Chemicals Skepticism – A Wide Divergence – Commodities vs Coatings

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Graham Copley

203.901.1629

graham@sector-sovereign.com

May 15th, 2012

Chemicals Skepticism – A Wide Divergence – Commodities vs Coatings

  • Extending our Skepticism Analysis (SSR Skepticism Index – SSRSI) to look at the sub-industries within Chemicals, we confirm lack of investor conviction in commodities – valuations underestimate current and expected returns. History shows that this corrects through relative outperformance of more than 11% over 6 months. Earnings estimates suggest very strong 3 year net income growth for commodities.
  • The overall Chemical SSRSI is balanced by what appears to be significant confidence in coatings and to a lesser degree, specialty chemicals. The diversified chemicals group has a high SSRSI and agricultural chemicals and industrial gases are fairly valued in this analysis.
  • The coatings SSRSI is close to 20 year lows – results have been good and returns on capital are above trend (despite slow residential construction), but many valuation multiples are at extreme highs. Investors clearly believe in a continued earnings momentum story in this sector.
  • We have also looked at expected earnings growth by sector and find that growth expectations for the commodity group exceed those for most sub-sectors including coatings. As the second chart below shows; the commodity chemicals group is a significant outlier, and the difference in valuation between commodities and coatings is clearly not driven by current earnings expectations.

Exhibit 1

Source: Capital IQ, Company Reports and SSR Analysis

  • Agricultural chemicals appear very fairly valued with a slight premium in current returns on capital reflected in a slight premium to mid-cycle value. (Ag Equipments stocks are very similarly valued). Estimates are for strong growth, but growth that lags the broader chemical space. History shows that what is currently discounted in value is almost guaranteed to be wrong. This group does not discount any expectation of shortages and price escalation in the broader agriculture space.
  • In an environment where there is clearly concern about global demand, it is unlikely that we will see much outperformance from the commodity chemical group without a change in sentiment around earnings. As indicated in our earlier piece, we would expect the story to play out through the year.

Overview

If we think about the drivers of returns on capital and earnings growth within the Chemical sector, there are some interesting themes and sub-themes today. Our analysis suggests that some of the themes have more of a following than others, and that the aggregate risk is not consistent with the aggregate valuation in a number of sub-segments.

  • There is the global demand theme – with all eyes on Europe for a downside surprise and cautious eyes on China. This should be reflected in all volume sensitive subsectors – more in diversified (which it is) and specialty chemicals, (which it is not) and less so in gases and coatings (which it is not).
  • There is the strengthening global agriculture theme – not really reflected in agricultural chemicals valuations, but not reflected in Ag Equipment either.
  • There is the cheaper natural gas in the US theme – not reflected at all in commodity chemicals valuations.
  • There is the US housing recovery theme (home builder stocks are close to 52 week highs) – where everyone appears to have gorged from the “cool-aid” hose – possibly too much so given the very high valuation of the coatings sub-group. Note that this theme should also positively impact commodity and diversified chemicals.

With the exception of specialty chemicals, every sub-group in the Chemical index is earning above its historical mid-cycle return on capital. Commodities more than the rest by quite a margin, but industrial gases, diversified chemicals and agricultural chemicals are also well above norm – Exhibit 2. This above trend return on capital is to a degree reflected in valuation in all but two groups – commodities, where there is a significant valuation discount and coatings where there is a premium.

Exhibit 2

Source: Capital IQ, Company Reports and SSR Analysis

We would suggest that coatings is discounting the idea that with housing starts at a low, there is only upside on the architectural side of the equation and auto and industrial coatings are far from a demand peak. Company valuations in the coatings group discount an (understandable) expectation that return on capital can go much higher.

However, if the world is right about US natural gas supply and the likelihood that oil prices remain high, the cost tailwind behind US commodity chemicals is no less pervasive than the demand tailwind behind coatings, and in addition, commodity chemicals and plastics would get a demand boost from housing. Yet valuations suggest real skepticism about commodities and real optimism about coatings as illustrated in Exhibit 1.

Our forward performance back tests do not work as well here as they did when looking at the more broad sectors – Exhibit 3. Part of the problem is that we are using a shorter data set – so fewer historical data points. They are broadly directionally correct and they certainly show upside for the commodity chemical group at a high SSRSI.

However, they also show upside for coatings at a low SSRSI. Coatings have only had one period of extreme optimism – NOW – and it continues; i.e. the stocks continue to outperform driving the SSRSI down further. We would expect a reversion to mean from these levels but we have had no prior point in history to act as a guide. However intuitive it might feel, we do not have an empirical basis for suggesting investors go long commodity chemicals and short coatings; only the long opportunity has a basis in history.

Exhibit 3

Source: Capital IQ, Company Reports and SSR Analysis

The agricultural chemicals space is fairly valued based on current returns on capital and the sector has had a bad couple of weeks following negative guidance. Valuations are not inflated, despite the more macro view that food availability (grain availability) is a longer-term and global issue. Returns on capital here are slightly above normal, but valuation reflects that almost exactly. The issue with agricultural chemicals is that there is a great deal of historic volatility, and valuations suggest that investors are sitting on the fence – not calling the next move in either direction.

If we create an earnings estimate for each sub-sector for 2014 and compare the growth rates by group, we see less enthusiasm around Agricultural Chemicals than we do the rest of the group. – Exhibit 4. Specialty chemicals earnings growth expectations are inflated by ECL where earnings are forecast to double post the Nalco acquisition. Without that they would be lower than the expected growth for commodity chemicals. Ag Chemicals estimates are negatively impacted by the expectation that CFs earnings fall over the next three years – without CF, Ag Chemical earnings are expect to rise by around 35%. We would expect the points on the chart to the right to follow a line from upper left to lower right. They do not, and again commodity chemicals looks like the extreme outlier.

Exhibit 4

Source: Capital IQ, Company Reports and SSR Analysis

The Chemicals sub-Sector SSRSIs

The results of or Skepticism analysis for each of the chemical sub-sectors are discussed below. We have made one significant methodology change in this work relative to what was
published at a broad sector level two weeks ago
. Here we have contained the comparative analysis to the period from 1990 to present (as opposed to 1980 to present for the broader analysis). This is because we do not have adequate sample sizes for each sub industry prior to 1990 and for agricultural chemicals we start in 1992 because again the data is not meaningful prior to that point. There are two drawbacks from this change. The first is that by using smaller sample groups we increase our margins of error, and the second is that with fewer historical data points for our analysis of forward performance we do not have enough cycles (this is especially evident in coatings as discussed already).

The companies included in each index are summarized in Exhibit 5:

Exhibit 5

Source: SSR Analysis

Commodity Chemicals – Solid Earnings and Bullish Forecasts, but No-One Believes

Return on capital in the commodity group is above trend, this is partly because pricing has generally recovered well from the lows of early 2009, while capital spending has been low; operating rates have increased and margins have expanded. However, for those companies exposed to US natural gas, there has been a step change in the returns on those focused assets, and
we would argue that it is a step that is not going away for some time
. This advantage is accruing to all companies in the US with natural gas or natural gas based electricity consumption, but it is a much more relevant gain for the commodity chemical group. For some it has been an instant windfall, either where there is a direct natural gas purchase or where ethane pricing has fallen, and where there was no hedging in place. For electricity consumers and for those rolling off older natural gas hedges, there is still some further upside to come.

Exhibit 6 shows the SSRSI for commodity chemicals and the scatter plot that matches returns to valuation. The current point, which is well off the trend line, shows the above “normal” returns. Historically all of this swing in ROC has been cyclical and skepticism was appropriate. Today we have a couple of differences: the natural gas phenomenon is without a doubt cyclical – these things always are – but it could be a very long cycle (7-10 years). Separately, if we believe the coatings story; i.e. more demand to come as housing recovers – then we have further demand and margin upside for the commodity group as they are important suppliers both to the coatings industry and housing. Eastman, which we have chosen to place in the commodity group, is more of a hybrid, with a very significant coatings exposure. Valuation for EMN is an outlier in the commodity group on the upside reflecting this exposure.

Exhibit 6

Source: Capital IQ and SSR Analysis

This is a sector with very clear fundamental upside, bumping into an investment community that is an instinctive seller every time there is a negative macro data point. The instinct comes from thirty or more years of that being the right thing to do. Consequently, we do not expect this sector to outperform quickly or without further evidence of the trends we expect. Estimates in this space are never right – they are either too low by a lot or too high by a lot (not a lot of finesse in commodities). Until we get confidence that numbers are going higher we would not expect to see much gain. The analysis suggests that the downside is fairly limited, but it is not clear whether any upside move in stocks will occur in three months or 12 months.

Diversified Chemicals – Appropriate Skepticism if you are a Demand Bear

This sector is a hybrid between commodities and specialty, some exposure to volatile raw materials, but also some opportunity to pass those costs on, and lots of operating leverage. The overwhelming driver here is volume growth and incremental margins. The sector has a high degree of skepticism because of the demand concerns and the negative impact of high incremental margins as demand falls.

It is hard to make a strong case for this group, either way as incremental margins can work in both directions and while exposure to the US and housing is high, exposure to Europe is also high – greater than 25% of sales. These are companies that are making money in Europe, so a fall in demand would be bad. Note that if you are a commodity manufacturer in Europe you are not making money anyway because of high costs, so a drop off in demand or a fall in the Euro is less relevant.

The SSRSI here looks interesting, but it is hard to make a compelling fundamental case near-term that it should correct through an increase in values – there is a real risk that volumes fall short and it corrects through a decline in returns on capital – Exhibit 7

Exhibit 7

Source: Capital IQ and SSR Analysis

Specialty Chemicals – Demand and Costs Set Conflicting Expectations – A little Expensive

The Specialty Chemicals sector is the only sub-group where returns on capital are below historic norms. A contributor to this is ECL, following the Nalco acquisition, but even accounting for this, the sector has returns relative to normal that lag the other groups. This sector has a robust demand environment and generally good incremental margins, but historically it has struggled with cost inflation as it serves end markets and consumers where passing on pricing can be challenging. In a high energy environment (remember that crude oil generally sets product pricing even if US natural gas is cheap), costs eventually catch up with this group and we see a bit of this going on today.

The level of confidence in the group is high (Exhibit 8) despite the oil based cost pressure, because of high incremental margins and a robust demand environment in the US. From an investment perspective there is no strong call in this group either way; although at the margin we would probably be more negative than positive. Like diversified chemicals, there is quite significant European exposure, and if Europe is a reason to drag down diversified chemicals it should also be a drag here and it is not reflected as such. There is a possible “long diversified; short specialty” trade here, but we would like the spread to be wider before we felt it was compelling.

Exhibit 8

Source: Capital IQ and SSR Analysis

Industrial Gases – Not Expensive on this Framework, but some Divergence

The SSRSI for industrial gases is surprising – Exhibit 9. We would have expected it to be more negative as this is has been the darling sub-sector of Chemicals for many years. The reality is that there is some divergence within the group.

While the group looks expensive based on our mid-cycle valuation framework, it does not look expensive when taken in the context of current returns on capital. This is a much less cyclical business than the rest of the chemicals space, but tends to get caught up in some of the more distressed or euphoric overall valuation swings. This has resulted in a volatile SSRSI, partly because the sector volatility is generally low in both returns and valuation and consequently a quick valuation swing is statistically very significant.

As current valuations appropriately discount current returns we would suggest that there is nothing really to do here. However, given the different take on the two main companies, it is worth noting that there is more Skepticism around APD than PX. While there may be good reasons for this, and while we are not going to comment on the merits of one company versus another, to close the SSRSI gap between the two, you would need to see around a 20% relative price move today.

Exhibit 9

Source: Capital IQ and SSR Analysis

Agricultural Chemicals – Forward Growth Estimates Too Conservative?

As the SSRSI charts for Ag Chemicals show – Exhibit 10 — this group is very fairly valued, in that the slight positive deviation in returns on capital from mid-cycle are effectively discounted in the valuation premium above normal. What is clear from the chart on the left in exhibit 10 is the extreme volatility in the group, from both a return on capital and a valuation perspective. The earnings fortunes of the group swing wildly, but valuation tends to swing wildly with them.

Exhibit 10

Source: Capital IQ and SSR Analysis

Current valuation does not adequately reflect forward earnings estimates as these can for the most part be achieved without excessive capital spending. However, the key question with this group is whether we really have much of a clue about the future. This is an industry that is potentially at a point of inflection and we have had a couple of false starts, where we thought we had run out of product (grain or fertilizer or seed, or land), but it was only short lived. Demand for fertilizer, crop protection chemicals and a modified seed is growing quite quickly, mostly because food demand is growing quite quickly, particularly outside the developed markets. We would argue that, while expected earnings growth for this group over the next three years is about 35% (excluding CF), it could be 100% and it could be 10% or zero.

As an aside, if you look at the two main US Ag Equipment suppliers, Deere and AGCO, consensus estimates have total earnings growth of around 35% from 2011 to 2014. On the surface, this is not inconsistent with what we are seeing for Ag Chemicals.

As we mentioned in the bullet points: If you are a strong believer in near or medium term wheat or corn shortages and price inflation this group does not discount that view.

Coatings – Off To the Races

The SSRSI for the coatings group is bouncing around an all time high and the trend has been compelling for the last 14 years. Not only has the industry seen major increases in returns on capital over the last decade, but the investment community’s confidence in the sector has increased relative to the returns. While most would have expected a major problem post the US housing melt-down it has not happened, and when you look at sales for the group it is easy to understand why there is such a positive mood. In Exhibit 11 we show sales for Sherwin Williams against US housing starts.

Exhibit 11

Source: US Census, Capital IQ and SSR Analysis

The SSRSI charts below in Exhibit 12 show the extreme to which the coatings group has moved and as we indicated in the summary, this is the most significant outlier on the less Skeptical (more optimism) side of the chart. As the recent decline in skepticism is the first time we have seen these negative extremes for the group we do not have any sort of reversion to mean history and

consequently the 6 month forward performance of the group in this range is still positive – i.e. this is the first time we have been here and enthusiasm for the sector continues to grow. (Recent volatility was an ROC move, not a valuation move, cause mostly by PPG’s write downs at the end of 2011).

Exhibit 12

Source: Capital IQ and SSR Analysis

Earnings growth expectations for the group are lower than they are for commodity chemicals, and for a couple of other sectors, so while valuations are discounting a bright future, the future is not expected to be as bright as it is for others that look much more interesting from a valuation perspective.

One of the clear positives of this group is that it can grow earnings without having to commit significant additional capital. There is a consensus view that this sector has seen a more permanent improvement in returns and that the businesses have become less capital intense. The return on capital trends at SHW and VAL, and to a lesser extent RPM, support this, but while there has been some improvement to the PPG trend it is far less conclusive.

©2012, 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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