • Despite recent weakness, soybean pricing has held some of its early gains for a year to date change of +11% compared to an 11% decline in wheat pricing and a 3% decline in corn pricing

Exhibit 19

Source: Capital IQ, SSR Analysis

ISM

  • After a disconcertingly sharp dip in August, the PMI rebounded in September
  • New orders came back strongly as well and inventories held steady while production edged higher

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
  • There was only a modest improvement in the trade balance in the latest data, and the 12 month rolling average (dotted green line) in Exhibit 22 continues to take 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 more than 100% of 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

US ethylene production for September was the lowest monthly output since early 2015 as unplanned outages from August bled into planned September downtime. Demand has flattened versus the 5% gains over the past year – consumption in Q3 and Q4 is estimated to be down 1% year over year (limited by ethylene availability for the most part), though 2017 will likely see a resumption of the strong demand trends, without which the US ethylene market will weaken very quickly given the expanded capacity base.

Production and operating rates are summarized in Exhibits 25 and 26.

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Crude stockpiles remain elevated but off their highs – the latest 1% weekly gain in commercial crude stocks was the biggest addition since April. Natural gas pricing reacted very positively to an inventory report that showed additions on the lower end of expectations. Yet inventories are tracking the high end of the 5-year range and the gas rig count showed the strongest percentage move higher in the history of the Baker Hughes count – albeit off a small relative base – the 11 rigs added were the largest absolute figure since 2014.

Natural gas inventories are high in absolute terms but given the increase in domestic consumption and the volumes contracted to LNG exports, inventories are not as high on a demand adjusted basis.

Ethane has seen large price gains recently, to the highest levels in several years, tracking natural gas but also aided by the increased demand coming from exports and expected quick demand growth as US ethylene capacity restarts. Given the more significant move in ethane relative to crude oil, the US is losing some of its competitive edge in ethylene.

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

Capacity continues to start up, to the north and the south – Nova completed construction of its facility in Alberta and production should start to ramp up by year end, while Braskem/Idsea has brought on both HDPE and LDPE facilities. North American export growth of polyethylene is expected to be 10% in 2017 as prices are cut to offload the domestic surpluses. It will be very hard to maintain US integrated polyethylene profitability under these circumstances unless global demand growth is robust enough to absorb all of these suprluses

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 5.

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.

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. No stocks currently show a skepticism extreme.

Exhibit 42

Source: Capital IQ and SSR Analysis

 

2016 Chemicals Research

October 14, 2016 – Versum and AdvanSix: Smaller Portions at Attractive Prices

October 10, 2016 – RPM: Not All Chemical Stocks Only Look Attractive When They Are Cheap

October 5, 2016 – China Coal: Not Out of the Petrified Forest Yet

October 3, 2016 – Chemical Deal Mania: When to Hold Them and When to Show Them

September 29, 2016 – Akzo: Underachieving – Need the PPG Path to Higher Valuation

September 23, 2016 – Trading Ethylene? Tread Carefully

September 14, 2016 – Change at Linde Suggests an Acquisition is Possible

September 6, 2016 – M&A in Chemicals: More to Come and Other Sectors to Follow

September 6, 2016 – The Olin Illusion

August 30, 2016 – AXTA: Not Cheap but 18 Months of Momentum

August 18, 2016 – MON: How Patient Are the Shareholders, Especially the New Ones

August 17, 2016 – PX/Linde: Are Desperation and Boredom Bigger Drivers Than Anything Else

August 16, 2016 – A. Schulman: A Personal Problem or A Leading Indicator

August 15, 2016 – Coatings: Developed Markets Peaking – China and M&A Can Keep Select Momentum

August 8, 2016 – CF: Analysis Suggests Dividend Can Be Sustained – Attractive Long Term Buy

August 1, 2016 – Eastman: A Bus Business, a Bad Strategy, or a Bargain?

July 19, 2016 – Monsanto: “A Bird in the Hand” – Hit the Bid – Now!

July 5, 2016 – Ethylene: You Can’t Fight the Fundamentals

June 24, 2016 – DOW/DD: We’ve Discussed the Upside, Now What Are the Risks?

June 22, 2016 – Agriculture: Likely at a Low, Seeds and Fertilizer Look More Interesting Than Equipment

June 14, 2016 – CE vs. EMN: Similar Current Valuations but EMN has the Potential

June 7, 2016 – Natural Gas Rising as Inventories Build: Not Got Good for US Chemicals

June 7, 2016 – Axiall: Don’t Listen for the Fat Lady Quite Yet! (blog)

May 31, 2016 – DuPont Adopting a “Go It Alone” Strategy, Which Raises Interesting Questions, Such as: What is Dow Doing/What Could Dow Do?

May 25, 2016 – MON-BAYER: What Price is Right?

May 23, 2016 – FMC: Can it Survive the Consolidation Wave? Should It Try?

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 Regardless

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 43 to 47.

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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