Chemicals Monthly – Brexit Bad for Chemicals, With Few Possible High Yield Exceptions

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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

July 18th, 2016

Chemicals Monthly – Brexit Bad for Chemicals, With Few Possible High Yield Exceptions

  • Brexit and the subsequent lack of consensus in Europe will likely lead to recession which, even if contained to Europe, will weigh on commodity (chemicals) markets
    • Chemicals one of the more Europe-exposed sectors in the Industrials & Materials space and has historically been a significant underperformer relative to the group and the market during economic slowdowns
    • Possible exceptions/standouts include stocks that could benefit from yield chasing given the current rate environment and elevated valuations in the obvious bond-proxy sectors – DOW, DD, and CF have sizable yields and the ability to cover dividend payments
  • More action in the Ag space – weaker fundamentals driving consolidation:
    • MON received a renewed bid from Bayer – a small increase which could be enough to get a deal done given the regulatory and currency/Brexit related risks – neither company has a better strategic option at the moment – MON should take this deal
    • Negative EPS revisions across the board as fertilizer and crop prices moved lower – MON (-2.9% over the past month), CF (-7.2%), MOS (-8.1%)
    • MOS responded to the market conditions by shutting one of its Canadian potash mines
  • Outside of Ag, revisions were mostly muted heading into Q2 earnings season
    • We expect negative revisions to come in particularly in the commodity names as Q3 is setting up to be challenging (see below)
  • Chemicals research published since our last monthly:
    • Ethylene – fundamentals pointing to a weak Q3
    • DOW/DD – having discussed the potential upside extensively, we analyze the potential risks
    • Agriculture – taking a holistic view of the industry, seeds and fertilizers look attractive particularly relative to the equipment side
  • 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 our concerns in most subsectors, and at the subsector level would only be overweight Ag Chemicals

Exhibit 1

Exhibit 2

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

Overview

Brexit is likely to cause a European recession in our view, and even if this does not extend to a larger global slowdown, one of the resultant effects would be a general weight on commodity markets (including chemicals). Fundamentals are already suggesting weakness in ethylene/polyethylene and a Brexit related recession would add a further – perhaps fast and strong – headwind. Since Brexit that has been nothing on the geopolitical front to suggest anything but a huge drop in consumer and business confidence in Europe. The UK may be the safer bet!

More stimulus might be expected but with rates at or below zero the ability of policy makers to combat a recession appears limited. The pervasive low/negative rate environment also suggests we could see a movement into more risky high yielding stocks given that the more obvious “bond proxies”, all outside Industrials and Materials, are reaching peak valuations. Cyclical Chemical stocks have not typically been considered safe havens in times of economic duress but we could see some of the more stable, high yielding Chemical stocks attract interest – cross referencing the highest divided paying stocks in the sector with EBITDA coverage of expected dividend payments and a historical measure of price volatility based on normal earnings, we narrow down to DOW, DD, and CF in the Chemical space (see recent research).

The other Chemical stock we remain positive on given the current landscape is MON. We think a MON-Bayer deal should and will happen. From MON’s perspective, earnings estimates have been coming down, corn prices have given back recent gains and there is a possibility prices could stay lower longer than anyone currently expects if ChemChina with Syngenta’s technology drives an extended oversupply situation as we have seen in other industries. For its part, Bayer likely considered the increased currency risk (lower value of the euro resulting from the Brexit) in its revised offer, which is probably still below what MON would like. We think MON’s suggestion of potential other partners is likely just posturing, as we do not see BASF coming in with a higher price than what Bayer has offered on the past week.

Valuation

Exhibit 3 summarizes our valuation work and the subsector classifications are summarized in Exhibit 4. Revisions were negligible outside of the Ag space as Q2 earnings are set to come in later in the month.

Exhibit 3

Exhibit 4

In Exhibit 5 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 6 we show discount by company. The valuation landscape is little changed. Commodity stocks have been growing cheaper and there is likely further downside for the group if Q3 turns out to be as weak as we expect.

Exhibit 5

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 6 – two fertilizer stocks (CF and MOS) remain at or near all-time discounts. EMN also continues to show value – see recent research on the stock. Coatings valuations are generally elevated – VAL reflects the SHW buyout premium. RPM is not as significantly expensive as SHW appears, but the stock is also at its 10 year valuation high. 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 6

Source: Capital IQ and SSR Analysis

Exhibit 7 shows absolute and relative performance by subsector since our last monthly report. As the Brexit raised uncertainty, investors became defensive – gases were the biggest winners, commodity stocks were weak. The gain in the Industrial Gas space was attributable to PX (+5.6%). APD was up as well (3.1%) but trailed the market’s 4% gain over the past month. The Ag Chem result is influenced by MON, which was down 4% from a month prior even after news of the raised bid from Bayer. MOS (+9%) traded higher after announcing it will idle one of its potash mines – China also finally signed a potash contract with Belarusian producers, which could help stabilize pricing. The improvement in industrial gases suggests a migration to the historic safer havens – we would prefer PX over APD on valuation and on lower exposure to Europe (assuming that Brazil is equally priced in for each name today).

Exhibit 7

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 8 through 10 show profitability at the sector, subsector, and stock level. All of the Coatings stocks with the exception of RPM remain 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 return on capital is depressed from the Rockwood acquisition, but the stock continues to perform well on strength in the Lithium market.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibits 9 and 10 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 have rolled over near historical peak levels and Ag margins have room to come down further to prior troughs. The biggest near-term risk here is in commodity chemicals in our view

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 11 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, and 2016 has seen generally better results to date – Exhibit 12. 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 somewhat different story as commodity stocks have enjoyed a bounce and performance has been strongly and consistently positive, particularly for the overlap group.

EMN is driving the overlap results in July to date, and CF has traded sharply higher as well to lift the valuation screen. On the short side, ALB continues to move higher but the other selections have not had enough momentum to offset the strength of the longs.

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. Currently we have a group of four stocks: AXLL, HUN, LYB, and POL, listed in valuation order most to least inexpensive – Exhibit 13.

Exhibit 11

Exhibit 12


Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures continue to trend higher
  • Spending on goods continues to drive much of the upside gains – 3.6% average year over year growth for the past year compared to 2.6% growth in services spending

Exhibit 14 Exhibit 15

Source: BEA

Construction

  • Revised data from the US Census Bureau shows construction spending stumbling a bit in recent months
  • The new April figure represented a 2% sequential decline – year over year spending was still up 5% but the 12 month average has been closer to 10% year over year growth
  • The most recent figure (May) showed another sequential decline of about 1%, and year over year growth slowed to 2.8%
  • Exhibit 16 shows the long term trend in US construction spending and Exhibit 17 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period

Exhibit 16 Exhibit 17

Source: US Census Bureau

Agriculture

  • Corn plantings in the US came in well above estimates – expectations had been for a decline in planted acres and the actual figures showed a 7% gain – pricing was off 6% in June, giving back most of the gains from earlier in the year, but is roughly flat two weeks into July
  • Soybean pricing has come down in tandem (-9% in July to date after a 10% gain in June)

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • The PMI posted a strong gain, rising nearly two points to 53.2, comfortably in the expansion range
  • New orders continued to trend higher, up to 57 at the end of June from 55.7 in May
  • Producer inventories rose, though customer inventories still have room to move higher, and production was up as well

Exhibit 19 Exhibit 20

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 24 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 the declining trend

Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: Capital IQ, SSR Analysis

Exhibit 23

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Capacity is returning to the market after spring turnarounds, just as the Brexit has added a layer of uncertainty that could compound seasonal demand weakness.

Exhibit 24

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

US stocks of crude oil and petroleum products made new highs in recent weeks – commercial crude stocks declined however, indicating the gains were mostly in petroleum products – Exhibits 26 and 27. Crude pricing is down 4% since the end of June however –year over year prices are about flat. Nat gas inventories are starting to build at slower than expected rates, but remain elevated – Exhibit 28 – pricing has retreated in July after approaching $3.00 per mmbtu at the end of June – Exhibit 29. We think the risk to natural gas is very much to the upside given low rig counts – at least in the near-term.

Exhibit 26 Exhibit 27

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

Exhibit 28

Source: EIA, SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Midstream Business and SSR Analysis

Exhibit 31

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 32

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing began weakening earlier in the year with the startup of Braskem/Idsea’s Mexican lines, and we see the risk of further, more rapid price deterioration unless oil pricing rises.

Exhibit 33

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 (34) summarizes the results and is a repeat of Exhibit 3.

Exhibit 34

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36



Source: Capital IQ and SSR Analysis

Exhibit 37



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

  • Valuation and returns are mostly in line for the Chemical subsectors – valuation changes over the past month have mostly been met with adjusted forward estimates and as such the skepticism index values are little changed
  • Where there are divergences, they are on the positive (skeptical) side – Commodity and Ag chemicals are cheaper than they are under-earning, while Coatings continues to over-earn by more than its valuation premium would indicate

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41 shows SI by company. No companies are currently near all-time skepticism extremes on either the high or low end.

Exhibit 41

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 42 to 46.

Exhibit 42



Source: Company Reports and SSR Analysis

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

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 47 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 47A

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 47B

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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