Chemicals Monthly – Performance for the Commodity Companies Defies Costs

gcopley
Print Friendly, PDF & Email

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 18th, 2014

Chemicals Monthly Performance for the Commodity Companies Defies Costs

  • Performance within the Chemicals space has been mixed since our last monthly, with the subsectors split between under and outperformers. Ag Chem and Coatings, have been the laggards, while the Commodity group has seen the most robust gains.
  • Crude oil is up marginally but the bigger story is natural gas. Inventories have been greatly reduced as the cold continues, and prices are up accordingly – we anticipate that this will have an effect on Commodity Chemical companies in Q1.
  • Not only will higher natural gas prices likely impact margins in Q1, but we also think that the extreme US winter will cut into demand – some of which may bounce back in Q2, but some of which will be permanently lost. High inventories could limit pricing opportunities in the seasonally strongest second quarter.
  • Recent Chemicals research includes our opinion of Dow in the face of investor activism, the above cited piece on natural gas and commodity chemicals, a 2014 ranking of the companies in our index, a review of our investment thesis on DuPont, and our take on the US ethylene market for the year ahead.
  • 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. We are also less concerned about ARG given its very strong earnings momentum. AXLL is now less of a concern as well – adjustments to our model leave the stock looking much more fairly valued.

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

Most of the companies in our Chemicals index have reported Q4 2013 earnings, and on the whole revenue growth has been positive. Commodity, Coatings and Specialty Chemicals show the strongest year over year gains, while only Ag Chem companies have seen negative revenue growth – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis
Earnings announcements have brought revisions, which have been generally driving performance since the publication of our last Chemicals monthly – Exhibit 4. Underlying the strong performance of the Commodity group was the only positive revision to 2014 EPS estimates among the Chemicals subsectors – we think these upward revisions are in all likelihood overoptimistic given the recent cold-driven spike in natural gas pricing . We see meaningful risk of significant negative revisions.

Exhibit 4

Source: Capital IQ and SSR Analysis

The strongest performance outside of the Commodity group has been in Specialty Chemicals, where we have seen the “overvaluation” extend as we update our models for year-end. This implies that updated net capital numbers are lower than trend would have suggested, leading to a slight decline in “normal earnings”/”normal value” and consequently an exaggerated premium.

In general we find the whole sector expensive and would remain focused on the diversified names, particularly HUN, DD 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 and AA.

Valuation

Exhibit 5 summarizes our valuation work.

Exhibit 5

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 6

Exhibit 7 shows subsector discount from normal value in standard deviations.

Coatings and Ag Chem remain the expensive and cheap outliers, respectively, and Diversified remains inexpensive by virtue of DuPont’s relative attractiveness. Specialty chemical valuations are on the expensive side for most companies (save EMN, which is nearly at fair value on our framework) but the overall result for the group is influenced heavily by ECL, which is the most expensive stock and by far the heaviest cap weight within the subsector.

Exhibit 7

Source: Capital IQ and SSR Analysis

In Exhibit 8, reproduced and updated from our past comprehensive Chemicals report , we show company discount from normal value as measured on our framework. WLK, LYB, POL and PPG are holdovers from last month. RPM is still statistically expensive on our framework but has moderated off its all time high. We should note the short history of LYB and that POL and CYT are near (within 1-2%) but not at relative valuation peaks. PPG is highlighted as well, and is a bit less than 4% off a valuation high. No company is currently at a valuation low – as recently as November OLN was, and although it remains one standard deviation below normal on our model it has been more than 5% off its peak since that time. It is easily the most undervalued Commodity stock.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibits 9 and 10 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our December Chemicals Monthly.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13, also repeated and updated from our state of the industry report , show profitability at the sector, subsector, and stock level.

In Exhibit 12 we have highlighted those companies at or near earnings highs – no companies screen at earnings lows on these time frames. The same companies that were at earnings peaks in January maintain their record level of earnings through mid February WLK, IFF, and VAL. WLK was also highlighted in the corresponding valuation exhibit (Exhibit 6) – record valuations are at least partly justified by record earnings.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 12 and 13 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

The February selections are shown in Exhibit 14. AXLL was part of the short overlap screen last month, and for several months before, but we have adjusted some assumptions in our valuation model (primarily because we do not believe that historical numbers for Axial are a good guide for the future, given the capital and portfolio changes). The stock is now much more fairly valued in our view. ECL replaces it in the overlap screen. The long picks are unchanged from January.

Exhibit 14

Source: Capital IQ and SSR Analysis

We have back tested the methodology and show the results for 2014 year to date and 2013 cumulative in Exhibit 15. Results have been mixed this year; February results have been strong across all screens midway through the month, rebounding from a notably poor January. Note that the 2013 cumulative figures are sums of the monthly returns for each screen, exclusive of transaction costs.

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures were up yet again in the latest data through December 2013 – for the year spending rose 2.4%, following a 1.9% gain in 2012.
  • The post crisis trend has seen PCE rise at a 2.4% compound annual growth rate, compared with a 3.6% CAGR from 1999 to 2007.

Exhibit 16

Exhibit 17

Source: BEA

Construction

  • Construction spending ending 2013 on a weak note. The preliminary December estimate was essentially flat month over month, and October and November estimates were revised down – Exhibit 18.
  • The longer term trend is still encouraging, after a bit of choppiness in 2012, recovering from a near term trough in early 2011. It took several years for spending to bottom and at a 6% annual growth rate (growth was 6.4% in 2011-2012, slowing to 5.3% in 2013), we will not reach the 2006 construction peak until early 2018.

Exhibit 18

Exhibit 19

Source: US Census Bureau

Agriculture

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • The overall US PMI dropped off a cliff in the January reading, down to 51.3 from 56.5 in December – Exhibit 21. Production also suffered a severe dip, and inventories were pared – Exhibit 22. New orders were markedly weaker as well.
  • These drops could be weather related, as notably frigid conditions have gripped much of the country – also refer to Rob Campagnino’s recent work quantifying the effect of the record breaking cold spell. We would expect another weak month in February as we sit here with another blizzard outside the window.

Exhibit 21

Source: ISM

Exhibit 22

Source: ISM

Trade

  • Chemical trade volumes dropped in the December data, but remained in surplus territory for the seventh time in the past eight months. There has been a series of lower highs, however, and the dotted 12 month rolling average trend line is still choppy.
  • 2013 saw the Japanese yen devalue by 22% versus the dollar. Emerging market currencies namely the Indian Rupee and the Brazilian Real) were also notably weaker on the year, down 13% and 15%, respectively, versus the dollar. Thus far, Q1 2014 has seen the dollar weaker versus the Euro year over year by a full 3%– Exhibit 25.

Exhibit 23

Source: US Census Bureau

Exhibit 24

Source: IMF

Exhibit 25

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our December piece on US ethylene demand for our recent more detailed perspective. We remain concerned that high absolute pricing for chemicals are constraining 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.

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. Note that Wood Mackenzie expects almost no production growth in 2014 and declining operating rates.

US ethylene inventories remain very high and this is keeping downward pressure on spot ethylene prices.

Production is summarized in Exhibit 26 and operating rates are summarized in Exhibit 27.

Exhibit 26

Source: IHS and SSR Analysis

Exhibit 27

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 28

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 28

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 29.

Exhibit 29

Source: HIS, Mackenzie Wood and SSR Analysis

Propane continues on its more positive trend associated with the economics of exporting, mainly to Europe. The blending season for winter gasoline is coming to an end in a month or so and butane is showing no signs of strength despite the higher demand – the export opportunity does not really for butane as it does for propane, but if prices keep declining you might see buying interest from European ethylene producers. The propane value in the US continues to create incentive to export US propane to Europe as an ethylene feed, despite better prices in the US, 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 turning and is unlikely get much lower – Exhibit 30.

Exhibit 30

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is lower in the US, as gains achieved in September were not sustained into December and do not look like they will move at all in January. However, producers have announced increases for February and March on the back of higher natural gas prices and it remains to be seen how successful these initiatives will be. Packaging companies are pushing price increases with their customers in anticipation of higher polymer prices. It looks like polyethylene demand in the US in 2013 barely increased and while markets are not significantly oversupplied, there is no real shortage of product, despite production cutbacks in Louisiana because of ethylene shortages. 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 in Texas would rather build ethylene inventories in the near-term versus pushing polymer into the export market.

Exhibit 31

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 (32) summarizes the results and is a repeat of Exhibit 5.
Exhibit 32

Valuation Charts – Exhibits 3335

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

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 only slightly under their historical earnings trend but investors are discounting a fall in returns. The Specialty group is being afforded a high valuation premium despite earnings that are actually slightly below the long term trend. See Exhibits 36 and 37.
  • LYB is now at its all time low SI value, as investors are discounting further improvements in already strong returns.

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

February 17, 2014 – Dow: Loeb versus Liveris – Watch From A Distance

February 9, 2014 – Rising Natural Gas Prices and Rising Commodity Chemical Company Estimates: How Can This Be?

January 9, 2014 – Chemicals Companies in 2014

December 30, 2013 – DD: Still An Interesting Investment

December 16, 2013 – US Ethylene: The Case for a Better 2014

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 39 to 43.

Exhibit 39


Source: Company Reports and SSR Analysis

Exhibit 40

Source: Company Reports and SSR Analysis

Exhibit 41

Source: Company Reports and SSR Analysis

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

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 44 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 44A

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 44B

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

©2014, 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.

Print Friendly, PDF & Email