Chemicals Monthly – Looking Pricey As We Enter A New Year

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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

December 16th, 2013

Chemicals Monthly Looking Pricey As We Enter A New Year

  • As the market faces some year-end fatigue after a strong 2013 (and with some Fed inspired headwinds), the Chemicals sector was notably sensitive to the dip. Only the Commodity group was able to outperform the S&P, which is interesting given its history of exaggerating market swings.
  • Brent crude is little changed from the end of November, but WTI has spiked up along with natural gas, which is currently above $4.00 per mmBTU. There are plenty of natural gas inventories and increasing supply, so even with the cold snap in the North, we would be surprised to see natural gas strengthen much further.
  • Recent Chemicals research has highlighted Lyondell, PPG, and restructuring possibilities at Dow and DuPont. Additionally, since our last Chemicals Monthly, we have analyzed the relationship between historical sell side recommendations and performance (notably poor with respect to DD), and offered our view on the export opportunities available to cost advantaged US based firms.
  • Chemical sector preferences are outlined below at the subsector and stock level. Note that we no longer have a favorite in the commodity space, and are also more cautious on Agriculture – these changes are touched on here and will be covered in new research shortly.

Exhibit 1

Source: SSR Analysis

 

Exhibit 2

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

Overview

With the broader market facing some Fed inspired year end headwinds, the Chemicals subsectors have dipped in tandem. Only the Commodity group was able to outperform the S&P 500, helped by relative strength from DOW and a strong move to the upside from OLN. Specialty Chemical names were hit the hardest, with IFF, ECL and EMN all down in excess of 4%.

DOW announced more details around its proposed divestments and this may have been a trigger of interest. The run up in Olin may simply have been a reaction to its very attractive value versus the group as the appreciation in the stock happened before Smith and Wesson announced very strong numbers last week. It is also possible that the DOW chlorine closure announcement was a positive trigger as there was clearly a broad concern about oversupply of both chlorine and caustic soda early in 2014. Despite this, we have taken OLN out of our favorite column in Exhibit 1 this month. While we are aware of its very attractive valuation, we are concerned about chlorine oversupply in the near term and its specific impact on OLN. While DOW may simply be replacing old capacity with new, Oxy and Westlake are adding new capacity and we cannot see how OLN fairs well here as it is likely to lose customers as a result. We think that forward estimates are too high on this basis.

We have also taken MON out of our favorites column despite its attractive value relative to its recent past. We have not yet done enough work on the subject, but we are reviewing our thoughts on US corn demand in the light of the change in the corn ethanol blending limits for 2014 and the further possible consequences of declining gasoline demand in the US. Declining US corn demand would negatively impact MON, DOW and DD, but probably MON more severely because of the earnings leverage and because of the current earnings multiple.

In general we find the whole sector expensive and would remain focused on the diversified names, particularly HUN and ROC and also PX, which while fairly valued probably has a higher and more reliable underlying growth rate than the rest. For those with mandates that spread further than chemicals, we would focus on the undervalued capital goods companies today, such as CAT and SWK, as well as DHR, MMM and GE.

Valuation

Exhibit 3 summarizes our valuation work.

Exhibit 3

The group composition is summarized below. As noted in our piece on transformational change from August , we have adjusted the group constituents, changing EMN from a Diversified to a Specialty company.

Exhibit 4

Exhibit 5 shows subsector discount from normal value in standard deviations.

Coatings and Ag Chem remain the expensive and cheap outliers, respectively. Specialty and Industrial Gases are fairly valued on our framework, and Diversified is brought to the cheap side due to Rockwood and DuPont’s relative attractiveness.

Exhibit 5

Source: Capital IQ and SSR Analysis

In Exhibit 6, reproduced and updated from our recent comprehensive Chemicals report , we show company discount from normal value as measured on our framework. RPM, WLK and LYB are holdovers from last month. PPG and ARG both dropped from their recent valuation peaks. POL rejoined the highlighted group of companies that are at or within 5% of 10 year or all time valuation highs. No companies currently screen at valuation lows.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibits 7 and 8 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our October Chemicals Monthly.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 9 through 11, also repeated and updated from our state of the industry report , show profitability at the sector, subsector, and stock level.

In Exhibit 9 we have highlighted those companies at or near earnings highs – no companies screen at earnings lows on these time frames. WLK was also highlighted in the corresponding valuation exhibit (Exhibit 6) – record valuations are at least partly justified by record earnings.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 and 11 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Portfolio Performance

The October selections are shown in Exhibit 12. DD remains attractive despite its recent performance, but this is partly because it is hard to find a cheap stock anywhere in the sector today. ARG is the only new company to these screens, replacing CBT.

Exhibit 12

Source: Capital IQ and SSR Analysis

We have back tested the methodology and show the results for the current year in Exhibit 13. Results have been mixed in recent months. In a pattern similar to that exhibited by our portfolio selections for the broader Industrial and Basic Materials group, year to date returns have been most robust for the overlap screen (10.2% in excess of the market, exclusive of transaction costs). The Skepticism Index screen has performed decently as well (5.5%), while the valuation screen has modestly trailed the market (-3.0%).

Exhibit 13

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures continue to climb higher in the latest data. July, August and September figures were revised down negligibly.
  • After the dip following the housing and financial crises, consumer spending has resumed its steady uptrend, albeit at a slower rate than was previously seen.

Exhibit 14

Exhibit 15

Source: BEA

Construction

  • Construction spending ticked up in the latest release through October but appears to have stagnated somewhat since the summer.
  • The longer term trend is still encouraging, recovering from a near term trough in early 2011. It took several years for spending to bottom and it could take several more before construction returns to its pre-crisis level.

Exhibit 16

Exhibit 17

Source: US Census Bureau

Agriculture

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • Industrial activity is apparently gaining some momentum heading into 2014. The November PMI reading showed an increase to 57.3, the highest level since April 2011. The overall index spent much of the past two years bouncing around the expansion-contraction line, but readings have been firmly positive since July.
  • The production subcomponent snapped a short term downtrend and inventories dropped. New orders were strong as well.

Exhibit 19

Source: ISM

Exhibit 20

Source: ISM

Trade

  • Chemical trade volumes dipped slightly in the latest figures, through September. This marks the third consecutive month that the balance has been positive. Volumes have been consistently volatile in recent history and this month’s change was the smallest month over month since April 2011. The dotted line – a 12 month rolling average – appears to be trending slightly upward, and we have expected the balance to be increasingly strong given the current cost advantage of domestic producers.
  • The Japanese Yen and the Indian Rupee have suffered the most over the past year, down 24% and 13%, respectively, versus the dollar. Thus far, Q4 has seen the dollar weaker versus the Euro by nearly 5%– Exhibit 22.

Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: IMF

Exhibit 23

Source: IMF

Commodity Fundamentals (unchanged from last month)

Supply/Demand

Please see our recent piece on US ethylene demand for our current perspective. We remain concerned that high absolute pricing for chemicals are constraining growth. Please also look for a more short-term piece on the US ethylene balance that we will publish within the next few days.

In both of the charts that follow we include IHS’ revised forecaster for the balance of 2013. IHS has made a significant positive revision to its estimate of Q3 production in the US, lifting operating rates to a healthy 92% of nameplate capacity. Interestingly they have not made a similar change to expected demand in Q3 and are instead showing an ethylene inventory build, which is repeated in their Q4 forecast. Producers suggest that operating rates are high, but neither domestic demand growth nor trade data is very supportive of the idea of a better market today. Note that while production is improving, operating rates are not.

Capacity is expected to grow by close to 2 billion pounds in 2014 versus 2013, which means that demand needs to grow by more than 3.0% in 2014 just to maintain current operating rates. According to IHS, US ethylene demand grew by 2.6% in 2012 and will be essentially flat in 2013.

Production is summarized in Exhibit 24 and operating rates are summarized in Exhibit 25.

Exhibit 24

Source: IHS and SSR Analysis

Exhibit 25

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 26

The Middle East continues to dominate the crude oil story but Brent is off its highs and continues to bounce around $110 per bbl. WTI has jumped up on the month. Natural gas has seen a recent spike based on cold weather and a surprising inventory number but remains relatively cheap.

Exhibit 26

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. While there has been a recovery from the low in June of this year, margins have now been negative for 14 months in a row and there is no expectation that this will change, as those operating fractionators are driven by the need to move ethane out of the gas stream rather than the economic benefit of the process itself – Exhibit 27.

Exhibit 27

Source: IHS and SSR Analysis

Butane continues on its more positive trend associated with the usual winter gasoline blending season and while propane is no longer declining relative to crude it is fairly stable and at an all time low (the line continues to decline in the chart as it is a 12 month average). This propane value in the US continues to create great incentive to export US propane to Europe as an ethylene feed, where logistics and feedstock flexibility exist – this is expected to continue and put a floor under US propane prices well above its break-even as an ethylene feedstock in the US versus ethane. The longer-term trend relative to crude remains negative, but is flattening out and is likely get much lower – Exhibit 28.

Exhibit 28

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is lower in the US, as gains achieved in September were not sustained into December, which is historically a hard month to hold on to pricing because of seasonal declines in demand as customers think about year-end inventory targets. Markets are not significantly oversupplied, but there is no shortage of product and the overall demand picture remains weak, more so overseas than domestically. High density polyethylene does have some surplus capacity in the US, but it is clear that producers would rather build ethylene inventories in the near-term versus pushing polymer into the export market.

Exhibit 29

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 (30) summarizes the results and is a repeat of Exhibit 3.
Exhibit 30

Valuation Charts – Exhibits 3133

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

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:

  • Diversified Chemical companies are over-earning by roughly one standard deviation, yet are some of the cheapest in the Chemicals space, giving the group the highest Skepticism Index value. Agricultural Chemical stocks are right in line with historical earnings but investors are discounting a fall in returns. See Exhibits 34 and 35.
  • PPG and LYB are highlighted in red in Exhibit 44, with skepticism index values within 5% of all time lows for each company.

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

December 10, 2013 – Exporting Shale: A More Logical Perspective

November 18, 2013 – The Recommendation Signal: Another Reason to Look at DuPont

November 7, 2013 – Lyondell: Growth or Income, Both Have Risk

November 7, 2013 – DuPont: An Unusual Stake in the Ground (blog)

October 29, 2013 – PPG: What Do You Have to Believe

October 21, 2013 – Common Sense Restructuring: Some Money to Be Made

September 23, 2013 – The State of the US Chemical Industry

September 15, 2013 – Optimism and Forecasting in the Chemical Industry

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?

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 37 to 41.

Exhibit 37


Source: Company Reports and SSR Analysis

Exhibit 38

Source: Company Reports and SSR Analysis

Exhibit 39

Source: Company Reports and SSR Analysis

Exhibit 40

Source: Company Reports and SSR Analysis

Exhibit 41

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 50 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 42A

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 42B

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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