Chemicals Monthly – End Market Exposure is Key

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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

August 16th, 2016

Chemicals Monthly – End Market Exposure is Key

  • Q2 earnings results for the Chemicals sector showed a range of outcomes reflecting differing subsector-level fundamentals
    • DOW and DD are both performing well pre-merger, cutting costs and growing specialty revenue
    • EMN, OLN, MON and the fertilizer companies continue to struggle with overcapacity and tepid demand issues in key industries
  • Chemical stocks almost universally underperformed across the board over the past month however
    • Performance was most negative for Coatings – SHW and PPG both down post-earnings as top line growth missed expectations
    • Diversified group the best performer, barely flat to the S&P
  • Most Brexit related commentary on Q2 earnings calls was dismissive with respect to near-term impacts
    • While it may be a company specific red herring, the recent guide-down from small cap Specialty chemical maker A. Shulman (SHLM) was concerning for the intensity and apparent rapidity with which demand has deteriorated over the summer – more than 50% of sales are in Europe
  • Ag markets remain troubled – outlooks from fertilizer producers were generally poorly received – more large negative revisions for CF and MOS
    • CF looks best positioned to maintain its dividend and high yield
  • Since our last monthly report, our Chemicals coverage has included work on:
    • Coatings – comprehensive look at the industry finds key drivers in their latter stages – AXTA interesting as a potential takeout candidate with some near-term cost opportunities, PPG from continued bolt-on M&A
    • CF – best positioned among the fertilizer stocks to maintain its dividend
    • EMN – missed their own guided down figures, indicating disconnect between management’s view of the portfolio and the delivered results – change is likely
  • 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

Q2 earnings results were mostly in line with prevailing narratives – Exhibit 3. DOW and DD are extracting costs and driving sales in advance of their merger. In the Ag space, declining fertilizer prices continue to take their toll on CF and MOS, while MON’s underwhelming numbers do not strengthen its bargaining position with potential acquirers. Specialty companies showed their lumps as ALB has been unable to translate higher lithium prices into results (though the stock recovered its post-earnings losses) while EMN under-delivered against lowered expectations (which is an inexcusable management error in our view) – the current strategy does not appear to be working.

Exhibit 3

Source: Capital IQ and SSR Analysis

At the sector-average level, we see a comparatively strong result from Industrial Gas, though expectations were tempered by tepid industrial production globally. APD is still benefitting from self-help levers, but PX actually posted marginally greater surprises on both the top and bottom lines. The Coatings group is facing slowing top-line growth, which should provide the impetus for further deals in the space. The Diversified result is significantly influenced by ALB, while in the Commodity space DOW and WLK mostly offset another weak quarter from OLN.

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 negative following Q2 earnings reports, particularly in the Ag space (driven by CF and MOS). Coatings were least affected from a revisions perspective, but the stocks were pricing in improvements and thus underperformed most significantly.

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. 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 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 6 – disappointing earnings results drove record discounts for the unloved stocks in the space – OLN, CF, MOS, and EMN. 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 7 shows absolute and relative performance by subsector since our last monthly report. PPG and SHW were both off after earnings, outweighing RPM’s strong move higher.

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. Above trend returns offer some justification for the premiums reflected in APD, SHW, IFF and ECL. Of the current under-earners, MOS is now at a 10 year earnings low, with fellow fertilizer producer CF not far off its own relative low.

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 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 continue to trend downward toward prior trough levels. The biggest near-term risk here is in commodity chemicals in our view

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).

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 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 somewhat different story as commodity stocks have enjoyed a bounce and performance has been strongly and consistently positive, particularly for the overlap group.

HUN is driving the long-side results in August to date. On the short side, ECL is offsetting most of the gains to 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. The negative revisions picture limits the list this month to only AXLL – Exhibit 15, which would only outperform in a declining market given the fixed price bid from WLK.

Exhibit 13

Exhibit 14


Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures continue to trend higher – 2.8% year over year growth marked the fastest pace since September 2015
  • Spending on goods continues to drive much of the upside gains – June’s spending gains mirrored the 12 month average growth figures, +3.6% for goods, +2.4% for services

Exhibit 16 Exhibit 17

Source: BEA

Construction

  • Construction spending in the US again showed weakness in what is historically a seasonally strong month – June spending was down modestly month over month and virtually flat versus the prior year
  • US construction spending averaged 10% growth from April 2015 to March 2016, but has slowed markedly since
  • Exhibit 18 shows the long term trend in US construction spending and Exhibit 19 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period

Exhibit 18 Exhibit 19

Source: US Census Bureau

Agriculture

  • Wheat was the big price mover over the past month, rising on poor weather and outlooks for European crops
  • Soybeans and corn were each off ~2%, bringing year to date movements down to +14% for soybeans and -7% for corn

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • The US Manufacturing PMI dropped a few ticks in the latest reading but held at firm expansion levels
  • New orders remained strong at 56.9 in July on the heels of a 57 mark in June

Exhibit 21 Exhibit 22

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 23

Source: US Census Bureau

Exhibit 24

Source: Capital IQ, SSR Analysis

Exhibit 25

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Capacity is returning to the market more slowly than planned after spring turnarounds, just as the Brexit has added a layer of uncertainty that could compound seasonal demand weakness. Near term concerns about supply have delayed the weakness that we had been expecting and ethylene and polyethylene pricing has remained robust in July and August through feedstocks have been quite volatile.

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

US stocks of crude oil and petroleum products made fresh highs in recent weeks – commercial crude stocks again continued to decline however, indicating the gains remain mostly in petroleum products – Exhibits 26 and 27. Crude pricing is back in the upper $40s after ending July in the lower $0, and has been range bound as such since March. Nat gas inventories are starting to build at slower than expected rates, but remain elevated – Exhibit 28 – pricing has come off in August after approaching $3.00 per mmbtu in June and July – Exhibit 29. We think the risk to natural gas is very much to the upside given low (though rising) rig counts – at least in the near-term.

Exhibit 28 Exhibit 29

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

Exhibit 30

Source: EIA, SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Midstream Business and SSR Analysis

Exhibit 33

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 34

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 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 subsectors. The first exhibit (36) summarizes the results and is a repeat of Exhibit 3.

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, Exhibit 41 shows the extent to which valuation is historically explained by returns, and Exhibit 42 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 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43 shows SI by company. Only IFF screens at a current skepticism extreme – the stock is more expensive than its above-trend return profile suggests.

Exhibit 43

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 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.

Appendix 2

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