Chemicals Revisions – Not Positive Enough and Not Supportive of Values for Many

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 15th, 2014

Chemicals Revisions – Not Positive Enough and Not Supportive of Values for Many

  • Short-term revisions for the Chemical group have turned less negative, but only 2 out of 30 companies raised guidance in their quarterly reports – only one, APD, lowered guidance. This contrasts with Capital Goods, where for the large cap names the mood has become more positive, though 2014 estimates were originally more conservative in our view.
  • Positive chemicals revisions year to date have been focused in the sub-sector with the greatest historic volatility – commodities, and specifically US Shale exposed companies. If this is your only story we think this is largely played out at this point – with the exception of DOW which could accelerate earnings growth through cost initiatives and divestments.
  • We continue to get mixed signals from the group on China, and any sort of slowdown would be a material risk for several stories we like; DD, DOW, EMN and PPG. Like Capital Goods, there is a consensus in this sector that Europe has turned and is improving – commodity margins are weak, but product groups with operating leverage should do better.
  • There is still significant valuation disparity within the group, with the good momentum stories of the last two years very expensive in our view, particularly in the light of more negative revisions. Most of the expensive names are pricing in positive surprises and consensus estimates are not moving up to support this view.
  • We remain most concerned about RPM, SHW, CYT, IFF and LYB. WLK is also expensive, but much less so on yield and an MLP construct. We think that there are further MLP opportunities in the group and would expect others to look at possibilities – WLK has the most to gain from such a move in our view.
  • We like DD, DOW, MON, HUN, EMN and PX, particularly relative to APD. Overall, we do not find this sector particularly exciting and would rather be overweight Capital Goods and increasingly Metals.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Following up on our recent work on
large cap Capital Goods
and on
DuPont
, we take a look at the broad US Chemical sector with a focus on revisions and valuation dispersion. Taking the broad chemical sector we do not get the same degree of change in earnings revisions that we saw for large cap Capital goods, but we do get a directional improvement and a better measure than we have seen in a year. If we do a direct comparison and simply look at the large cap chemical group, we get a better picture on revisions, though all of this is coming from LYB and DOW – Exhibit 2. However, the picture is still not as positive as for Capital Goods and the dispersion story is not as extreme.

Exhibit 2

Source: Capital IQ, Company Reports and SSR Analysis

In Exhibit 3 we show a summary of Q1 2014 earnings for the broader group. There was much more weather impact in this group than for Capital Goods, given the natural gas price effect more than anything else, but also because of the slower pace of commerce and manufacturing in Q1. There is broad consensus that Europe is improving, as we have seen elsewhere, but only the paint companies point to improvements in the US, and while most US companies will suggest that they can “smell” a US recovery – very few seem to be “tasting” much of it yet.

Like Capital Goods we see mixed messages in China. We repeat the China comments here that we made in the Capital Goods piece.

  • The debt to GDP ratio is a concern to many – as China’s most obvious tool to bring this under control is to actively manage towards slower growth.
  • The demographic changes in China as well as the development of more advanced manufacturing industries are beginning to change some of the demand patterns, both for locally manufactured goods and for imports.
    • Both Dow and DuPont have pointed to growth, in some cases strong growth, in the more value added products they produce – advanced materials, more sophisticated packaging products etc. They point to stronger middle class demand for better consumer durables and better food packaging (changing behavior in food purchase), paint, etc.
    • There is a concern that the demand for more run of the mill products is slowing and import demand is rapidly being replaced by domestic production.
    • The different demand views from different companies are likely a function of where their products lie in the value chain.
    • We have written recently about the risk of higher China exports in a slower domestic growth environment.

Exhibit 3

Source: Capital IQ, Company Earnings Reports

China should remain a concern and something we watch very closely – Asia exposure (including China) for the companies which provide a breakdown is summarized in Exhibit 4. There is much more broad exposure than there is for Capital Goods. China would be one of the largest risks to our positive stances on DD, DOW, EMN and PPG. Note that one of our more significant concerns around APD is its more recent significant investments in China, and APD specifically noted a slight deceleration in China in its calendar Q1 (fiscal Q2) results.

From an end market perspective we still do not like the basic petrochemicals and polymers business. We see high absolute pricing constraining demand and encouraging supply where feedstock advantage exists. Slow global growth and rapid global expansion bodes very poorly for operating rates and profitability for companies structurally disadvantaged from a feedstock perspective. As long as the spread between global crude oil prices and stranded surplus natural gas geographies, such as the Middle East and North America, remains at current extremes (or even close to current extremes), producers in those regions will continue to make outsized returns and will be incented to build. This group continues to see positive revisions, but remains very levered to swings in oil relative to natural gas in the US and for LYB and WLK we see more downside risk to earnings than upside today and consequently think that the easy money has been made.

While we like the paint market, given both the strength in the US new home and resale markets, we also think that this is largely priced into both SHW and PPG at this point and more than priced into RPM.

Exhibit 4

Source: Capital IQ, Company Reports, SSR Estimates

We like the engineering and advanced plastic industries for the same reason that we like Aluminum – more consumption in the Auto and Aero industries and higher demand growth rates. High global energy pricing is a headwind as it results in high pricing relative to Aluminum and to a lesser degree steel.

We like Agriculture, given our view that farmers will continue to pay for yield, and will do so in a wide range of grain pricing scenarios. This space is more interesting from a valuation perspective in our view – particularly in the seed and chemical areas. We remain concerned that potash pricing may still have some downside, so our positive view on the sub sector does not extend to MOS.

Revisions – Improving – But Only in Terms of Becoming Less Negative

Revisions have not yet turned positive for this group, and as shown in Exhibit 5 more companies have seen negative revisions to 2014 expectation than positive year to date. However, in aggregate the trend has improved over the last couple of months, relative to recent history and relative to the broader Industrials and Materials sector – Exhibit 6. For the large cap names the picture is a little better, as also shown in Exhibit 6, with DOW and LYB pulling up the average.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Valuations – Some More Interesting than Others – Some Extreme Relationships

In Exhibit 7 we show current valuation and skepticism values for the 30 chemical companies. The data shows quite a range and a lack of correlation and unlike the large cap Capital Goods space has some real disconnects between valuation and skepticism. Momentum has clearly worked and the companies that have done well in 2012 and 2013 are very highly valued and for the most part have high degrees if skepticism – suggesting that valuation will only be supported going forward by positive revisions. We would exclude WLK from that group as the MLP move will materially alter our view of “normal value”, but RPM, SMG and IFF look like accidents waiting to happen without meaningful earnings surprises. To a lesser extent the same can also be said for SHW, LYB, PPG and DOW, but we think that Dow will manage the positive revisions through cost cuts and PPG through acquisition related synergies and operating leverage.

At the other end of the scale we have MON, AXLL, MOS, OLN, PX and DD – see
our DD piece
from earlier this week. Exhibit 8 shows the components of the Skepticism Index for all companies and interestingly, while DD screens very well ( assuming revisions are turning more positive), HUN has the biggest disconnect and the most upside if investors get comfortable with estimates.

PX is both cheap and under-earning: PX seldom under-earns and never for very long so we remain comfortable with our more positive stance on PX.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

In Exhibits 9 through 14 we show some of the current extreme valuation relationships within the group. The most noteworthy chart is DOW, which is close to an extreme high value relative to the group. What this chart suggests is that Dow will need to keep delivering earnings momentum to encourage investors to keep taking the relative risk.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

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