Chemicals Monthly – Chemicals Starting to Look Expensive (Except for Ag)

gcopley
Print Friendly, PDF & Email

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 16th, 2013

Chemicals MonthlyChemicals Starting to Look Expensive (Except for Ag)

  • The Chemical sector is now looking quite expensive – the exceptions being the Ag and Commodity sub-sectors. This month, most groups outpaced the market, with notable outperformance in Diversified Chemicals – partly driven by the rally in DD.
  • The dissolution of one of the world’s primary potash cooperatives had widespread implications, and potash producers suffered accordingly. We have written several short pieces on this subject.
  • Natural gas dipped as low as $3.23 per mmBTU before settling back into the $3.50 range mid-month, while crude oil pricing stayed strong as Egypt gets worse. Ethylene margins are virtually unchanged in the US, but demand remains disappointing despite the better ISM numbers.
  • It was a generally positive earnings season for the Chemical space. On average, the companies in our universe saw year on year revenue growth of 8%. Revisions were mostly negative however, based on expected conservative guidance, and estimates continue to come down, notably in the Coatings subsector which we have long seen as discounting overly optimistic returns.
  • We would focus on DD and possibly MON – we would not chase the cheaper potash related stocks and we are more concerned about a valuation peak in RPM.

Exhibit 1

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

Overview

Divergent performance from several sub-sectors this month was mostly event driven – with activist investor interest driving performance in both the Industrial Gas and Diversified sectors, and the Potash cartel collapse negatively impacting the Agricultural sub-group. The strength in the Commodity sub-group was in part a function of lower natural gas prices, but the market seems to like the restructuring plans discussed by Dow on its quarterly call.

We are struggling to find any compelling stories in this sector or any others in the Industrials and Materials today. The risk/reward relationship of old is being largely ignored, with the very risky names over-penalized and everyone else at a minimum expensive and more often very expensive. Stocks that are meeting or exceeding expectations are being driven ever higher, and often the earnings beat is being capitalized at ridiculous multiples.

We still 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.

US consumer spending numbers were up again and revised up historically, making the sustained gains of the past year all the more impressive, and somewhat enigmatic – less take home pay as a result of the higher payroll tax indicates spending is coming at the expense of saving, but it is worth wondering how long this can or will continue.

Construction spending figures were also revised, but only for the year 2012; changes here were mainly to the positive side. The most recent estimate has spending down slightly month over month but still up over 3% year on year.

Industrial production seems to be gaining steam. The PMI reading was the healthiest it has been since mid 2011. Chemical trade volumes were solidly positive for the second straight month and also rose to a level not seen since 2011. Many are pointing to employment and production indicators out of Europe as evidence of a demand trough but few anticipate a rapid rebound. More positive economic indicators from Europe this week were more than overshadowed by events in Egypt.

The differential between crude oil and natural gas widens, yet the Commodity subsector’s valuation has been impinged by weakness in Europe and slowing growth in key emerging markets. Demand may not be strong enough to get the price rises internationally that the higher price of oil might suggest. If this is the case it will be harder to raise domestic US pricing. The US commodity margins remain high, but they may not rise to the highs of the first quarter even with the stimulus from crude.

Valuation

Exhibit 2 summarizes our valuation work.

Ag Chem stocks look considerably cheaper after
the much discussed maneuverings in the potash market
. DD took another leg higher shortly after our last Chemicals monthly – the stock is up 33% since
we wrote about it in January
. This has the Diversified group as a whole looking much more expensive than it has been, but we believe that there
could be further upside in DuPont
if the company makes a move to separate its chemical businesses. The negative revisions for the subsector were mostly driven by Rockwood Holdings which had its EPS estimate slashed 29% over the past month. ROC looks very attractively valued at these levels, particularly if we think we have turned a corner in TiO2.

Valspar came out with an earnings miss and lowered guidance, leading to negative revisions. 2013 EPS estimates for Sherwin Williams continued to fall as well. This drove underperformance for the coatings sector despite continued strength from PPG and RPM.

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.

Exhibit 4

Exhibits 5 and 6 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our
July Chemicals Monthly
. All of the subsectors with the exception of Agricultural Chemicals and Coatings produced positive absolute returns. Unlike last month, where most sectors underperformed relative to the S&P, four groups outpaced the broader market, with significant outperformance from Diversified Chemicals. Commodity and Industrial Gas stocks gained strongly as well.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Monthly Topics:

We wrote a comprehensive piece comparing DD and EMN
, and focusing more on the opportunity that we think still exists in EMN, but we did not write any industry thematics that require contextualizing for the Chemical sector in this report.

As a consequence of the work that we did on EMN we will be including EMN in our specialty chemical index starting with the September report, and at that time we will highlight any changes that the move may make to prior analysis of overall sector attractiveness.

Portfolio Performance

The full August selections are shown in Exhibit 7. In the exhibit we still show EMN as expensive, but this is driven by our historic model. When we make the changes discussed above, it is likely that EMN will drop off this screen. Note that SHW has dropped off our “expensive” screens, having been there for much of the last year. 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 7

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 8. Results have been mixed in recent months but the last month has been one of the best we have enjoyed as, rarely in the last 18 months, we have seen expensive stocks underperform and cheap stocks gain. 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 8

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Estimates of personal consumption expenditures were universally revised upward in the latest release from the BEA. The trend, for both the long and short term, remains strongly positive.
  • Less take home pay as a result of the higher payroll tax indicates spending is coming at the expense of saving, but it is worth wondering how long this can or will continue.
  • A more conservative tone from Walmart this week may indicate that we are reaching an extreme here.

Exhibit 9

Exhibit 10

Source: BEA

Construction

  • April and May construction spending numbers were revised up 1% and 2%, respectively. The data for June showed a slight decline from the newly revised May figure, but spending is up 3.3% year over year.
  • In the latest release, the Census Bureau revised construction spending numbers upward for 2012 but the longer term trend was little changed – Exhibit 12.

Exhibit 11

Exhibit 12

Source: US Census Bureau

Agriculture

  • The turmoil in the fertilizer market was a huge distraction and at the same time, and possibly linked, we saw sharp declines in prices for agricultural commodities. Wheat fell 6%, Corn was down 14%, and Soybeans tumbled 16%.
  • These movements in commodity pricing are having a negative impact on all of the agriculture focused companies.
  • See our colleague Rob Campagnino’s work on the implications of the EPA’s renewable fuels mandate with respect to ethanol.

Exhibit 13

Source: Capital IQ, SSR Analysis

ISM

  • The July PMI reading came in very strong, rising to its highest level since June of 2011.
  • The production component of the index was notably robust. Inventories dropped, and the trend for inventories is stable to slightly downward.

Exhibit 14

Expansion

Contraction

Source: ISM

Exhibit 15

Source: ISM

Trade

  • The Chemicals trade balance spiked to a level of export surplus not seen since before the financial crisis. The rolling twelve month average (the dashed line in Exhibit 16) still shows a slightly downward trend.
  • The Indian Rupee snuck over 60 rupees per dollar and has depreciated 15% since January as the burgeoning subcontinent has hit several snags in its economic growth – Exhibit 17.
  • About midway through Q3 the dollar is weaker versus the Euro by over 5% year over year – Exhibit 18.

Exhibit 16

Source: US Census Bureau

Exhibit 17

Source: IMF

Exhibit 18

Source: IMF

Commodity Fundamentals

Supply/Demand

Ethylene production estimates for the second half of the year were revised down again by industry experts IHS, in what has become a recurring theme. However, Q2 was a little stronger than expected and consequently they still show 3% growth in US ethylene production for 2013. They are expecting almost zero growth in 2H 2013 and consequently have operating rates falling – given that capacity has increased. This is a function of less confidence in a global recovery in the second half as well as slower growth in the US domestic market. As
we have discussed in recent research
, demand is disappointing consistently, which we think is as much a function of high prices as it is a weaker economy. 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 19. 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 20.

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 16 – 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 19

Source: IHS and SSR Analysis

Exhibit 20

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 21

The events in Egypt combined with some significant US inventory reductions have maintained an upward pressure on crude oil prices and WTI has been sitting in the $105 to $110 per barrel range since early July. Brent crude is only a couple of dollars higher reflecting the significant logistic improvements that have been made in getting US light crude to refining centers in the last 6-9 months. Natural gas remains quite cheap – bouncing around in the $3.25-3.50 per MMBTU range – production is increasing and the weather has not been too severe.

Exhibit 21

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 22.

Exhibit 22

Source: IHS and SSR Analysis

Butane and propane pricing has stopped declining relative to crude oil and the rolling average for butane has turned more positive, while propane is essentially flat. Ethane continues to weaken incrementally, though slowly, but this firmly reestablished ethane as the preferred ethylene feedstock in the US, even if you are short of the co-products for which production would increase with heavier feeds. The longer-term trend relative to crude remains negative – Exhibit 23.

Exhibit 23

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is incrementally weaker both in the US and internationally. 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 24 to start moving down more quickly from the relative stability so far this year.

Exhibit 24

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 (25) summarizes the results and is a repeat of Exhibit 1.
Exhibit 25

Valuation Charts – Exhibits 2628

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

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 29.

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

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 31 to 35.

Exhibit 31


Source: Company Reports and SSR Analysis

Exhibit 32

Source: Company Reports and SSR Analysis

Exhibit 33

Source: Company Reports and SSR Analysis

Exhibit 34

Source: Company Reports and SSR Analysis

Exhibit 35

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 36 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 36A

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 36B

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.

Print Friendly, PDF & Email