Chemicals Monthly – DowPont and PPG and Not Much Else

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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

January 18th, 2016

Chemicals Monthly – DowPont and PPG and Not Much Else

  • We see more reasons for optimism for a consumer rebound versus an industrial recovery in 2016 given mostly positive employment news, continued lows in crude, and consecutive months of manufacturing contraction from the PMI
    • There has been some support for this thesis two weeks into the year with SMG easily the best performing Chemical stock – flat in a very weak market
    • IFF the second best performer and also more levered to the consumer
    • Personal consumption expenditures continue to steadily increase and growth is focused on goods rather than services
  • We are skeptical of the sustainability of current global ethylene/polyethylene economics
    • With a significantly flatter cost curve than in recent years, dynamics could change quickly to the detriment of US producers – see research referenced below
  • Valuation is little changed over the past month – while absolute performance may look scary, the chemical sector has similar periods of relative underperformance regularly.
    • A handful of commodity stocks look cheap, but deservedly so
    • The Coatings sector looks marginally less expensive after we fine-tuned our models for year’s end (and also for our piece on PPG – see research reference below) but retains the only premium among the Chemicals subsectors currently
  • The commodity rout continues and China scares are intensifying
    • Crude is off nearly 40% from a year ago and natural gas is down 20% – generally a positive for Chemical producers but the closing of the gas/oil spread is a significant competitive threat for US companies
  • Research published since our last monthly included our views on ethylene in 2016, a stock specific piece on PPG, and a reiteration of our preference for DOW/DD
  • Our favorites in the sector are shown in Exhibit 1
    • Still positive on DOW/DD – weak start to 2016 provides better entry point
    • 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

Early on in 2016 the commodity rout has continued – the list of the worst performing stocks so far is composed almost entirely of commodity exposed companies (Exhibit 3). The underperformance of DD and DOW, however, strikes us as strange and we have written on this topic recently. With a very uninspiring macro outlook it is hard to find a story in our space with more potential offsets to a slow growth environment than DowPont. The situation could be helped by better and more cooperative corporate messaging – our overall impression is that the dip simply provides a better entry point for investors looking to be long these stocks. We struggle to see a scenario which justifies current relative value for DOW and DD which does not have severe negative implications for LYB, WLK or MON.

Outside of this opportunity, we would focus on several areas: companies on the right side of commodity surpluses, selling products driven by consumer rather than industrial demand, and those with solid balance sheets and strong cash flows. PPG is a standout on this basis as we recently noted – benefitting from TiO2 oversupply for the last two years and now likely lower latex costs, exposed more to the consumer, and with solid fundamentals. The stock has held in relatively well during the recent market selloff, but still remains much cheaper than SHW and the Industrial Gas names, which while possibly less volatile than the old PPG may not be less volatile than the new PPG and have fewer tailwinds and more headwinds in 2016.

Two weeks into the year, the pockets of strength have indeed been those stocks with consumer driven demand – SMG (a seasonality effect as well) and IFF stick out as the two best performers in 2016 to date.

Exhibit 3

Source: Capital IQ, SSR Analysis

It has cooled off a bit in the northeast but there has not been enough heating demand to draw down gas inventories, which remain above the historical range – Exhibit 4. Crude inventories are also at record levels – Exhibit 5. All told, gas pricing is down 20% from this time last year, but crude has fallen nearly 40%. This contraction of the crude/oil spread (and the subsequent flattening of the global cost curve) partially informs our cautious outlook for US ethylene as discussed in recent research.

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. Aside from modest positive revisions in the Coatings space and little change for Industrial Gas, revisions have come in negative and significantly so for Commodity and Ag. Macro headwinds should lead to continued negative pressure on EPS estimates absent further deals.

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. The Coatings sector looks somewhat less expensive than it has in prior months after our model updates at year end and for our recent piece on PPG. All other sectors are fairly valued or showing some degree of discount, but nothing is overly compelling in absolute terms.

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. IFF and ARG (with its buyout premium) are screening at 10 year valuation highs.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 shows absolute and relative performance by subsector in 2015 year to date. Coatings and Industrial Gas stocks have just kept pace with the market – all other Chemical groups have been weak, particularly the Commodity stocks. DOW and DD notably have seen underperformance that in our view is unwarranted, could be improved by better messaging from the companies, and overall presents a better entry point into the stocks.

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level. PX is the extreme under-earner in Exhibit 11, at a 10 year return low, but performance has stabilized thus far in 2016 (+3% versus the S&P). Conversely, APD is at a 10 year peak but has been behind the market year to date (-2%). A pair of Coatings companies (SHW, PPG) and ECL are also at 10 year earnings peaks.

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 ticked higher over the past month and returns remain historically elevated. All subsectors save Ag saw improved margins.

 

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. That DOW and DD screen as unattractive is mostly a function of the inexpensive nature of the sector overall, and does not accurately reflect the massive opportunity in front of the companies.

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, but the shorts have capitulated more through the first weeks of 2016, giving us a positive result two weeks into January.

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.

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 continue to trend higher, but the 2.5% year over year growth in the latest data point (through November) was the lowest rate seen in 2015 to date
  • 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 and the most recent data point showed an even greater divergence (3.6% growth in goods, 2% growth in services)
  • Further segmenting the goods component, durable goods have averaged 6.2% 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

  • The latest month of construction spending data (November) showed 10% year over year growth for the seventh consecutive month – the slight sequential decline is not unusual for the month, which has historically been a slow one for construction
  • Spending figures from 2005 to the present were revised but we remain below the prior peak
  • 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

Exhibit 19 Exhibit 20

Source: US Census Bureau

Agriculture

  • Agricultural commodity pricing continues to show signs of stabilization – wheat and corn saw minimal movement over the past month and soybean pricing was up 2%
  • Prices are now down less than 10% from the prior year, but remain depressed relative to the 2012 peaks – all down at least 48% from those highs

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • The PMI remained in contraction levels for the second consecutive month – new orders improved sequentially but are still a tick below 50 (49.2)
  • Inventory and production readings both held steady

Exhibit 22 Exhibit 23

Source: ISM

Trade

  • The US Chemicals trade balance (ex. Medicinal & Pharma) dipped down again and remains highly volatile
  • 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 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. Our views on ethylene in 2016 can be found in our recent ethylene-specific research – in short, we see current economics as fragile and see risk across the stocks in this space (DOW an exception on the DD deal).

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Stocks of crude oil have breezed past the two billion barrel mark – Exhibits 29 and 30 – contributing to steady declines in crude pricing. Brent broke $30 per barrel for the first time in over 10 years. 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 has not closed a month at these levels since March 2012. Ethane and propane ended 2015 at the year lows but have recovered modestly through the first two weeks of January.

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 continue to be strong even as prices are flat to down – costs are down more significantly. The current shape of the cost curve is concerning, however, with the regional cost differential much lower than is has been in recent years. We are concerned that US exports would be suddenly disadvantaged if prices decline as costs have.

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:

  • Valuations in the Ag space are anticipating further negative revisions
  • The Coatings group remains an outlier here but less so than in recent months after we fine-tuned our models both for the year end and for our piece on PPG
  • The skepticism in the Commodity group reflects above trend earnings for LYB and DOW and the inexpensive valuations for AXLL and HUN

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. Most sectors are stacked around the SI equalization line where returns and valuation are aligned – Coatings is the visual outlier but is closer aligned than in previous months and the Commodity group actually has a higher SI value in absolute terms.

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 have only one stock (OLN) at a 10 year extreme.

Exhibit 43

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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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