Chemicals Monthly – China on the Ropes, Europe on the Mend

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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

November 15th, 2015

Chemicals Monthly – China on the Ropes, Europe on the Mend

  • Q3 saw most Chemical companies miss the top line but record a positive EPS surprise
    • Revenue down more than 6% year over year versus the most difficult compare of ’14
  • Mixed commentary on Europe from earlier in the year turned almost universally positive in Q3, although the magnitude of the positive is not a panacea for everything else
    • Conversely, Chinese and Latin American sentiment has soured over the course of the year and all recent data points give cause for continued concern
  • Ag Chemical stocks remain inexpensive, but is largely justified by weaker earnings and negative revisions. Coatings retain a significant premium
    • Other subsectors look more or less fairly valued
    • The move higher in DD has taken the discount out of the Diversified Chemicals group
    • Buyout premiums in CYT and SIAL mask the value in EMN within Specialty Chemicals
  • A third of the stocks in our Chemicals index remain statistically cheap but a convoluted and generally uninspiring global demand picture prevents us from taking a more aggressive stance on the sector in aggregate
    • As the weak have gotten weaker, the strong have gotten stronger, and dispersion continues to trend higher
  • Since our last monthly report we published a comprehensive piece comparing DOW and DD, exploring these companies’ opportunities within the agricultural sector and beyond
    • We have also published again on EMN, where the results and value are obscured by continued poor messaging
  • Long term, our favorite names remain those with limited exposure to our thesis of Chinese commodity export dominance and insulation to a potential Chinese move into downstream derivative markets
    • The short term is more troublesome, given the messaging issues at EMN, the apparent disconnect between volumes and industrial production for PX, and the recent move higher in DD that has eroded most of the discount in the stock
    • As we think about possible consolidation in Ag space we like DOW more than we did

Exhibit 1

Exhibit 2

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

Overview

Q3 results have indicated a generally strong operational quarter for the Chemicals sector, as many companies posted positive EPS surprises on weaker than expected revenues – Exhibit 3. At some point we will need to see some relief on the top line. As we have noted previously, currency is only partly to blame for the poor progression of revenue growth in Exhibit 4 – demand has played a major role as well. Commentary from management indicates that China has weakened over the course of 2015 (not surprisingly) and that the European outlook has improved nearly across the board (somewhat surprisingly). Exhibit 5 summarizes the change in outlook year to date for the major global Chemical companies.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Earnings Transcripts, Capital IQ, SSR Analysis

Moving forward, we can see some positive trends for the commodity producers on the back of declining natural gas prices. Inventories are currently above the five year range, not unexpected given very mild fall weather and continued gas production – Exhibit 6. Most commodity companies benefit from a widening gas/oil spread even at $45/barrel crude, but in future research we will look to explore how other companies in our group could be impacted in a world of sustained lower natural gas pricing. Exhibit 7 summarizes the impact of natural gas on various chemical companies where there has been historical commentary on the topic.

Exhibit 6

Source: EIA, SSR Analysis

Exhibit 7

Source: Earnings Transcripts, Company Presentations, Capital IQ, SSR Analysis

Valuation

Exhibit 8 summarizes our valuation work and the subsector classifications are summarized in Exhibit 9. EPS estimates for OLN, CBT, and CF were all cut at least 10% over the past month, and these were the primary drivers of the negative revisions figures for Commodity, Specialty, and Ag chemicals respectively. MOS also saw a 9% decline. Elsewhere revisions were modest but tended to be negative – notable exceptions in Coatings and for DOW and DD. The cut at CF comes despite the likely benefit of lower natural gas prices in the US and reflects the broader global pressure on urea pricing as costs fall in other regions.

Exhibit 8

Exhibit 9

In Exhibit 10 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 11 we show discount by company. Another strong month from the Diversified group (namely DD) has the subsector looking fairly valued. It has been a quick move here, as just two months ago this was the cheapest of the Chemicals subsectors. Coatings continues to look historically expensive, and Ag remains the best value, if you assume a reversion to mean.

Exhibit 10

Source: Capital IQ and SSR Analysis

At the stock level, EMN and MOS remain at their respective all-time discounts. PX and MON, also highlighted in green in Exhibit 7, are at 10 year extremes. On the expensive side, SHW is within 5% of its recent all-time valuation peak. CYT and SIAL reflect buyout premiums.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12 shows absolute and relative performance by subsector since our last monthly. As an aggregate the Chemicals sector was flat to the market, but there was significant dispersion of results. DuPont was again the major contributor to the sector leading result for the Diversified Chemicals, easily the best performer in the entire Chemicals index (up 17%). Weakness in ECL and EMN outweighed a 9% gain for CBT – Specialty Chemicals was the laggard over the past month. SHW was the only Coatings stock to outpace the S&P but its ~40% weighting in the subsector drove the result.

Exhibit 12


Source: Capital IQ and SSR Analysis

Profitability

Exhibits 13 through 15 show profitability at the sector, subsector, and stock level. The inclusion of APD’s fiscal 2015 capital data has the company at an all-time ROC peak above trend, joining SHW, ARG, and VAL.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibits 14 and 15 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. The past few months have seen a quick move down off the peak from earlier in the year, but profitability remains historically elevated. Diversified looks like the primary contributor to the sector’s overall deterioration in net income – most subsectors have seen margins continue to trend higher, particularly in Coatings and Industrial Gas.
Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 16 summarizes the top five attractive and unattractive stocks on our normalized earnings valuation and skepticism index frameworks. 2015 has not been a successful year for these selections across the board, despite a strong October result. Results for the skepticism and overlap portfolios had been robust in 2013 and 2014.

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 18 – the lackluster revisions picture is responsible for a shorter list here than we have seen in recent months.

Exhibit 16

Exhibit 17

Source: Capital IQ and SSR Analysis

Exhibit 18

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Another increase in personal consumption expenditures in October marked the 14th consecutive month of 3% plus year over year growth
  • Revisions to August and September figures were negligibly negative
  • Growth in goods (~35% of spending) continues to outpace growth in services (~65%) – 12 month average year over year growth has been 3.5% for goods and 2.5% for services
  • Further segmenting the goods component, durable goods have averaged 6% year over year growth during the past two years, compared to 2.4% average growth for non-durables
  • Exhibit 19 summarizes personal consumption expenditures for goods and Exhibit 20 shows expenditures for services

Exhibit 19 Exhibit 20

Source: BEA

Construction

  • Strength in construction spending continued in September, coming in 14% over the prior year – this was the fourth consecutive month of at least 13% year over year growth and represented the greatest increase since January 2006
  • If growth slows to just half of the sequential rate seen over the past year, we would reach the 2006 spending peak in mid-2017
  • Most of the remaining slack in construction markets is in the residential sector – nonresidential spending is nearly back at pre-crisis levels.
  • Exhibit 21 shows the long term trend in US construction spending and Exhibit 22 shows the trend over the past several years

Exhibit 21 Exhibit 22


Source: US Census Bureau

Agriculture

  • Agricultural commodity pricing has trended lower over the past month – Exhibit 23. Soybeans, corn and wheat are all off more than 2.5% since the end of October. Year over year corn and wheat prices are essentially unchanged, but soybean pricing is down 10%. Prices remain depressed relative to the 2012 peaks – all down at least 44% from those highs.
  • The corn and soybean harvests are both ahead of schedule relative to the prior year and the five year average. 93% of corn acres (88% five year average) and 95% of soybean acres (93% average) have been harvested as of November 8.

Exhibit 23

Source: Capital IQ, SSR Analysis

ISM

  • The overall US PMI inched down again in October and while the reading barely indicates expansion, the inventory drawdown over the past few months could prevent the seemingly inevitable manufacturing contraction – Exhibit 24.
  • New orders rose nearly 3 points to 52.9 and in addition to the decline in producer inventories (Exhibit 25), customer inventories declined as well after registering large gains over the past two months.

Exhibit 24 Exhibit 25


Source: ISM

Trade

  • The US Chemicals trade balance (ex. Medicinal & Pharma) was down sharply in the latest data, as a significant rise in imports was compounded by a modest decline in exports – Exhibit 26.
  • The 12 month rolling average (dotted green line) is taking on a more pronounced downslope. A sustained period of lower oil prices does not help the case for US chemical exports.

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene production is summarized in Exhibit 29 and operating rates are summarized in Exhibit 30. See prior ethylene-specific research for more detail on our views.

2015 is shaping up as a year of relatively low outages, especially compared to the past three years. Much of this additional supply has made its way into HDPE destined for export (up nearly 20% versus 2014) as domestic demand growth is stuck around 2%. Ethylene inventories continue to trend higher and are expected to reach multi-year highs through Q1 ’16.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Stocks of crude oil crossed the two billion barrel mark over the past month, but are perhaps starting to roll over – Exhibits 31 and 32. Natural gas inventories have broken above the high end of the five year range – Exhibit 33. After briefly flirting with $2.00 per mmbtu and ending October at $2.32, natural gas pricing is currently back in the $2.50 range – Exhibit 34. Brent approached $50 per barrel towards the end of last month, but has fallen nearly 9% back down into the mid $40s.

Exhibit 31 Exhibit 32

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

Exhibit 33

Source: EIA, SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Ethane prices in Q4 to date are roughly 10% higher than they were in Q3, but ethane remains the favored ethylene feedstock in the US (Exhibit 35) and the extraction margin is approaching breakeven levels – Exhibit 36.

Exhibit 35

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 36

Source: IHS and SSR Analysis

Basic Plastics

Ethylene margins have been steadily declining but remain in an advantaged position relative to history. At current levels of ethylene pricing margins are still considerable and allow for strong margins downstream as well.

Exhibit 37

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 (38) summarizes the results and is a repeat of Exhibit 8.

 

Exhibit 38

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40



Source: Capital IQ and SSR Analysis

Exhibit 41



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 42 summarizes Skepticism Index values by subsector, and Exhibit 43 shows the extent to which valuation is explained by returns:

  • Returns and valuation are now nearly exactly aligned for Industrial Gases and Diversified Chemicals; both were showing modestly positive skepticism values as of last month
  • The Specialty group remains the only Chemicals subsector showing a negative value on our Skepticism Index (indicating market “optimism”) but this is likely to moderate when the buyouts of SIAL and CYT are complete; we have on several occasions noted the skepticism surrounding EMN (see research out this month)
  • Coatings’ returns remain well above trend and valuations are beginning to anticipate a fall in those returns, but the group retains the highest SI value due to the mismatch of earnings relative to historical trends
  • The skepticism value for the Commodity group reflects the dichotomy within the subsector, which remains cheap in aggregate (driven by OLN, AXLL, and HUN) and continues to over-earn relative to trend (driven by LYB)

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44 plots the individual SI components, valuation discount and deviation from return on capital trend, for each of the Chemical subsectors.

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 40 shows SI by company. Highlighted in green are companies that are at all-time or 10 year peaks in skepticism. OLN has a high skepticism value because it is currently inexpensive and its return on capital is reflecting the inclusion of DOW’s chlor-alkali business, giving the appearance that the company is over earning – this will likely moderate when we adjust the capital base for 2015 actual data. Again note the buyout premiums embedded in CYT and SIAL.

Exhibit 45

Source: Capital IQ and SSR Analysis

2015 Chemicals Research

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)

September 17, 2015 – APD Materials Spin: The Right Strategic Move, But Not Much Value Add (blog)

September 10, 2015 – DuPont: Has the Third Envelope Gone Back in the Drawer? We Hope Not!

August 17, 2015 – Ethylene: Not Ground into the Floor by China but Losing Steam Quickly

July 29, 2015 – DuPont: Investor Exodus (blog)

July 29, 2015 – Eastman: The Silver Lining of the Propane Cloud (blog)

July 28, 2015 – LyondellBasell: Hard to Fault (blog)

July 28, 2015 – Dow Chemical: Neither Fish nor Fowl (blog)

July 8, 2015 – DuPont and Chemours: Strategically Challenged

July 6, 2015 – Agriculture Musical Chairs, But With Different Music

June 5, 2015 – DuPont Question 2: Chemours is a No Win Scenario

June 5, 2015 – Skepticism + Positive Revisions = Outperformance

May 27, 2015 – DuPont – Question 1: Is the Return on R&D Investment Positive?
May 13, 2015 – The DuPont Vote – Short Term Noise – Change is Coming Either Way

May 12, 2015 – Corporate Complexity – Less Is More

May 6, 2015 – EMN – Time to Focus on the Shareholders

April 27, 2015 – DD and DOW – Backing The Activists

April 20, 2015 – Air Products is Running Out of Gas – Praxair is Refueling!

March 9, 2015 – Prices Falling, Dollar Rising – Stocks Defying Gravity

February 9, 2015 – Industrial Gases – Pricing Coming and Good for All

January 27, 2015 – US Ethylene – Who Will Blink First

January 13, 2015 – Own Goal Investing – EMN Presents Another Opportunity

January 12, 2015 – Favorites for 2015 & Industrials & Materials Methodology Review

January 5, 2015 – The Ethylene Conundrum: EMN the Value Play

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 46 to 50.

Exhibit 46



Source: Company Reports and SSR Analysis

Exhibit 47

Source: Company Reports and SSR Analysis

Exhibit 48

Source: Company Reports and SSR Analysis

Exhibit 49

Source: Company Reports and SSR Analysis

Exhibit 50

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 51 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 51A

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 51B

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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