Chemicals Monthly, March 2017 – Need for M&A Clouds a Confident US Economy

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Graham Copley / Nick Lipinski



March 16th, 2017

Chemicals Monthly, March 2017 – Need for M&A Clouds a Confident US Economy

  • Merger moves remain in focus in the Chemicals space as slow growth and lack of term near catalysts prompt companies to look at large scale deals
    • PPG/Akzo the latest potential pairing
      • PPG at fair value following deal related volatility; not expensive in our view vs. others
      • We have previously written about the upside possibility at Akzo some of which has been achieved with the emergence of PPG’s interest
    • Gas companies continue to struggle – worst performing Chemicals group over the past month
      • APD’s chances to acquire Chinese competitor Yingde took a hit with the emergence of a rival bidder (Hong Kong private equity firm)
  • Volatility and some weakness in energy markets as rig counts remain on the rise
    • Rebound in US oil production has crude in storage setting new highs and fresh records weekly, offsetting OPEC output cuts and driving pricing down 10% since the end of February
    • At the same time, natural gas is 8% higher, tightening the oil/gas spread to the detriment of US based chemical producers – the gas move is likely cold weather driven and short-term.
  • Ag markets remain challenged – stocks show value but tough to gauge the turning point
    • Higher production estimates of corn in Brazil and soybeans in the US weighed on crop pricing
    • Fertilizer stocks remain cheap but real recovery looks increasingly like a 2018 event, although 2016 was likely the trough with some “bounce” off the bottom in 2017
  • Domestically the macro situation appears quite positive on the surface – but the US is still in desperate need of more robust GDP growth than we have had for the last 5 years
    • US manufacturing on solid footing with growth in nearly all surveyed industries, strong improvement in new orders, and low inventory buildup suggesting strong demand
    • Business and consumer confidence measures remain robust, which may be enough to sustain momentum until fiscal measures to stimulate demand take effect
  • Our preferences in the Chemical sector are summarized in Exhibit 1
    • We are positive on most of the large cap names in the space (DOW, DD, LYB) but have concerns in most subsectors, and at the subsector level would only be overweight Commodities and Ag Chemicals – in part because of valuations, in part because of improving fundamentals – for commodities we are assuming that oil stays around $50.
    • We have moved Industrial Gas and Coatings to underweight – if we had to invest in these sectors we see relative upside for Air Liquide in Gas and AXTA/Akzo Nobel in Coatings

Exhibit 1

Exhibit 2

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


PPG is the latest chemical company to indicate interest in large scale M&A. Though its initial offer for Akzo was rebuffed we see potential for a deal to be worked out given the companies’ history (PPG bought Akzo’s North American architectural business), stalling Coatings growth, and the apparent need for a shakeup at Akzo. A combined PPG/Akzo would move ahead of the pending SHW/VAL entity as the largest global Coatings producer. After the noise surrounding the disclosure of PPG’s bid and Akzo’s rejection, PPG stock is about where it started, roughly in line with mid-cycle value – earnings are more significantly above trend than at any point in the past 10 years. Valuation suggests that PPG has run out of growth and that the recent earnings trajectory cannot be maintained (the company missed Q4 earnings and guided down for 2017) – this is impetus in itself for exploring external growth opportunities.

Exhibit 3

Source: Capital IQ and SSR Analysis

Recent developments in energy markets have the potential to disrupt what has been a relatively stable pricing environment, particularly with respect to crude. Surging US oil production has been compounded by Saudi output that appears to have far exceeded the nominal OPEC reported figure for February. Efficiency gains have lowered the breakeven point of US production economics so we may not see an investment cut because of the recent price declined. The Permian in particular appears very profitable at current pricing and with both technology and infrastructure improving every day we do not expect to see a slow-down here without a major step down in crude prices. We also believe that the Permian will likely be the source of ample ethane to feed all the new US Gulf ethylene, as well as provide an export surplus.

The rig count chart in Exhibit 4 is likely a little misleading. The wells in the Permian are classified as oil as that is the primary product targeted. These wells produce significant natural gas and NGLs and while the natural gas rig count may be low the gas supply from the Permian is rising with the crude supply.

Exhibit 4

Source: Capital IQ and SSR Analysis


Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6.

Exhibit 5

Exhibit 6

In Exhibit 7 we show subsector discount from normal value as measured by our valuation framework, and in Exhibit 8 we show discount by company. Valuation at the subsector level grew more dispersed over the past month, with Ag Chem growing cheaper on continued negative revisions and Coatings looking slightly more expensive with the inclusion of full fiscal 2016 capital data – the Akzo story drove PPG higher but gains were short lived. The Diversified group is also trending more expensive with ALB’s move higher post-earnings and DD rising on the expectation of regulatory approval for its merger with DOW.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – fertilizer names are back near extreme discounts after continued pricing weakness led to further significant negative revisions for CF. Estimates were more resilient for MOS but a brief boost from a story that Eurasian producers were set to cooperate on output quickly dissipated and the stock again trended downward.

Eastman is the stand-out in Exhibit 8 – at an extreme valuation low while US economic growth is improving. We still believe that there is significant value to unlock at Eastman but are unconvinced that the current management team is focused on the right things – in other words we struggle to see a catalyst. The other stand-out in Exhibit 8 is WLK, where despite the improved stock price the market is not giving the company the benefit of the doubt regarding its ability to integrate and extract value from the Axiall acquisition. Betting against WLK in these situations in the past has generally been the wrong move.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 shows absolute and relative performance by subsector since our last monthly report. Standouts driving the results at the extremes include ALB in the diversified group, which was up strongly after earnings and continued to trend higher. Gas names remain weak, focused in APD over the past month.

Exhibit 9

Source: Capital IQ and SSR Analysis



Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. Both PPG and SHW are now at 10 year return peaks, suggesting why mergers are currently in focus in the Coatings space. CBT is also near an earnings peak – this is a stock that we highlighted on the negative side in our Chemicals SMID work. On the under-earning side, considerably sub-trend returns help explain the valuation discounts seen in the fertilizer stocks.

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 despite a downward trend in recent months. Margins remain elevated in Coatings, appear to have crested in Industrial Gas, and are attempting a turn in Ag Chem.

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 (see Exhibit 1 for our preferences by Chemicals subsector).

Ag stocks have weighed on the long valuation selections recently. In the overlap OLN has continued to perform well but this has been offset by weakness in EMN. DD has boosted the short selections and we note the stock would not appear on the least attractive screen if we allow for the benefit of DOW synergies.

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. The revisions picture limits the list this month to just MOS and LYB – Exhibit 15. Exhibit 16 shows the recently updated performance results for companies meeting these conditions at various ranges.

Exhibit 13

Exhibit 14

Source: Capital IQ and SSR Analysis

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

  • The first consumer spending data point of 2017 showed a sequential decline but 2.8% year ove year growth, slightly above the monthly average seen in 2016
  • The smaller goods component (+4.3% year over year growth, 35% of total consumption) continues to outpace spending on services (+2%, 65% of total consumption)
  • In particular, durable goods spending continues to show exceptional strength – 8.8% year over year growth in the January data is the highest since early 2015 and the third month above 8% in the past four

Exhibit 17 Exhibit 18
Source: BEA


  • Similar to consumer expenditures, construction spend saw a sequential decline but 3% year over year growth
  • Revisions to November and December data were significant (+0.6%, +0.9% respectively)
  • Exhibit 19 shows the long term trend in US construction spending and Exhibit 20 shows the trend over the past several years
  • After falling precipitously in the middle of the year, growth in construction spending is again on the upswing – Exhibit 23

Exhibit 19 Exhibit 20

Source: US Census Bureau

Exhibit 21

Source: US Census Bureau


  • It has been a down month for ag pricing – corn, soybeans, and wheat all down 3% – driven by higher than expected production estimates for Brazilian corn and US soybeans
  • Pricing remains well below the mid 2012 peaks – roughly 45% below for soybean pricing, and nearly 55% for corn pricing

Exhibit 22

Source: Capital IQ, SSR Analysis


  • Another strong reading for US manufacturing – 17 of 18 surveyed industries reporting growth
  • Production has also risen sharply and the absence of a pronounced inventory build up suggests strong demand
  • New orders notably remained above 60 for the third straight month, rising above 65

Exhibit 23 Exhibit 24

Source: ISM

Exhibit 25

Source: ISM


  • Our trade balance exhibit excludes medicinal and pharmaceutical products to more accurately reflect the composition of our chemical index
  • We see trade risk from a Trump presidency as a potentially significant headwind for the US Chemicals space
  • The trade balance rebounded in the latest data through January

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals


US ethylene operating rates are hovering around 90%. The first Q4 drawdown since 2010 has left inventories below seasonal norms but capacity growth should add to current levels as Oxy/Mexichem ramps up and Dow and Indorama have confirmed plant startups by year end. The 2017 outage schedule looks comparatively light. A weak start to the year on the demand side is expected to be offset by growth in 2H.

Production and operating rates are summarized in Exhibits 29 and 30.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis


Crude pricing has weakened as US production has surged, and a discrepancy in the public data indicates Saudi output likely rose in February despite pledged supply reductions. In the US, commercial crude stocks have never been higher and are setting fresh highs weekly – Exhibit 32. Meanwhile natural gas in storage is above the five year average but no longer tracking the high end of the range – Exhibit 33. Gas pricing is back around $3.00 per mmBTU, boosted in the short term by a northeast blizzard – Exhibit 34. Ethane pricing has come down in 2017 after trending higher for much of the prior year – Exhibit 35.

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

Exhibit 35

Source: Midstream Business and SSR Analysis

Exhibit 36

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 37

Source: IHS and SSR Analysis

Basic Plastics

February outages have impacted polyethylene supply but Ineos is slated to start an HDPE unit in Texas at the start of Q2 and completed turnarounds will offer additional sources of supply.

Exhibit 38

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 (39) summarizes the results and is a repeat of Exhibit 5.

Exhibit 39

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

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 43 summarizes Skepticism Index values by subsector, Exhibit 44 shows the extent to which valuation is historically explained by returns, and Exhibit 45 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 43 would suggest additional downside for the industrial gas companies. For Coatings, we think it more likely that returns normalize to equate current valuations, rather than valuations improving to match above-trend returns.

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46 shows SI by company. ALB and ASH are the only companies currently at skepticism extremes, influenced somewhat by recent M&A moves. Returns for these two stocks are sub-trend even with the inclusion of 2016 capital data adjusting for portfolio adjustments – valuations indicate the companies are expected to see returns move back to trend.

Exhibit 46

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

March 9, 2017 – PPG/Akzo: A Smart Deal Rather Than a “Me Too” Acquisition/Merger

February 20, 2017 – Looking to Westlake for Clues

February 9, 2017 – Betting Against the Sell Side: Follow Up

February 7, 2017 – SMID Cap Chemicals: Plenty of Interesting Ideas

February 3, 2017 – Lyondell: Momentum Turning into 2017 So Far

January 31, 2017 – Chemical Commodity Rally: Just Getting Started

January 23, 2017 – Air Products: “Me Too” Folly or an Inspired Fix for a Tricky Problem

January 6, 2017 – Chemours, DuPont and Teflon: Understanding the Dimensions of the Iceberg

January 6, 2017 – Chemicals: Value and Momentum Unaligned – Limited Choices for ’17

January 5, 2017 – Dow/DuPont: Again in 2017!

December 21, 2016 – Praxair: Linde: Keeping Everyone Happy, Except Perhaps the Shareholders

December 19, 2016 – Mosaic: A Necessary Move, But Value Unclear

December 12, 2016 – LYB: Several Reasons to Pay Attention

December 9, 2016 – Paints Wars: A Reminder and Some Fresh Perspective

December 2, 2016 – Praxair: Compensating for Lack of Growth!

November 28, 2016 – Whyondell?

November 21, 2016 – Could or Should Aramco Buy Lyondell?

November 18, 2016 – Dow or DuPont? We Suggest DuPont

November 14, 2016 – Ethylene: Discounting Too Much Downside, Despite the Trump Trade Risk

November 8, 2016 – Fertilizers: Fundamentals at or Close to Trough – Attractive Risk/Reward

October 31, 2016 – How Concerned Should We Be About the US Paint Market

October 24, 2016 – When is a Sell a Buy? (When the Sell-Side Says So)

October 17, 2016 – Paint Wars! Sending Negative Signals

October 14, 2016 – Versum and AdvanSix: Smaller Portions at Attractive Prices

October 10, 2016 – RPM: Not All Chemical Stocks Only Look Attractive When They Are Cheap

October 5, 2016 – China Coal: Not Out of the Petrified Forest Yet

October 3, 2016 – Chemical Deal Mania: When to Hold Them and When to Show Them

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 47 to 51.

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

Exhibit 51

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 52 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 52A

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 52B

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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