Chemicals Monthly – Expanding Feedstock Advantage = Higher Values

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@ssrllc.com

January 16th, 2013

Chemicals Monthly – Expanding Feedstock Advantage = Higher Values

Exhibit 1

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

Overview

The conclusions from this month’s analysis are as follows.

  • The Chemicals sector (and all its sub-sectors) meaningfully outperformed the market since our last report. The Commodity subsector was the standout for the second period in a row, outpacing the S&P by 8%.
  • This outperformance from the Commodity group comes as the gap between natural gas based ethylene feedstocks and oil based ethylene feedstocks expands to an all time extreme – with NGL extraction margins collapsing.
  • Our model portfolio continues to do poorly, as the stocks that screen as most stretched continue to do better than those that look most attractive in our screens. As indicated in our second “Monthly Topic” below, some of these top end valuations are looking very aggressive.
  • In our Monthly Topics we identify the Chemical names that made our “13 for 13” cut at the beginning of the month. In this analysis DD screened as the most attractive name across all of Industrials and Basic Materials. We also recap our recent piece on the high values in the Coatings sub-sector.

Valuation

Exhibit 2 summarizes our valuation work. With the outperformance in December and now January, all sub-sectors are trading above mid-cycle “normal” relative value. It is not unusual for this group to do well at the beginning of the year: as it is levered to an economic recovery that is also often hoped for at the start of a year. Overlaying this is an ever widening cost advantage gap for commodity producers in the US.

The Coatings subsector continues to look most extremely overvalued and we address this later in the report.

Exhibit 2

The group composition is summarized below.

Exhibit 3

Exhibits 4 and 5 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our December Chemicals Monthly . The Chemical space as a whole has meaningfully outpaced the market, and every sector did better than the S&P500. The Commodity subsector has posted impressive gains now for 2 months since last month, led by advances in LYB, WLK, DOW and GGC (see our commentary of feedstocks). Ag Chemicals have had a good two months, bouncing off low valuations.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Monthly Topic 1: Stock Ideas for 2013

Early this month we published some ideas – attractive and less attractive for 2013 . We wanted stocks that were attractively valued, particularly relative to current profitability and the profitability discounted in forward estimates. We identified a total of 13 attractive and 13 unattractive large cap companies for 2013. The chemical companies that made the lists are summarized below in Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

For the most part, in 2012 expensive stocks got more expensive and cheap stocks got cheaper as investors looked for earnings consistency, dividend certainty and improving results (which were focused in the already expensive stocks and away from the larger-cap names). There is a risk that this could happen again in 2013, but some of the expensive stocks now look very expensive and discount results (particularly return on capital improvements) that are not likely in 2013 given the economic backdrop. Moreover, for many, they are not predicted in 2013 earnings estimates.

We use our valuation, skepticism and earnings estimate work to look for stocks that offer attractive value combined with a positive disconnect between value and current returns on capital as well as “reasonable” estimates for 2013. In defining reasonable we want earnings growth in the forecast but we want the forecast to be reasonable in the context of both the economic backdrop and the historic ability of companies to predict forward earnings. All of these measures have been covered in detail in research published in 2012.

We then group the companies into quintiles, recognizing that an absolute ranking suggests a level of comparative accuracy that we are unlikely to achieve. Based on the quintile rank we then weight the measures; 40% valuation, 20% skepticism, 20% earnings growth and 20% estimate accuracy. This way we are in aggregate using valuation for half of the decision and revisions for the other half – our skepticism index is assumed to be 50% valuation and 50% revisions/earnings.

Of the smaller cap chemical names, only ROC screened as attractive, though HUN was close to making the list. On the unattractive side no mid or small cap chemical made the list, though RPM, FUL and CYT were close to making the list.

Monthly Topic 2: The Bubble In Paint

We use our Skepticism analysis to explore what is discounted in the very high valuation for the Coatings sub-sector of the chemical space today and while we find that expectations are high for all companies, they are at historic extremes for SHW. For SHW, valuation today expects growth rates and improvements in return on capital that are unprecedented historically and hard to rationalize even with bullish views of market growth, market share gains, pricing and cost controls. While the company is doing all the right things and is clearly the beneficiary of favorable market structure trends and feedstock movements, it is hard to see what more can be done to justify valuation gains from current levels. Others in the group also have some impressive earnings/return on capital gains discounted in valuation, PPG particularly, but the return on capital expectation in PPG’s valuation is an improvement to the level already present at SHW and a level the company has seen before (albeit with the help of a chlor-alkali cycle which it will not have going forward).

Exhibit 7

Source: Capital IQ, Company Reports and SSR Analysis

There is a lot of discussion about the US housing cycle, but our estimates suggest that if we get back to a new build rate in the US of 1.5m homes per year, this will only add 14-15% to architectural coatings volume growth. Furthermore, if we look at longer-term expectations and take consensus estimates for 2015 which suggest strong growth for all four companies, only Valspar has expected earnings that drive a return on capital estimate that is higher than currently implied in share prices.

There has been some very good momentum in this group. Earnings have grown despite a relatively weak housing environment and margins have improved because of capital discipline and some formulation advances. This was certainly the sub-sector to be in for 2012. The companies are doing everything right, but at some point prices are too high.

What has happened in other sectors at times like these is that consensus estimates creep up, partly because analysts do not want to change their (successful) recommendations and need higher growth to justify a higher target price (in some cases simply to avoid a “sell” recommendation) . Eventually these estimates surpass what is possible, even from those companies who consistently guide conservatively. The result is negative guidance or an earnings miss and a correction in the stock price.

Stretching the Limits

In all of our work on Skepticism Coatings is the stand-out, as it is not only the most expensive on a mid-cycle basis, but it only gets partial support for this with its current return on capital. By contrast, Paper, which we have highlighted as expensive for the last 10 months, is supported by its much higher than normal returns on capital. Paper had an SI of around -0.3 at the end of December, while Coatings is closer to -1.5. Exhibit 8 shows the SI for coatings from 1990 and clearly identifies the current extreme. Exhibit 9 shows return on capital over the same period. The last time the sector discounted this sort of increase in returns on capital was in the early 1990s and the SI fell to zero as returns increased in 1992 and 1993, so the very negative SI was appropriate. Today we have the same level of expectation but from a much higher (historic peak) level of returns on capital. A great deal is going to have to go right for this to work.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

If we then break-down the sector into the 4 composite stocks (Exhibit 10) we get even greater extremes and Sherwin Williams and PPG set the outer band. RPM is well above normal value, but this is more or less explained by its higher profitability. Valspar lags on both premium to normal value and premium return on capital, but the two are in phase.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

The full January selections are shown in Exhibit 11.

Exhibit 11

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April and we show these results and the performance since we created the screens in Exhibit 12. We had generated good results for the overlap group through mid-September, but have done really poorly since, as we have now seen 5 months of the higher valued stocks getting more expensive and the cheaper stocks languishing. We would expect this to normalize at some point, either due to macro concerns or specific earnings guidance or shortfalls from one or more of the overvalued group.

Exhibit 12

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Spending numbers continued their generally positive trend after ticking down sharply in October. Figures for July through October were revised down slightly.
  • The longer-term spending trend remains positive – Exhibit 14
  • European spending and sentiment numbers continue to drift lower

Exhibit 13

Source: BEA

Exhibit 14

Source: BEA

Construction

  • The recent increasing trend in construction spending petered off in the most recent monthly data, though the longer term trend and forecast are encouraging.
  • Stocks within the chemical space that are exposed to this sector continue to show some resilience (with DD now the only real exception), anticipating a return to a positive trend However, machinery stocks remain well off their highs of the year and appear to be discounting more bad news – there is an inconsistency here with some of the higher valued Diversified and Specialty Chemical companies and the Coatings sub-sector
  • The picture outside the US has not changed materially

Exhibit 15

Source: US Census Bureau

Exhibit 16

Source: US Census Bureau

Agriculture

  • Soybean pricing is off about 8% since our last report. Wheat and, to a lesser degree, corn also saw declines over the month.

Exhibit 17

Source: Capital IQ, SSR Analysis

ISM

  • The ISM Purchasing Managers Index rose back above the 50 level in November, indicating expansionary expectations. In recent months the index has been darting above and then falling below the critical line demarcating expansion and contraction, reflecting the ongoing uncertainty permeating the global economic atmosphere – Exhibit 19.
  • The troubling trend of increasing inventories and decreasing production has reversed in recent months – Exhibit 18.
  • We still do not see enough positive news here for us to feel any less concerned about 2013 earnings

Exhibit 18

Source: ISM

Exhibit 19

Contraction

Expansion

Source: ISM

Trade

  • Chemical trade volumes fell sharply in November. The balance went resoundingly negative for the first time since 2011.
  • If the US is going to get real advantage from its lower natural gas prices, we should expect to see this line trend upwards.
  • The dollar continued to weaken against the Euro since a low in July – Exhibit 21. However, the fourth quarter of 2012 saw the dollar stronger against the Euro year on year by around 4% – Exhibit 22.

Exhibit 20

Source: US Census Bureau

Exhibit 21

Source: IMF

Exhibit 22

Source: IMF

Commodity Fundamentals

Supply/Demand

Overall demand for ethylene remains subdued, and the better Q3 numbers were in part a function of some inventory rebuild post the summer. Operating rates have recovered from the Q2 lows, partly because of plant availability, post a series of shutdowns in the first half of the year – Exhibit 23.

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. 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 19 – we are not seeing 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 trends down in November for the first time in a year.

Industry experts IHS are calling for a 7% increase in US ethylene production in 2013 over 2012. There are some easy comps in the first half of the year because an unusual level of plant operational problems in 1H 2012, but given the recent trade data and the lack of any real increase in exports from the US in 2012 it is unclear where this additional production will go. The economics for increasing exports do not get any better than this.

Exhibit 23

Source: IHS and SSR Analysis

Exhibit 24

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 25

Brent prices have been fairly stable over the last few weeks, but WTI prices have increased back into the mid $90s as consumption has increased.

Natural Gas has weakened again in January, from December, but are off their lows early in the month which were driven by expectations of warmer weather and higher inventories. Today’s price, at $3.38/MMBTU is exactly where it was in the middle of December, though month to date January prices average well below (15-12 cents/MMBTU)December month averages.

Exhibit 25

Source: Capital IQ

NGL pricing remains very weak; even with improved ethylene production, the increased availability is swamping the market. Supply is rising as more and more new wells are drilled in the “wet gas” regions of the West Marcellus and as logistics help increased crude shipment from the Baaken shale play in The Dakotas, Wyoming and Montana. This crude has high levels of associated gas in many locations. Ethane margins remain below break-even extraction costs for the average producer in January, and have now been negative for three months – Exhibit 26. Part of the problem for ethane producers is the price of propane which remains very depressed and makes propane as attractive to many ethylene producers as ethane – this keeps the squeeze on ethane. Attempts to raise propylene pricing in January, if successful, will put even more pressure on ethane as they will lower the production cost from propane even further.

Exhibit 26

Source: IHS and SSR Analysis

One thing that we continue to see is the price of NGLs fall relative to crude – Exhibit 27. In January this is coming more from the strength in crude prices, but we are now at all time lows for ethane, propane and normal butane (despite the seasonal benefit that normal butane generally sees at this time of the year from gasoline blending demand).

Exhibit 27

Source: IHS and SSR Analysis

Basic Plastics

Lower input costs in December and possible higher polyethylene prices in January should lift polymer margins further – Exhibit 28. International pricing remains weak.

Exhibit 28

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 (29) summarizes the results and is a repeat of Exhibit 1.
Exhibit 29

Valuation Charts – Exhibits 3032

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We have updated the charts and tables from the Skepticism work that we completed in May – see our past research for more detail . The primary conclusions are:

  • Specialty, Ag Chem and Coatings continue to have valuations that discount an increase in return on capital from current levels and with the outperformance of the last four weeks that expectation has increased. The other subgroups all have values that anticipate a fall in returns on capital – Exhibit 33
  • The gross margin trend analysis suggests that this expected decline is probably appropriate for commodity chemicals based on historic volatility, but not based on the widening oil and/gas ratio that we see today.
  • Gross margin analysis calls into question whether the coatings sector should be discounting further improvements in returns on capital as the sector is already over-earning. As mentioned earlier, the Coatings sub-sector has consensus estimates for 2013 that do not support the return on capital gains discounted in valuation – furthermore, the sub-sector has a very good track record for accurate forward earnings projections – Exhibit 34

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

January 10, 2012 – A Lesson In Expectations: Is There A Bubble In My Paint?

January 3, 2012 – 13 Attractive, Bad or Overyhyped Ideas for 2013, Assuming No Macro Change

December 10, 2012 – Over-Confidence Destroys Value

November 29, 2012 – Guidance Matters, Even for Chemicals

October 9, 2012 – Commodity Chemicals: Building in the US, An Adventure or An Investment

October 9, 2012 – Coatings Expensive? The Sellers Seem to Think So (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 35 to 39.

Exhibit 35


Source: Company Reports and SSR Analysis

Exhibit 36

Source: Company Reports and SSR Analysis

Exhibit 37

Source: Company Reports and SSR Analysis

Exhibit 38

Source: Company Reports and SSR Analysis

Exhibit 39

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 40 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 40A

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 40B

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.

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