Chemicals Monthly – Outperformance Despite Negative Revisions

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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

May 15th, 2013

Chemicals MonthlyOutperformance Despite Negative Revisions

  • As we progressed through Q1 earnings, it was clear that the broad based more conservative outlook was in fact an upside surprise. Despite broad negative revisions during the month, it is clear that investors were expecting something worse, as every sector has outperformed the broader market since mid-April.
  • The gas/oil difference is stable, and extreme, but off its Q1 highs; natural gas is off its April highs and crude oil is relatively flat. While the correlation is poor, there is an inverse relationship between the performance of the commodity sub-sector and the movement in natural gas prices.
  • High stock prices remain at odds with the general more muted expectations for demand growth this year. We remain concerned about price weakness eating into margins. That concern is greatest in sectors where valuation discounts rising returns on capital – coatings and specialty chemicals.
  • Our valuation screens highlight OLN and ROC as attractive both on valuation and on skepticism. We would continue to highlight APD, which is attractive on our normal value screen – an unusual situation for an Industrial Gas company.
  • This month we update our view on DD, suggesting that some of the upside we discussed in January has occurred, but that there is further to go.

 

Exhibit 1

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

Overview

It remains a sentiment and revisions driven market in aggregate, and the market is paying very little attention to value, buying stocks with positive news and believable stories, regardless of other valuation metrics and selling anything with increased uncertainty. If we look at performance in April we clearly saw a slight panic going into earnings – “maybe guidance was going to be very negative and maybe estimates for Q1 had been too ambitious”. While we saw some broad negative revisions since reporting ended, we have seen positive revisions in commodities and clearly in other sectors the revisions were not as negative as feared. The big laggard year to date has been the industrial gas business, lagging the S&P by almost 10%, but it has also experienced the greatest negative revisions.

  • Valuations remain for the most part high and meetings that we have with institutional clients confirm that many feel the same way, but struggle to find better value alternatives in the materials or broader industrials sector.
  • Some of the economic indicators globally have been more negative than expected and the more specialty sectors have high operating leverage and so require volume growth to hit estimates – as mentioned already estimates are falling broadly.
  • Natural gas prices are stable and the current relationship with crude oil generates very high margins for US producers – albeit off a peak in Q1 2012. NGL markets remain very weak and supply is increasing almost daily, with no obvious ability for demand to increase meaningfully in 2013.
  • Weaker demand domestically and internationally has driven pricing incrementally lower for ethylene and more so for propylene, as well as for derivatives.
    • We have highlighted this latter risk to this group in recent work; stagnant economic growth can mean declining chemical volumes and increased price competition.
  • Every chemical subsector except commodities saw its 2013 EPS estimate revised downward again over the month, although the revisions were most pronounced in the specialty, diversified, and industrial gas groups.

Valuation

Exhibit 2 summarizes our valuation work. The extreme in valuations for the coatings group is something we have written about at length – and we can partly explain the premium to normal with the current very high level of earnings, but the sector continues to discount rising returns on capital from already very high levels.

The commodity group shows the investor dilemma, as the economics in the US remain extraordinary and should result in very high earnings and cash flows – as expected, we saw some records in Q1. The negative is the global economic picture, as this is a subsector that never does well in a weakening economy as more subdued demand almost always results in price pressure and lower margins – prices have fallen again in May. Today that is definitely the case in Europe and Asia, where pricing is bouncing along close to the break-even cost of production for many. Those companies with larger portfolios outside the US are clearly suffering as a consequence and this is offsetting the US advantage.

Exhibit 2

Exhibit 3

Source: Capital IQ and SSR Analysis

The group composition is summarized below.

Exhibit 4

Exhibits 5 and 6 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our April Chemicals Monthly . It was a solid month for the group as none of the subsectors trailed the market, and several saw substantial outperformance. The already expensive Coatings group saw the most robust gains, while Commodity Chemicals posted impressive outperformance as well.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Monthly Topic: Year to Date Performance

Last week we published a piece on the performance of the broader industrials group year to date and what if any screens had been effective. For the broader group we concluded that valuation had been largely irrelevant over the last 4 months and that revisions and, more importantly, good stories had been the primary driver. Reworking this analysis for the chemical subgroups we get the same lack of correlation with valuation and less of a positive correlation with revisions. So it must all be story and momentum driven.

The next 4 Exhibits suggest the conclusions/comments, which follow:

  • Revisions did not really work, given that only the gases sector shows both the direction and magnitude required to make it work in the first two exhibits – the correlation chart shows a slight positive incline, but it is clear that chemicals reduced the correlation shown in the earlier report.
  • Commodity chemicals were relatively cheap at the beginning of the year and have reacted well to expectations that this year will remain strong from a margin perspective. We would caution that the real weakness in 2012 was not evident until the end of Q2.
  • Ex DuPont, the diversified group has underperformed this year. The group was expensive (again ex DD) at the beginning of the year.
  • The most interesting story surrounds the “stories”; coatings and increasingly specialty chemicals. Despite negative revisions, the specialty chemicals sector has done well, and coatings has recovered from a negative swing early in the year and continues to outperform.
  • These are the two sectors that are most “over their skis” in our skepticism analysis, in that they are the only sectors where valuations anticipate further expansion of return on capital (see Exhibits 33 and 34 later in the report). Note also that current return on capital for both groups is well above normal and well above the cost of capital.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

At the end of the industry report we published a table showing the 20 stocks that had performed best in 2013, the possible drivers of that performance, and whether the stocks still looked attractively valued today. Only three chemical stocks appeared on the list of best performers; AXLL, SHW and ROC, but only ROC is also still attractively valued in our view. However, DD would have been the next on the list if we had extended our screen to 21 stocks, and we see DD as attractively valued today also.

Portfolio Performance

The full May selections are shown in Exhibit 11. It has been our contention for some time that our sectors are not cheap, and the normalized value work supports that. In a rising S&P world, we would expect Industrials and Materials to underperform.

Exhibit 11

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April 2012; we show the results for the current year in Exhibit 12. Results have been generally strong thus far in 2013. At publication in April our portfolios were mixed but finished the month on a high note on all three metrics. Thus far in May they have produced slightly negative returns on a cap weighted basis.

Exhibit 12

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures kept trending higher in the most recent data through March 2013 and are up over 2% year over year. January figures were revised up marginally, and February figures were down similarly.
  • Government spending cuts and an increase in the payroll tax have yet to have any effect on spending through the first quarter of 2013.

Exhibit 13

Exhibit 14

Source: BEA

Construction

  • Construction spending has hit a rough patch in recent months after being a boon to the economy for some time. Spending was down in March and figures for January and February were revised down by 2%.
  • A reconsideration of optimism in this area led E&C stocks to a 15% decline in April. Spending is still well off of pre-crisis highs (Exhibit 16) but the trend over the past few months has been decidedly negative after plateauing at the end of 2012.

Exhibit 15

Exhibit 16

Source: US Census Bureau

Agriculture

  • Ag prices saw less extreme changes than a month ago but were generally lower with the exception of soybeans, up 1.4% since our last report. The anticipation of record grain crops has driven the recent price weakness in corn and wheat.

Exhibit 17

Source: Capital IQ, SSR Analysis

ISM

  • The PMI reading for April came in barely above the neutral 50 level. The readings have been bouncing around the delineation of expansion and contraction for more than a year, reflecting the business uncertainty responsive to the larger economic questions at play.
  • Inventories dropped for the second consecutive month while production edged up slightly in April.

Exhibit 18

Contraction

Expansion

Source: ISM

Exhibit 19

Source: ISM

Trade

  • Chemical trade volumes surged again in March after a big spike in February and are near a multiyear high.
  • The dashed line in Exhibit 20 is a rolling 12 month average that cuts through the monthly volatility. The effects of the much discussed US natural gas advantage may finally be beginning to play out.
  • The Euro retraced some of early year gains it had made on the dollar but the currency story of note has been the devaluation of the yen – Exhibit 21. The Japanese currency is up nearly 25% year on year and crossed over the 100 yen/$ mark in early May.
  • Q1 2013 saw the dollar weaker versus the Euro by 0.7% year over year – Exhibit 22.

Exhibit 20

Source: US Census Bureau

Exhibit 21

Source: IMF

Exhibit 22

Source: IMF

Commodity Fundamentals

Supply/Demand

Ethylene production estimates for the first quarter and the second quarter were revised down recently by industry experts IHS, in what is now a common pattern. Forward estimates are a function of a more normalized world, driven by a more normalized growth rate. As we discussed in research last month , demand is disappointing consistently as we think that it is as much a function of high prices as it is a weaker economy. Accordingly, we see a pattern of negative revisions to near-term demand projections broadly (not just from IHS) and an increase in demand estimates three or four quarters out – probably driven by that all important forecasting technique of “it has to get better at some point”. In both of the charts that follow, the recent uptick is more a function of eliminating a very weak Q1 2012 in a 4 quarter rolling average than it is an improving market. Part of the production story should be new capacity from DOW and WLK, but these are small increments relative to the total – Exhibit 23. Given the better consumer spending numbers and the better housing numbers in the US we do see some support for the better production levels and without this spending increase we would be concerned that the extra production is going into inventory. Trade data suggests that US production should be getting a boost from demand offshore, but it still appears to be insufficient to drive very high operating rates.

Operating rates are summarized in Exhibit 24.

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, at this time. 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 20 – 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 trend is only barely positive.

Exhibit 23

Source: IHS and SSR Analysis

Exhibit 24

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 25

Prices for both Brent and WTI have fallen off recently, Brent much more so than WTI, but averages for May are marginally above averages for April at this point in the month. Natural gas has retreated from its April high as inventories have surprised a little on the upside in recent weeks.

Exhibit 25

Source: Capital IQ

NGL pricing remains very weak as the increased availability is keeping the market oversupplied. 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 and have fallen slightly again in May, and have now been negative for 7 months in a row – 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.

Exhibit 26

Source: IHS and SSR Analysis

One thing that we continue to see is the price of NGLs fall relative to crude on a rolling average basis and while they were up incrementally in April, they are essentially unchanged in May. The longer-term trend remains negative – Exhibit 27.

Exhibit 27

Source: IHS and SSR Analysis

Basic Plastics

HDPE pricing has declined slightly in the US in May as expected and there remains downward pressure because of lackluster demand. PVC export prices remain weak because of weak demand, but domestic demand is robust. International polyethylene pricing remains weak (and weaker than US pricing), but above break-even for most local producers. Unless we see some sort of pick up in global demand we would expect the price and margin lines in Exhibit 28 to start moving down more quickly than they have in May.

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 Chemical and Coatings continue to have valuations that discount an increase in return on capital from current levels but with the underperformance of the last four weeks that expectation has decreased further for Ag and Coatings– though only slightly. The Commodity and Diversified subgroups both have values that anticipate a fall in returns on capital, while valuation and ROC seem to be fairly aligned for the Industrials Gas companies – Exhibit 33
  • 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 discussed in previous research, 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 of 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

May 13, 2013 – DuPont: Betting the Farm – Bur Perhaps a Need to Crop the Portfolio?

April 10, 2013 – US Energy Advantage – Unintended Consequence; Global Overbuilding of Petrochemicals

March 6, 2013 – R&D in Industrials and Basics: Just Not Effective

March 5, 2013 – Low Cost US: The Shift is Underway, SLOWLY Reversing a 40 Year Trend (Blog)

February 12, 2013 – US Basic Chemicals Economics: It Can’t Get Much Better Than This

January 25, 2013 – DuPont: The Uncomplicated Story and The What If?

January 10, 2013 – A Lesson In Expectations: Is There A Bubble In My Paint?

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

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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