Chemicals Monthly – Summary – Sentiment Reacting To US Costs

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 30th 2018

Chemicals Monthly – Summary – Sentiment Reacting To US Costs

  • This report contains a summary for the month, recommendation changes etc., and the accompanying two PowerPoints focus on the large cap and SMID data respectfully.
  • Sentiment has deteriorated for the chemical sector in general over the last month, in part because of increased evidence that commodity margins have deteriorated meaningfully in US and partly because of further trade concerns.
    • Within our broad coverage universe 10 of the worst 12 performers in September were chemical companies – Exhibit 1.
    • The market remains very unhappy with TiO2 – with TROX, VNTR, CC and HUN impacted. OLN, LYB, WLK and DWDP have been impacted by US cost increases
  • PX should get a boost from the China deal approval today – this only leaves the US approval and we suspect that terms have already been reached.
    • PX remains our top US pick
  • US ethylene remains a problem. Integrated polyethylene margins weakened again because of higher ethane pricing and incrementally lower polyethylene pricing. We remain concerned about Q3 and 2H estimates for LYB and DWDP (more so for LYB).
    • None of the ethylene exposed names look expensive today – but we have never seen meaningful negative revisions because of ethylene margins without stock price erosion.
  • Outside of commodities the US, the industry is not in bad shape and some select stories are working – especially where there is M&A activity (hence our recommendation bias)
    • Our deal driven preferences include PX, FUL, DWDP (although momentum here could be negative for a while) as well as intermediates names which look likely M&A candidates.
      • TSE, CC, HUN, EMN, WLK (cyclical bottom buyer), KWR
    • Otherwise the fertilizer group has done well – perhaps too well for CF at this point.
  • SMID group did considerably better than the large cap group in September: ideas unchanged – Electronics, TSE, VNTR (now a real value stock), IPHS, KRA, KWR

Exhibit 1.

Source: Capital IQ and SSR Analysis

Details

Fundamentals have worsened in the US ethylene/polyethylene markets in September and spot ethylene margins have been below variable production costs from ethane for the whole of Q3. Polyethylene prices continue to weaken at the margin in the US, compressing US margins below historic averages – Exhibit 2. Outside the US both ethylene and polyethylene prices are holding well above cash costs but have a downward bias. While ethane prices have been more volatile than directional over the last week they remain high enough to put US ethane-based producers at the top of the global cost curve today and US exporters need the global price umbrella today as they have no cost advantage to fall back on.

The cost problems are all in the US Gulf – US producers outside the Gulf and producers in Canada are not seeing this cost squeeze. Ethylene stocks however are weakening globally, the right move if global pricing starts to weaken – especially in the face of higher crude oil, but it is creating some very low values based on current earnings expectations in the international markets – Exhibit 3

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

This month we have done significant work on return on capital cycles across Industrials and Materials and we concluded that Chemical valuations – at least on a relative basis – do not reflect current profitability – which is far from peak. The sector is not seeing the same level of profit recovery (based on return on capital) that the Industrial sectors are seeing – even though net margins are high. Sub-industries like TiO2 appear to be peaking in terms of expectations at per-pound margins that are well below prior peaks. The overall industry average is summarized in Exhibit 4 and there is more detail in the attached monthly file – the original work is liked here. As shown in Exhibit 5, the average return on capital deviation from normal has components that have a wide range today – SHW at the low end because of its significant capital increase with VAL – HUN at the high end because we have no history of an up-cycle for HUN’s current business mix.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

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