Chemicals Monthly – Trumped Up Performance Potentially Temporary

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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

November 17th, 2016

Chemicals Monthly – Trumped Up Performance Potentially Temporary

  • Results of the US presidential election have boosted the Chemicals space, though the largely anticipatory stock moves require further analysis and likely present opportunities on both the long and short side (see research out today)
    • Infrastructure seems a logical first move, and related stocks are some of the best performers post-Election Day
      • Building Products (WLK), Construction Chemicals (FUL), and their precursors (OLN)
    • Trade issue is more convoluted
      • CF the best performing Chemical stock since Election Day – the US remains a net importer of urea
  • Q3 earnings recap:
    • Generally positive commentary/outlook from the fertilizer companies
    • Continued execution from DOW/DD on costs, rare revenue growth in a tough macro
    • Signs of weakness in the Coatings market – see below
  • Since our last monthly report, Chemicals research has focused on:
    • The Paint market – heavy discounting leading into Q3 earnings followed by a run of negative guidance and lackluster earnings reports – SHW most expensive and potential for forced divestments presents some VAL-related downside
    • Fertilizers – firming prices, generally lower inventories, robust planting intentions, limited supply additions moving forward all point to attractive risk/reward in this space
    • Ethylene – some Trump trade risk exists, but conditions are in place for a tighter than expected market in 2017 – LYB most interesting on valuation – WLK challenged as a net buyer post-AXLL – DOW our favored play but only because of the DuPont deal
  • Our preferences in the sector are summarized in Exhibit 1
    • We are positive on most of the large cap names in the space (DOW, DD, LYB,MON) but have concerns in most subsectors, and at the subsector level would only be overweight Ag Chemicals – in part because of valuations, in part because of improving fundamentals
    • As we wade through Trump possibilities this table may evolve quickly

Exhibit 1

 

Exhibit 2

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

Overview

The best performing Chemical stocks in the aftermath of the Trump election reflect optimism about various tenets of the President-Elect’s campaign platform – CF, POL, OLN, HUN and MOS are likely beneficiaries from trade barriers; makers of construction products (WLK, FUL) or their precursors (OLN) stand to gain from an infrastructure stimulus. In our view the trade angle is somewhat dubious – the infrastructure initiative is more likely to gain widespread support and see more immediate traction.

Exhibit 3

Source: Capital IQ and SSR Analysis

The earnings summary in Exhibit 4 highlights several of the themes we have explored in 2016. Continued execution on the cost front from DOW and DD has been complemented by impressive revenue growth in a still sluggish global demand environment.

Elsewhere in the space, fertilizer results were generally better than expected – POT stands out in the exhibit below, MOS blew out its EPS estimate by a wider margin than the exhibit is scaled for, and CF posted an unexpected profit, albeit on weaker than expected revenues.

CC’s bottom line beat is a red herring for the TiO2 market in our view, and we remain negative here as the premise of pricing power rests on continued demand from what appears to be a weakening paint market. AXTA appears to be enjoying focused share gains and continued cost opportunities, as expected.

Exhibit 4

Source: Capital IQ and SSR Analysis

Valuation

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6. Revisions from Q3 guidance came in mainly to the downside – OLN notably so in the Commodity group. Mixed revisions in the Ag space – CF down 30%, MOS up 24%. Specialty showed strength with EMN, NEU and CBT all seeing positive revisions of 3%+ related to guidance.

Exhibit 5

Exhibit 6

In Exhibit 7 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 8 we show discount by company. The Ag space continues to show the best value – influenced to an extent by the large weighting for MON, but also reflective of significant upside potential for fertilizer producers CF and MOS. The Coatings group has long screened as the most expensive in the Chemicals space but the magnitude of the premium has been coming down – the group was within a standard deviation of normal value when SHW touched $240 earlier this month.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – the Trump rally pushed most stocks off their lows, leaving only CF within 5% of a 10 year extreme. SHW has some deal-related downside if there are significant forced divestments associated with closing the VAL deal.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 shows absolute and relative performance by subsector since our last monthly report. Ag Chemical stocks had mixed reactions to earnings but rallied strongly post-Trump. At the other end of the spectrum, earnings related weakness in IFF and ECL offset a big move from EMN post-earnings.

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. ALB’s return on capital is still suppressed by the increase in its capital base from the Rockwood acquisition – returns on tangible capital are higher. ASH reflects the spinoff of its Valvoline business. SHW and IFF are the only two companies currently at 10 year earnings extremes. APD had been a constant on the right side of Exhibit 10, but incorporating fiscal 2016 capital data, returns are now much closer to trend.

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. We are seeing a possible sign of stabilization in Ag margins, while Commodity margins continue to roll over near historical peak levels – this could continue through Q4, with potential for a rebound in 2017. Coatings margins are a concern –plateauing as input costs rise and heavy discounting at the retail level suggests elevated inventories.

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 – OLN, for example, screens as cheap but we see good reason for this and have long been concerned about the stock (see Exhibit 1 for our preferences by Chemicals subsector).

2106 results have been generally positive (particularly in the overlap group) and more in line with what was seen in 2013 and 2014 – Exhibit 14. Cheap commodity stocks AXLL, OLN, and HUN were mainstays on the long screens in 2015 and this was a yearlong headwind for the selections – 2016 has been a different story as commodity stocks have mostly enjoyed a bounce. This has continued post-election with CF, MOS, OLN, HUN, and POL all up over 10% in November to date. Combined with a capitulation in IFF, November is shaping up to be a very strong month for these portfolios.

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. This month EMN and MOS are the only two stocks to appear on this screen – Exhibit 15.

Exhibit 13

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • US personal consumption expenditures rebounded (latest data through September) after a slight dip in the prior month
  • Continued strength in durable goods in particular, +5.7% year over year, +1.8% month over month
  • With spending data now through Q3, US personal consumption expenditures year to date in 2016 have grown 2.6% on the back of a 3.4% equivalent gain in the prior year

Exhibit 16 Exhibit 17

Source: BEA

Construction

  • Significant positive revisions to July (+0.8%) and August (+1.1%) estimated construction spending – these figures now show slight year on year growth
  • The latest data point (September) was down sequentially, however, and now marks the first year over year decline in construction spend since July 2011
  • Year to date growth in construction spend remains strong at ~4.5% against a strong 10.5% figure in 2016, but the trend has slowed significantly in both residential and non-residential end markets over the past few months
  • Exhibit 18 shows the long term trend in US construction spending and Exhibit 19 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period

Exhibit 18 Exhibit 19

Source: US Census Bureau

Exhibit 20 Exhibit 21

Source: US Census Bureau

Agriculture

  • Soybean pricing has been virtually flat since the end of September, while corn and wheat have shown 3% gains over this time
  • Despite recent weakness, soybean pricing has held some of its early gains for a year to date change of +11% compared to an 11% decline in wheat pricing and a 3% decline in corn pricing

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • The overal US PMI ticked higher for the second consecutive month following the abrupt drop in August
  • The New Orders reading was down versus a month ago but remained above the 50 mark indicating expansion

Exhibit 23 Exhibit 24

Source: ISM

Trade

  • 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 has been trending higher over the past several months, countering an extended downward move in the 12 month rolling average

Exhibit 25

Source: US Census Bureau

Exhibit 26

Source: Capital IQ, SSR Analysis

Exhibit 27

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

US ethylene production for September was the lowest monthly output since early 2015 as unplanned outages from August bled into planned September downtime. Demand has flattened versus the 5% gains over the past year – consumption in Q3 and Q4 is estimated to be down 1% year over year (limited by ethylene availability for the most part), though 2017 will likely see a resumption of the strong demand trends, without which the US ethylene market will weaken very quickly given the expanded capacity base.

Production and operating rates are summarized in Exhibits 28 and 29.

Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Crude stockpiles have been moving off their highs from earlier in the year despite a recent tick higher – pricing continues to hover in the mid $40s. Natural gas pricing is back below $3.00, with record levels in storage and a steadily rising rig count – inventories are high in absolute terms but given the increase in domestic consumption and the volumes contracted to LNG exports, inventories are not as high on a demand adjusted basis.

Ethane has seen large price gains recently, to the highest levels in several years, tracking natural gas but also aided by the increased demand coming from exports and expected quick demand growth as US ethylene capacity restarts. Given the more significant move in ethane relative to crude oil, the US is losing some of its competitive edge in ethylene.

Exhibit 30 Exhibit 31

Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Exhibit 32

Source: EIA, SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Midstream Business and SSR Analysis

Exhibit 35

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 36

Source: IHS and SSR Analysis

Basic Plastics

Capacity continues to start up, to the north and the south – Nova completed construction of its facility in Alberta and production should start to ramp up by year end, while Braskem/Idsea has brought on both HDPE and LDPE facilities. North American export growth of polyethylene is expected to be 10% in 2017 as prices are cut to offload the domestic surpluses. It will only be possible to maintain US integrated polyethylene profitability under these circumstances if global demand growth is robust enough to absorb all of these increases, which we believe is possible – see recent research.

Exhibit 37

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

Exhibit 38

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40



Source: Capital IQ and SSR Analysis

Exhibit 41



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

Notable this month is the move for Industrial Gas – with fiscal 2016 data available for APD, returns on capital are now much closer to trend. Combined with PX’s sub-trend ROC, the group as a whole is under-earning by more than its modest premium would imply.

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45 shows SI by company. No stocks currently show a skepticism extreme.

Exhibit 45

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

September 29, 2016 – Akzo: Underachieving – Need the PPG Path to Higher Valuation

September 23, 2016 – Trading Ethylene? Tread Carefully

September 14, 2016 – Change at Linde Suggests an Acquisition is Possible

September 6, 2016 – M&A in Chemicals: More to Come and Other Sectors to Follow

September 6, 2016 – The Olin Illusion

August 30, 2016 – AXTA: Not Cheap but 18 Months of Momentum

August 18, 2016 – MON: How Patient Are the Shareholders, Especially the New Ones

August 17, 2016 – PX/Linde: Are Desperation and Boredom Bigger Drivers Than Anything Else

August 16, 2016 – A. Schulman: A Personal Problem or A Leading Indicator

August 15, 2016 – Coatings: Developed Markets Peaking – China and M&A Can Keep Select Momentum

August 8, 2016 – CF: Analysis Suggests Dividend Can Be Sustained – Attractive Long Term Buy

August 1, 2016 – Eastman: A Bus Business, a Bad Strategy, or a Bargain?

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 46 to 50.

Exhibit 46



Source: Company Reports and SSR Analysis

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

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 51 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 51A

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 51B

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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