Chemicals October: Strong Momentum In Many Sectors Likely to Show in Earnings – Except Coatings

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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

October 17th, 2017

Chemicals October: Strong Momentum In Many Sectors Likely to Show in Earnings –

Except Coatings

  • Hurricane impacts to Chemical production are becoming clearer but the full extent is likely to be revealed only after earnings reports in the next several weeks
    • However, is likely that we will see a significant number of positive results and positive guidance on a hurricane adjusted basis – demand remains robust and pricing is generally positive.
    • Concerns would be in fertilizers where near term pricing strength in Urea may be short lived.
  • Another month of universal outperformance at the Chemical subsector level – Coatings most positive despite the worst recent revisions profile – we see significant risk here
    • Through Q3 commodity stocks have been the big winners (TiO2, WLK, HUN, OLN) along with electronic chemicals suppliers (VSM, KMG, CCMP), and select Coatings (SHW)
    • Ag has continued to lag (UAN, MOS, SMG among five worst performers) and certain Coatings/ Industrial Gas companies (RPM, AXTA, APD) reflecting weak underlying fundamentals also
  • Since our last monthly, our Chemicals work has focused on:
    • Ethylene – reaffirming our positive call on the ethylene cycle, with greatest upside seen in WLK and LYB
    • Revisions – as part of our broader work on operating leverage and momentum in Industrials & Materials, we analyzed the cross section of value and rising estimates in the Chemicals space – WLK, VSM, BASF, and Covestro notable positive outliers
    • Hunstman/Clariant – we still do not see much upside to this merger but recognize that the companies may be lacking viable strategic alternatives
  • Our preferences in the Chemical sector are summarized in Exhibit 1
    • We are positive on most of the large cap names in the space – DWDP, LYB, PX – but have concerns in most subsectors
    • At the subsector level, we are overweight the Diversified group given the large weight of DWDP, in addition to our continued overweight positions in Commodities and Industrial Gas
      • In part because of valuations, in part because of improving fundamentals or mergers – for commodities we are assuming that oil stays around $50
      • Order of preference within Industrial gas is PX/LIN over Air Liquide
    • We remain underweight on Coatings; our Akzo concern is tempered by Elliott’s continued (increased) presence; SHW continues to look stretched in our view, approaching $400/share after another big gain over the past month
      • We would be underweighting the coatings group, US and Europe and underweight Ag, at least through the end of the year – otherwise the broad picture is quite positive

Exhibit 1


Exhibit 2

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

Overview

We have written recently about an ostensibly improving global macroeconomic picture and this appeared to be confirmed by the positive revisions to the IMF’s global GDP forecasts – Exhibit 3. Our only real concern with respect to the Chemicals group is in Coatings, automotive in particular. The generally improved outlook, along with Hurricane related chemical production losses, should tighten markets and result in an inventory driven demand pull, leading to better pricing – see our recent work on operating leverage and momentum in the Chemicals space.

Exhibit 3

Source: IMF

In a similar vein, comparing the stock performance through Q3 shown in Exhibit 4 with the valuation plot in Exhibit 5, the real outlier is DWDP. While many of the stocks that have worked in 2017 no longer screen attractive. DWDP has fared better than the S&P year to date (using historical DOW pricing) and we see considerable upside to earnings and the stock price.

In Exhibit 4 the divergence between CF and UAN is interesting – suggesting that the urea market might get bad enough for UAN to fail, or have to dilute shareholders, but not bad enough to threaten CF, which benefits from extreme leverage in any recovery – we think that urea has another weak winter ahead.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5 plots return on tangible capital versus enterprise value. This is a valuation plot we have used in the past for our SMID work to overcome the limitations of historical data and lack of proxies. It also highlights how cheap TSE remains, despite the performance last year and this year. Skepticism with respect to the styrenics markets is holding TSE back, but if some of our growth theories are right, TSE’s products should remain in reasonably tight supply – albeit with the volatility associated with the sector. At current values TSE could be a very accretive takeout for anyone wanting to consolidate in basic chemicals.

Exhibit 5

Source: Capital IQ and SSR Analysis

In Exhibit 6 we detail our Chemical subsector composition, and our usual valuation summary is shown in Exhibit 7.

Exhibit 6

Exhibit 7

Valuation

Exhibit 8 summarizes discount from normal value at the sector level, and Exhibit 9 shows a stock level view. Coatings remains the valuation concern – the premium for the Diversified group is not inclusive of the DWDP synergy upside. Only Ag screens cheap at the sector level but we are cautious on the fundamentals in this space – CF the possible exception.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 10 we show performance by Chemical subsector over the past month – universal outperformance led by Coatings (SHW +12.6% the biggest driver but PPG also up 6.5%)

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

 

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level. SHW’s returns are inflated as the capital base does not yet accurately reflect the acquired VAL assets.

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. The new subsector classification demonstrates the recent strength in the combined DWDP and also highlights a flat to declining trend in commodity chemicals net income margins over the past several years.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 14 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 (see Exhibit 1 for our preferences by Chemicals subsector).

Results are tracking well again in 2017, particularly in the overlap group which continues to produce the most robust returns – Exhibit 15.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions –Exhibit 16. The only change in the composition of this group over the past month is CF replacing EMN, which fell off due to negative revisions. Exhibit 17 frames the historical performance results that inform this portfolio selection methodology.

Exhibit 14

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Latest consumer spending data showed a slight sequential decline for the first time since January but year over year growth remained in the 2.5% range seen for much of the year
  • Services (65% of consumer spend) were slightly up but the decline in goods spending more than offset this in the overall results

Exhibit 18 Exhibit 19
Source: BEA

Construction

  • Construction spending picked up again in the latest data through August
  • The recent trend is uninspiring but year over year growth has remained positive
  • Exhibit 20 shows the long-term trend in US construction spending and Exhibit 21 shows the trend over the past several years

Exhibit 20 Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: US Census Bureau

Agriculture

  • Year over year ag pricing is little change – soybeans, corn and wheat all within 3% of last year’s prices as of mid-October

Exhibit 23

Source: Capital IQ, SSR Analysis

ISM

  • The ISM’s manufacturing PMI breached 60 for the first time since June 2004 – Exhibit 24
  • Production remained healthy and inventories were drawn down – Exhibit 25
  • New orders remain robust – Exhibit 26

Exhibit 24 Exhibit 25


Source: ISM

Exhibit 26

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
  • As all of the new capacity scheduled for this year in the US comes on line in basic chemicals and plastics we would expect a significant upward trend in the data from here, and the 12 month rolling average (dotted green line) is trending higher quickly

Exhibit 27

Source: US Census Bureau

Exhibit 28

Source: Capital IQ, SSR Analysis

Exhibit 29

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Wood Mackenzie is reporting US ethylene production was down 33% in September – LYB and CPChem most affected – demand was less impacted but also down.

Production and operating rates are summarized in Exhibits 30 and 31.

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 31

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

US stocks of crude continue to decline – Exhibits 32 and 33 – and gas in storage is right around the five year average. Harvey related production and supply disruptions are manifesting in short term price gains for crude and gas – Exhibit 35.

Exhibit 32 Exhibit 33


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

Exhibit 34

Source: EIA, SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36


Source: Midstream Business and SSR Analysis

Exhibit 37


Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 38


Source: IHS and SSR Analysis

Basic Plastics

Low availability of alpha olefins related to Hurricane Harvey impairments is weighing on domestic polyethylene production, and boosting prices.

Exhibit 39

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 (40) summarizes the results and is a repeat of Exhibit 7.

Exhibit 40

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42


Source: Capital IQ and SSR Analysis

Exhibit 43

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 44 summarizes Skepticism Index values by subsector, Exhibit 45 shows the extent to which valuation is historically explained by returns, and Exhibit 46 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46

Source: Capital IQ and SSR Analysis

Exhibit 47 shows SI by company. SHW and ALB currently sit at the skepticism extremes as estimates and capital bases are showing a dislocation as they adjust to recent acquisitions.

Exhibit 47

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

October 9, 2017 – Chemicals Revisions: Some Cheap Stocks With Earnings Momentum

October 3, 2017 – Feedstock Price Increases: Ethylene’s Friend!

September 26, 2017 – What A Real Ethylene Cycle Looks Like: More Upside for LYB and WLK

September 20, 2017 – HUN/Clariant: The Art of the Possible vs. The Ideal

September 13, 2017 – DowDuPont: A Fast and Large Capitulation, but No Change to the Investment Thesis

September 11, 2017 – The Hurricane Boost: Enough to Bridge the Ethylene Gap! Moving to Overweight

September 5, 2017 – DowDuPont: The Moves the Activists are Suggesting May Be Exactly the Wrong Thing to Do at Exactly the Wrong Time

August 21, 2017 – Coatings: Heading for Bad Patch – Hard to Identify Winners

August 10, 2017 – Air Liquide: Good or Great Will Depend on Approach to Costs

August 8, 2017 – Air Products: Needs to Find a Very Big Rabbit in a Very Small Hat

August 7, 2017 – Linde/Praxair: The Size of the Prize is Substantial

July 27, 2017 – VSM: A Beat and Raise Coming Up!

July 25, 2017 – Akzo: Everybody Loses When Management Does Not Have a Clue

July 24, 2017 – Lyondell: A Poor Capital Allocation Decision

July 17, 2017 – Ethylene: A Tough 12 Months to Model – Likely Very Volatile

July 5, 2017 – PX/Linde: Hard to Quantify but Possibly the Largest Opportunity – CAPEX

July 5, 2017 – Clariant: We Are Not Alone in Questioning This Complex Deal

June 30, 2017 – FUL and SHLM: Potential Divergent Optimism Paths

June 27, 2017 – Nitrogen Fertilizers: A Game of Thrones Winter!

June 20, 2017 – Eastman: Misplace Rally on the Blackstone-Celanese News

June 13, 2017 – Akzo: Time for a New Game! Problem or Opportunity for PPG?

June 7, 2017 – LYB, WLK: A Risk to the Upside – Albeit Remote – Qatar

June 5, 2017 – Akzo/PPG: Maybe the DEVIL is in the Details – Did PPG Dodge a Bullet?

June 2, 2017 – PX/LIN: Buy Both – Now We Have the Deal Terms Out of the Way

June 1, 2017 – PPG/Akzo: Probably the Right Move for PPG but Disappointing – Unanswered Questions for Akzo

Appendix 1 – Exhibit 2 Analysis

In Exhibit 2 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 48 to 52.

Exhibit 48

Source: Company Reports and SSR Analysis

Exhibit 49

Source: Company Reports and SSR Analysis

Exhibit 50

Source: Company Reports and SSR Analysis

Exhibit 51

Source: Company Reports and SSR Analysis

Exhibit 52

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 53 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 53A

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 53B

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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