Chemicals September – DWDP Comes in Like a Hurricane

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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

September 17th, 2017

Chemicals September – DWDP Comes in Like a Hurricane

  • Significant developments in the Chemicals space over the past month with production impacted by hurricanes and the completion of the DowDuPont merger – and the quick subsequent realignment of the projected spin companies
  • Chemicals research since our last monthly has been motivated by some of these events:
    • DowDuPont – reshuffled materials/specialty portfolios do not change our long term positive thesis and could offer upside if new composition is rewarded with higher multiples for the spin companies – stock could see $100 within 12-18 months
    • Ethylene – disruptions of and related to Hurricane Harvey should provide a pricing, demand, and capacity bridge to 2018 and the improvement in fundamentals we see for that year
    • Coatings – remain underweight given headwinds in underlying demand drivers – potential long term concerns for market disruption in distribution, architectural demand, and autonomous driving
  • DWDP has been the big winner in the Chemical space since it began trading at the start of September as its portfolio reclassification was greeted favorably
    • Most of the Chemicals subsectors have outperformed, with only Specialty more or less flat to the market
    • Outside of the DWDP led Diversified gain, Commodity and Industrial Gas stocks have been most positive – ethylene boost for LYB and WLK, manufacturing/demand pickup for APD and PX
  • As a new inclusion this month, we show a plot of return on tangible capital by company versus an enterprise value multiple of the tangible capital base – this is a valuation tool we have used in the past for our SMID work to overcome the limitations of historical data and lack of proxies
    • TSE and VSM look like valuation outliers on this metric – DWDP and EMN among large caps
  • 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 now 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 as detailed above and have removed PPG from our favorites within the subsector; our underweight on Akzo is tempered by Elliott’s continued (increased) presence; SHW continues to look stretched in our view

Exhibit 1


Exhibit 2

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

Overview & Valuation

The Hurricane Harvey fallout is beginning to come into focus, with disrupted chemical production notably dragging on US factory activity in the latest data. The immediate impact, in our view, is most pronounced for ethylene, which now has a short-term bridge to the improvement in fundamentals we expect to see in 2018. Our reasoning for this view, as detailed in research earlier this week and updated in our weekly Friday email, is summarized below in Exhibit 3. Note that while we see Harvey and Irma as largely positive for demand given increased need for building products and manufacturing in general, the immediate impact will be negative – lost production and some lost consumption and consumer spending in September and October. Earnings for Q3 and outlooks for Q4 will be more impacted by the negatives than the subsequent positives – Q4 and 2018 will likely end up being upside surprises.

Exhibit 3

Source: Company Releases, SSR Analysis

The timing of the hurricane somewhat marred and overshadowed the completion of the DowDuPont merger, which has significantly restructured the landscape of the US chemical industry. We have adjusted our subsector compositions as shown in Exhibit 4, and our usual valuation summaries for the new categorizations are shown in Exhibits 5 and 6.

The commodity group ex. DOW has a history that is limited by post-bankruptcy LYB – the subsector index dates from 2010, making the group in aggregate look less cheap than the individual components would suggest as WLK and OLN have several more years of (more richly valued) history than LYB which are driving the discount in their individual relative multiples. Exhibit 7 shows the valuation summary by stock. Diversified is dominated by the cap weight of DWDP and shades expensive only because we have not added any synergies to the company’s normal earnings figure yet.

We may look to add others to these indices over time but we are hitting a couple of constraints – one being market cap and the other limited trading history – for example, CC would probably fit fundamentally in the diversified group, but not only do we have limited trading history, but there are no obvious proxies to drive an approximate mid-cycle return on capital or trend for that return. We remain more inclusive in other valuation methodologies and will herein include a return on capital versus enterprise value plot in these monthly reports given increasing interest in companies like, VSM, ASIX, CC, TSE, CE and others – see Exhibit 8. 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. Note that VSM and TSE appear to be valuation outliers for their return on tangible capital level – the combined DWDP also screens well here.

Exhibit 4

Exhibit 5

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

In Exhibit 9 we show performance by Chemical subsector since the start of September rather than since our previous monthly as we usually do, to allow for the inclusion of DWDP, which began trading on the first of the month – the stock has been the big winner in the Chemical space during this time, driving the Diversified result as the quick turnaround on its recategorization of businesses was greeted favorably. PX and APD were also top performers, as were LYB and WLK in the Commodity group – OLN less so.

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 10 through 12 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 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. 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 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 (see Exhibit 1 for our preferences by Chemicals subsector).

Results are tracking well again in 2017, even after a difficult September to date, particularly in the overlap group which continues to produce the most robust returns – Exhibit 14.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions –Exhibit 15. These four stock remain on this list from last month. Exhibit 16 frames the historical performance results that inform this portfolio selection methodology.

Exhibit 13

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Continued, steady, month over month gains in all consumer spending categories
  • Year over year growth remains most robust in durable goods, which fell just below 6% for the first time in 10 months

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • Latest construction data through July showed the third month over month decline in the last four, despite 1%+ positive revisions to May and June figures
  • Year over year growth was still positive but below 2% for the first time since November 2011
  • Exhibit 18 shows the long-term trend in US construction spending and Exhibit 19 shows the trend over the past several years

Exhibit 19 Exhibit 20


Source: US Census Bureau

Exhibit 21

Source: US Census Bureau

Agriculture

  • The USDA continues to raise corn and soybean yield forecasts, weighing on pricing

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • The ISM was back at its highs in the August reading, and new orders remain strong – inventories saw a sharp gain however

Exhibit 23 Exhibit 24

Source: ISM

Exhibit 25

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 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Our estimate of supply disruption related to Hurricane Harvey was summarized in Exhibit 3. The temporary boost in operating rates should sustain the industry until fundamentals tighten in 2018. Production and operating rates are summarized in Exhibits 29 and 30.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

US stocks of crude continue to decline – Exhibits 31 and 32 – 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 34.

Exhibit 31 Exhibit 32

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

Exhibit 33

Source: EIA, SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Midstream Business and SSR Analysis

Exhibit 36

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 37

Source: IHS and SSR Analysis

Basic Plastics

We expect polyethylene demand to get a boost from Harvey repair – pricing is already starting to respond.

Exhibit 38

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

Exhibit 39

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41



Source: Capital IQ and SSR Analysis

Exhibit 42



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

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46 shows SI by company. SHW and ALB currently sit at skepticism extremes as estimates and capital bases are showing a dislocation as they adjust to recent acquisitions.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 47 to 51.

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

Exhibit 51

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 52 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 52A

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 52B

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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