Chemicals Monthly – Outlook Still Cloudy

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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

March 16th, 2015

Chemicals Monthly Outlook Still Cloudy

  • Since the start of 2015, conversation topics in the chemicals space seem to be limited to downward revisions, currency weakness and the vicissitudes of energy markets. March marks another month of continuing our diet of these three steadfast topics with oil down, the USD up and revisions mostly lower across the chemicals space.
  • With energy prices brought low again by concerns about US oil inventories, margins for ethylene and polyethylene remain depressed. HDPE prices are still far from their highs in the fall of 2014. Today, HDPE sits under 50 cents per pound for the second month in a row. Low prices in polyethylene and ethylene will undoubtedly damage margins in commodity names as we wrote earlier this month.
  • Commodity chemicals companies mostly underperformed over the last month. Of DOW, LYB and WLK, LYB saw the weakest performance which is fitting with our thesis that the company will suffer the most from depressed margins in ethylene and polyethylene. DOW and WLK both underperformed as well but to a lesser extent.
  • In following with our recent work on these companies and on optimism, we expect underperformance from LYB, WLK and DOW in particular and the Commodity group more generally as margins contract and expectations continue to fall for 2015.
  • Coatings names have held on to their notably high valuations since we last published. SHW remains the most expensive of the bunch. The group performed about the same as the S&P 500 over the last month with little news on the outlook front.
  • Our favorite names have not changed despite modest swings in price over the last couple of months. Nelson Peltz has apparently driven DD to all times highs while EMN’s recent poor performance only gives it a more compelling valuation. This is also true of PX.
  • Chemicals research since our last monthly has included a piece on the unjustifiable valuations observed in commodity chemicals names. We also published a piece on the detrimental effects of management optimism on capital allocation and shareholder returns.

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

Getting constructive on the chemicals space has been more difficult of late as a result of several factors. First is the collapse of the euro, making European exporters more competitive with their global counterparts. The currency move also works against US based companies in that their foreign segments will take a translation hit when their results are reported in the strengthening USD. Energy is also working against the bull case for many chemical companies, with lower oil bringing the North America natural gas cost advantage closer to parity with the rest of the world. While certain companies are able to get around these headwinds (Westlake, for example, with the vast majority of its business in the US), we generally believe that these paradigm shifts, temporary or otherwise, act against commodity names in particular and also those companies that generate a significant portion of revenues outside of the US.

After a trying period for Trian Fund’s effort with DuPont, Nelson Peltz has come out firing with a lengthy CNBC interview further cementing our belief that he is determined to bring about change at the company. The activist appears unfazed by DuPont bringing on Gallogly and Breen and continues to point out improvements to cost base and corporate structure that he could make should he secure himself a seat on the board. Still, the struggle over board seats has been contentious and whether or not Mr. Peltz will be able to sit on the board with another member of his choosing is unclear. So far, the offer has not changed from just one board seat for Trian. Nonetheless, we view Trian’s DD stake as a lever to the upside for shareholders and we believe that his involvement with the company is one of the reasons that it is hitting all-time highs recently even as markets sputter.
Last month, we focused on
industrial gas companies
and the pricing gains that they should see in 2015. Price increases have since been observed and we wrote a
blog commenting on this phenomenon
. However, we think that the commodity names are a much more interesting story this time around. This is because of a deterioration in the economics of ethylene and polyethylene and because one of them in particular – Dow – is a serial value destroyer. In our recent work on optimism, we showed that Dow is one of the three most “optimistic” companies in our chemicals coverage. Unfortunately for Dow and its shareholders and as we explained in more detail in the piece, optimism is a condition associated with a proclivity for poor capital allocation and an inability to accurately forecast a company’s future. This leads to chronically low ROC which in turn drives poor earnings and ultimately gives little to justify share appreciation. Dow has suffered as a result of this optimism – Exhibit 3. We show two trendlines, both of which delineate the negative long term trend in return on capital.

Exhibit 3

Source: Capital IQ, SSR Analysis
The methodology works beyond the chemicals space as well with conservative companies consistently outperforming optimistic companies over a 10 year period – Exhibit 4. Note that DOW, ASH and CYT are the three most “optimistic” companies in our chemicals coverage while POL, WLK and CF are the three most “conservative” companies.

Exhibit 4

Source: Capital IQ, SSR Analysis

Looking at the shorter term outlook for Dow, Lyondell and Westlake, we see little cause for optimism. We believe that the current economics of polyethylene and ethylene cannot support consensus EPS estimates, even after they have seen downward adjustments in recent months. When combined with the impacts of the strong dollar, one must make some heroic assumptions about each companies’ other businesses to arrive at consensus. We compare the rates of decline in consensus estimates and the rates of decline in HDPE and ethylene margins in exhibit 5.

Exhibit 5


Source: Capital IQ, Wood Mackenzie, Industry Sources, SSR Analysis

Though oil has been volatile, it is still decidedly negative for the commodity names at these prices. Even with cost advantaged feedstocks, pricing is so low that margins are shrinking. Still, there has been little news related to cancellations of plans for plants due to come online in the 2017-2018 time frame.

Nearer term, should the Williams plant come back online with other plants in 2Q 2015, the market may be inundated with supply and potentially swimming in ethylene. In that scenario, even if oil should rise above its current levels, pricing would likely still remain weak with the export argument the only real “winner.”

Our
preferred names
and underlying reasoning are mostly the same as they have been in previous months: DuPont because we believe the cost opportunity is large and activist involvement provides a catalyst to achieve it, though fundamentals and valuation are less inspiring than in our other favorites;
EMN
, because of the greater relative value afforded by recent downward moves and heightened clarity on the propane hedge; and PX, based on valuation, pricing improvements coming across the gases names plus a history and outlook based on excellent cost and capital management.

Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. Downward revisions continue across the chemicals space with commodity names seeing the most negative revisions over the last 6 months. Should oil continue on its trajectory of the past few weeks, this trend will likely continue. Performance has been mixed as downward revisions weigh on optimistic names and oil’s troubles have halted the upward march in names like LYB, DOW and WLK. Ag and coatings continue to be the bright spot in terms of resisting negative revisions and their shares have performed relatively well in recent months because of this. Whether or not they are delaying the inevitable or are actually immune to the negative sentiment seen elsewhere is unclear.
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. Subsector valuations have largely maintained their relative positions since the beginning of the year despite gyrations in energy markets and 2015 EPS revisions. Ag names remain the least expensive but there is some variance across the names, with SMG screening modestly expensive while MOS screens inexpensive and CF appears appropriately valued. Coatings remain expensive with SHW, VAL and PPG marked in red due to their 10 year valuation highs in exhibit 9. NEU and IFF have also been added to this 10 year valuation high list since we last published.

 

Exhibit 8


Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 and 11 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our February Chemicals Monthly. Diversified was the best performing group of the month and the only group with positive performance in absolute terms. With oil sliding after its recent rebound, so too did commodity names. Ag chemicals were the worst performers, likely as a response to recent USDA announcements – see
recent comments from our colleague Rob Campagnino
.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis
Profitability

Exhibits 12 through 14 show profitability at the sector, subsector, and stock level.

In Exhibit 12 we highlight several companies in green – all are at 10 year or all time peaks in return on capital. RPM and CYT therefore have some earnings support for the valuations in Exhibit 9, and HUN is still inexpensive and overearning and therefore makes our Exhibit 1 screen. Coatings also stick out here in that their high valuations appear to be explained by their high earnings.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibits 13 and 14 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. Earnings continue to exhibit strength but negative revisions are apparently being realized in that the steep upward trend of recent months has flattened.
Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

The March portfolio selections are shown in Exhibit 15. With such a short time period to measure performance over, our results look less than stellar. However, historically the names with favorable readings in terms of valuation and
our Skepticism Index
have produced alpha and this was true in 2014 as well – Exhibit 16.

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

  • Downward revisions have hit November and December’s numbers but January showed a strong move higher. With January’s number, spending’s move above trend continues and can be seen clearly in Exhibit 17.
  • January’s strong posting puts consumer spending 3.4% higher than it was in January of 2014 which itself was 1.94% higher than January 2013. Despite storms and frigid weather, consumers started 2015 with strong spending.

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • After positive revisions for several months, we see very modest downward revisions for the numbers from the end of 2014. Still, in absolute terms, December had a very strong showing and January’s 1% decline is not a disappointment given December’s high water mark.
  • January’s construction was up 1.75% from January 2014. Construction growth continues to be relatively slow even though the numbers are high in absolute terms. Still, January has been one of the weakest months of the year over the past several years and we are not sure that such a modest sample is enough to signal stress in construction.

Exhibit 19

Exhibit 20

Source: US Census Bureau

Agriculture

  • Crops were a mixed bunch over the last month. Soybeans and corn are both up roughly 1.5% since we last wrote while wheat is down roughly 5%. The USDA again predicted oversupply in wheat hence its larger decline. Wheat has actually climbed over the past week as the USDA lowered its estimate for domestic and global supplies.
  • See our colleague Rob Campagnino’s recent research for more thoughts on the agricultural space.

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • February continued the downward trend seen since Octomber’s ISM peak but the index is still in expansion territory at 52.5. New orders declined, from 52.9 to 52.5 and production declined from 56.5 to 53.7. Also troubling in the latest data is that inventories continue to rise, further painting the picture of slowing production and demand.
  • Growth around the world remains a regional story. North America appears to be the preferred geography as a result of accelerating growth but a strong USD threatens companies with international exposure. Greece continues its struggles with creditors and appears as squeezed for cash as ever but quantitative easing by the ECB has recently taken an equal share of the headlines. We are still wary of concerns at the global level with China recently announcing a 7% growth target for 2015 and only small hints of accelerating growth in Europe.

Exhibit 22


Source: ISM

Exhibit 23

Source: ISM

Trade

  • The dotted line in Exhibit 24 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years. The recent slowdown can in part be explained by a lack of basic chemical supply in 2014 in the US because of the well documented production issues for ethylene, but it is also interesting to note that China’s imports of polyethylene have stopped growing in 2014, which may be a broad negative signal for export volumes generally.
  • The US Dollar continues to outperform against almost all other global currencies. Over the last year, the Russian ruble is off 72% against the dollar and the Brazilian real is down 22%. The Euro has crumbled in recent weeks, with the USD now 16.8% stronger versus the Euro YTD 2015 vs. 1Q14 – Exhibits below.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Please see our
December 2013 piece
for the way in which we think about ethylene supply/demand and our more recent
September update
. We remain concerned that high absolute pricing for chemicals are constraining growth. Given the significant production outages in the US in 2014, we would have been in all sorts of supply and pricing troubles had there been robust real demand growth.

Note that we have made a change to our external data source in 2014 and that we are now using chemical market data from Wood Mackenzie. The supply/demand data for 2013 is very similar to that of IHS and we have not changed our historical data.

As is shown in Exhibits 27 and 28, 2014 had some uninteresting overall ethylene production and operating rates (of nameplate capacity) given the additions to capacity and the expectations that existed at the beginning of the years. Production problems were the root cause of lower production in 2014 and they continue as most operating capacity has been doing so at a very high rate. Problems were well above average in 2014 and unplanned outages are expected to continue in the beginning 2015 though their extent is difficult to predict. This has restricted availability of ethylene which, in combination with a global price collapse, has contributed to lower exports. Operating ethylene facilities are running at rates in excess of 90% and with the Williams plant apparently offline again, they will likely stay high. We expect the currently operating units to run on at their high rates as inventories continue to be restored. Some companies delayed late 2014 maintenance shutdowns because of the lack of product and now appear to be paying for that. In short, 2015 has started with some production difficulties, hence our expectation that plants will run full out until the end of Q1 and possibly into Q2. Ethylene prices have been mostly flat over the past month as oil gave up some of its gains while the Williams plant shutdown again. This marks the sixth of month of supply disruptions at that plant apart from the brief period of attempted restart. US ethylene spot prices have not moved meaningfully from $0.35/lb. We suspect that this is due to oil’s fall being offset by more problems at the Williams plant.

We have maintained a cautious outlook on ethylene supply and we again warn that more available capacity and higher operating rates starting in Q2 2015 could flood the US market, causing the export push to re-emerge and having a broad negative effect on pricing. While margins are not nearly as attractive as they were last year, the plants that can run are running all out while unplanned outages attempt to be remedied quickly.

Production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28. Note that at no point in the forecast period do we see operating rates that would suggest a tight market as in 2000 and briefly in 2005/2006.

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis
Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

The only thing certain about energy now is uncertainty. After price gains in response to capex cuts, Brent and WTI have come back down again since we last published. The expectation is that oil production in the US will decline over the next several months and quarters but all eyes appear to be on inventory levels for the time being. With the demand outlook still fuzzy, supply questions are driving the market. Even as war has curtailed production in Libya, markets continue to focus on rigs counts and inventory numbers in the US.

Natural gas prices in the US are volatile, as one would expect in winter, but generally lower than they were during a year ago. Despite a few frigid weeks in February and March, natural gas has hovered around $2.80 per MMBtu.

Exhibit 29

Source: Capital IQ and SSR Analysis

Ethane remains very weak because of favorable economics associated with cracking propane as a result of somewhat resilient coproduct values. However, recent gains in propane may offer support to ethane given its incredibly low cost basis. Margins are tight and the outlook is uncertain for both feedstocks. After propane prices rose over 20% from January to February, they have…. We see ethane eventually getting support given its incredibly low cost basis. The Conway – Mont Belview spread continues to tighten and sits at the tightest since the start of 2013, barely more than 1/10 of a cent per gallon.

Exhibit 30


Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 31

Source: Midstream Business and SSR Analysis

Propane and Butane remain the most attractive feedstocks for the time being. However, as discussed above, we believe that it is likely that propane prices will rise and thus their cash costs will rise. According to Wood Mackenzie, we are already seeing this with cash costs for propane up from $0.10/lb to over $0.20/lb. This scenario sees flexible crackers producing the highest volume possible from propane until co-product credits can no longer offset rising cash costs. Still, oil’s rise has kept the ratio of propane and butane to crude low, hence their relative attractiveness – Exhibit 32.

Exhibit 32


Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has strengthened over the last month with buyers now stepping in, perhaps nervous about paying higher prices as inputs rise. Note that the contract prices shown in Exhibit 33 are “list” against which there are significant discounts depending on customer scale. HDPE spot prices linger below 50 cents per pound as they did last month. The recent tumble in oil has not helped the pricing situation. While costs will come down, this polyethylene collapse is virtually guaranteed to be associated with margin deterioration at producers – hence our bearish stance on LYB, WLK and, to a lesser extent, DOW. Exhibit 33 uses price data from the energy database which is inconsistent with the data from IHS from a week or two ago. Prices shown are inconsistent with our comments above. How should we go about changing this chart to reflect today’s depressed prices/margins?

Exhibit 33

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 (34) summarizes the results and is a repeat of Exhibit 6.
Exhibit 34

Valuation Charts – Exhibits 35-37

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36


Source: Capital IQ and SSR Analysis

Exhibit 37

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:

  • Exhibit 38 shows each subsector’s Skepticism Index value. We found a data reference error in our model and have been understating the SI for the commodity group for some time. The sub sector SI is again at an all-time high given that the companies are still overearning despite the flattening of their margins after a strong 2014 (see Exhibit 14) and the expectation for falling earnings. Exhibit 39 shows R2 by subsector, measuring the extent to which valuation is explained by return on capital. Exhibit 40 shows that the Commodity, Specialty and Ag subsectors have some disconnects between valuation and earnings. In Exhibit 41, EMN is the standout, with valuations suggesting a fall in earnings and far more of a decline than can be explained by losses from feedstock hedging. HUN is also notable in this framework.

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

March 9, 2015 – Prices Falling, Dollar Rising – Stocks Defying Gravity

February 9, 2015 – Industrial Gases – Pricing Coming and Good for All

January 27, 2015 – US Ethylene – Who Will Blink First

January 13, 2015 – Own Goal Investing – EMN Presents Another Opportunity

January 12, 2015 – Favorites for 2015 & Industrials & Materials Methodology Review

January 5, 2015 – The Ethylene Conundrum: EMN the Value Play

December 9, 2014 – Weaker Global GDP Suggests Some Heroic Expectations/Assumptions

December 8, 2014 – LYB and DOW – A Holiday Present From Europe With Interesting Implications

December 4, 2014 – LyondellBasell and Westlake – Not Yet!

November 24, 2014 – Praxair – An Unusual GARPY Opportunity

November 11, 2014 – Eastman: A Good Story, But At Risk Of A Complexity “Own Goal”

November 6, 2014 – Capital Allocation – Why The Activists Are Where They Are

October 31, 2014 – The Power of Positive Thinking – APD and the DD read-through

October 16, 2014 – Commodity Chemicals – Overdone? Maybe Not

October 2, 2014 – DuPont Can Be a Bad Stock: If Trian is Right, But Gives Up

September 23, 2014 – Why 2015 Could Be a Short Sharp Storm for US Ethylene

September 17, 2014 – Rising Dollar and Falling Crude: Bad For Commodity Chems

September 11, 2014 – Oil: The Big Uncertainty for US Chemicals
(blog)

September 9, 2014 – Marcellus Opportunity: Why We Should See More Chemical Investment

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 42 to 46.

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

Source: Company Reports and SSR Analysis
Exhibit 44

Source: Company Reports and SSR Analysis

 

Exhibit 45

Source: Company Reports and SSR Analysis

Exhibit 46

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 47 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 47A

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 47B

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

©2015, 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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