Chemicals Monthly

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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

January 15th, 2014

Chemicals Monthly

  • The Chemicals sector was been universally strong through end of 2013 but has lagged since the start of 2014. Despite this early January lag, all subsectors outperformed the S&P 500 since our last report. PPG, LYO, RPM, WLK and POL are all at 10 year valuation relative highs – no-one is at a relative low.
  • Crude oil pricing has moderated and natural gas is bouncing around the $4.00 per mm BTU range. There are plenty of natural gas inventories and increasing supply, so even with the cold snap in the North, we would be surprised to see natural gas strengthen much further. Ethane remains very cheap relative to natural gas and supply should increase in 2014
  • Some seasonal and cold weather operating disruptions have impacted basic chemical production in early January, and spot prices have moved slightly higher for ethylene as a result. However, production cutback have been short-lived and not material. Propylene spot pricing has weakened in January
  • Recent Chemicals research has included 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.

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

Chemicals stocks ended 2013 on a high note but this strong performance has not carried over into 2014 thus far. All subsectors outpaced the S&P through December 31st – this was most pronounced in Coatings and Specialty, incidentally the two most richly valued groups within Chemicals. Similarly, Ag Chem stocks were the “weakest” outperformers and valuations here remain subdued. Since January 1st, most sub-sectors have underperformed (the big outlier being Coatings which has outperformed well) and the chart in Exhibit 3 should be compared with our normal “mid-month to mid-month” chart in Exhibit 10.

Exhibit 3

Source: Capital IQ and SSR Analysis

We have seen the “overvaluation” extend in Specialty Chemicals as we update our models for year-end, suggesting 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.

One risk that we see today is that estimates are high for 2014, in part to justify either buy or hold recommendations. January/February revisions over the last four years for the Industrials/Materials universe have deteriorated – as shown in Exhibit 4. Estimates were increased following year-end guidance in 2010, increased slightly less in the same period 2011, decreased in 2012 and decreased slightly more in 2013. For chemicals the pattern was similar, but with a higher average – Exhibit 5. While we can argue for a better economy in 2014, we did in each of the prior years and yet revisions were relatively more negative. With valuations far more stretched, expectations are much higher in 2014, and companies could throw a dampener on this over the next few weeks.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

On the commodity side we are sitting on the fence a little for 2014, but still believe there is a risk that profitability declines from Q2 through the balance of the year. One of the industry commentators is more bullish than we are and another one is more in line.

Valuation

Exhibit 6 summarizes our valuation work. We have begun to incorporate 2013 data into our valuation models and this has resulted in a slight shakeup

Exhibit 6

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 7

Exhibit 8 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 8

Source: Capital IQ and SSR Analysis

In Exhibit 9, reproduced and updated from
our past comprehensive Chemicals report
, we show company discount from normal value as measured on our framework. RPM, WLK, LYB, and POL are holdovers from last month. We should note the short history of LYB and that POL is near (1%) but not at its relative valuation peak. PPG is highlighted as well, and is also just below (1%) a valuation high. No company is currently at a valuation low – as recently as November OLN was, at over one standard deviation below normal value, but a strong move up has moderated its valuation discount.

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 December Chemicals Monthly.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 12 through 14, 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. WLK was also highlighted in the corresponding valuation exhibit (Exhibit 6) – record valuations are at least partly justified by record 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.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

The October selections are shown in Exhibit 15. DD remains attractive despite its recent performance, but this is partly because it is hard to find a cheap stock anywhere in the sector today.

Exhibit 15

Source: Capital IQ and SSR Analysis

We have back tested the methodology and show the results for January thus far and 2013 cumulative in Exhibit 16. Results have been mixed midway through the month. The 2013 cumulative figures are sums of the monthly returns for each screen, exclusive of transaction costs.

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditure numbers for July through October were revised upward, and the most recent data reported the greatest month over month increase since February 2012.
  • The trend in Exhibit 17 is beginning to look parabolic. The longer term trend shows a relatively small trough in the aftermath of the crisis, and a subsequently strong recovery that leaves spending levels at all time highs.

Exhibit 17

Exhibit 18

Source: BEA

Construction

  • After a relatively flat couple of months, construction spending has returned to its strong uptrend. Figures for September and august were revised up nearly 2% each, and the November number was even stronger – Exhibit 19.
  • 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 it could take several more before construction returns to its pre-crisis level.

Exhibit 19

Exhibit 20

Source: US Census Bureau

Agriculture

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • The overall US PMI dipped slightly in December, to 57 even from 57.3 the previous month. The New Orders subcomponent was very strong; the 64.2 reading marked the highest level achieved since April 2010.
  • Production was off slightly, but remains at elevated levels, while inventore3is continue to moderate.

Exhibit 22

Source: ISM

Exhibit 23

Source: ISM

Trade

  • After staying in surplus territory for five consecutive months (and strongly so for the last two) chemical trade volumes plummeted in October before rebounding sharply in November. Volatility here remains high.
  • 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. Q4 2013 saw the dollar weaker versus the Euro year over year by a full 5%– Exhibit 26.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: IMF

Exhibit 26

Source: IMF

Commodity Fundamentals (unchanged from last month)

Supply/Demand

Please see our recent piece on US ethylene demand for our current perspective. We remain concerned that high absolute pricing for chemicals are constraining growth. Please also look for a more short-term piece on the US ethylene balance that we will publish within the next few days.

In both of the charts that follow we include IHS’ revised forecaster for the balance of 2013. IHS has made a significant positive revision to its estimate of Q3 production in the US, lifting operating rates to a healthy 92% of nameplate capacity. Interestingly they have not made a similar change to expected demand in Q3 and are instead showing an ethylene inventory build, which is repeated in their Q4 forecast. Producers suggest that operating rates are high, but neither domestic demand growth nor trade data is very supportive of the idea of a better market today. Note that while production is improving, operating rates are not.

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. According to IHS, US ethylene demand grew by 2.6% in 2012 and will be essentially flat in 2013.

Production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28.

Exhibit 27

Source: IHS and SSR Analysis

Exhibit 28

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 29

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 29

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 30.

Exhibit 30

Source: IHS 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 31.

Exhibit 31

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. Markets are not significantly oversupplied, but 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 32

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 (33) summarizes the results and is a repeat of Exhibit 6.
Exhibit 33

Valuation Charts – Exhibits 3436

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

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 right in line with historical earnings but investors are discounting a fall in returns. See Exhibits 37 and 38. The Specialty group is being afforded a high valuation premium despite earnings that are actually slightly below the long term trend.
  • No companies currently show an SI value that is at all time high or low.

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 40 to 44.

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

Exhibit 44

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 50 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 45A

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 45B

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.

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