Friday Findings – February 23rd, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
February 23, 2018
- Chart of the Week
- Material Opportunity – HUN, 1COV, TSE and Others
- Best and Worst of Q4 2017 – Focus On Metals, Packaging and Chemicals
- Weekly Winners & Losers
This week Covestro confirmed what we have been suggesting for some time – that 2018 is showing tightness in materials markets and that companies are getting pricing. This is reflected in the very positive revisions that the material companies are seeing for 2018 earnings and the chart shows the aggregate for Huntsman, Covestro, BASF and Trinseo. For the most part these companies are in businesses with high operating leverage and consequently any combination of pricing and volume can accelerate earnings quickly. If the economy continues on its current track it is likely that the trend in the chart will continue.
The company missing from the chart is DWDP, in part because we do not have consistent estimate data – estimates only began in September 2017 – but mostly, as shown in the comparative chart below, because estimates have not moved. All of the things that are good for HUN, 1COV and the others are also good for DWDP and the lack of movement in estimates is, in our view, a function of a couple of things:
- Confusing and overly conservative guidance on the Q4 call
- The complexity of modeling the company today, with the possibility that analysts are trying to ignore the next 18 months and wait until the splits before pulling together comprehensive models
While all of these stocks look interesting to us, the real upside in our view is in DWDP as the revisions are yet to come – either revisions or meaningful earnings surprises – and the stock is inexpensive.
- Material Opportunity – HUN, 1COV, TSE and Others
Those who read our chemicals monthly this week might have noticed HUN screening as one of the most expensive companies in the group on our “normal” framework. So, how come it is one of our favorite picks? The answer comes down to “what is normal” and a group of companies that are seeing a renaissance in product groups that have not been in the limelight for decades. At no point since HUN became a public company have the materials segments had product shortages or real pricing power – that is until now. Underinvestment in polyurethanes, epoxies, styrenics and polycarbonates for many years has allowed demand growth (albeit slow) to catch up with supply. Now there is pricing and now companies have operating rates at which they are seeing margin leverage. HUN is expensive based on a long history of poor returns in underperforming businesses – it is not expensive if we were to put reinvestment margins into our models. TSE exists because styrenics and polycarbonates were so poor for so long that Dow wanted to get rid of the business. Covestro exists for similar reasons.
As shown earlier – estimates are rising quickly for this group.
If we were to put a 12% return on capital in our HUN model as normal, the right current value for the stock would be $45-50 per share. We do not have much history for TSE and even less for 1COV, but both trade at very low multiples of EBITDA and if we put a $45 price on HUN and back the same level of valuation into TSE and 1COV based on the same EV/EBITDA value (10x), we get $132 per share for TSE and $204 per share for 1COV. While we have not included BASF in this valuation analysis below – the company remains equally leveraged in many of its businesses and also looks inexpensive. It is not hard to argue for 20-25% upside in the stock from here.
Below we show the top and bottom three stocks in each I&M sector ranked by year over year earnings growth (2017 vs. 2016). Note that these results are un-adjusted for M&A moves – thus the large negative figures for ASH, FLS, and SEE, which have all sold sizable portions of their legacy business over the past year. In this context, GE is a standout as easily the worst non-E&C earnings performer in 2017.
Most topically, the poor SHLM result speaks to our concerns about whether LYB understands what it is acquiring. Elsewhere in Chemicals, the tightening commodity narrative (referenced above) is highlighted by results for OLN, Covestro and CC.
CAT and DE are also exhibiting strong operating leverage, as are certain of the downtrodden Metals & Mining names (CLF and FCX most notably, albeit off admittedly low bases).
In the plot below we show these earnings standouts (positive and negative) with an EV/EBITDA overlay. Despite the earnings momentum, Covestro and CC continue to see relatively reasonable multiples. The large absolute earnings growth at OLN is countered by the negative earnings surprises that indicate the company was perhaps overly optimistic about its acquired assets from DOW, and this stock would be one of our few concerns in the commodity chemical group.
Anything in the bottom right quadrant of the chart below is worthy of a look for 2018, with our only concerns around the things that we cannot model – one of which is why OLN is doing as poorly as it is with respect to expectations, while proxies for the individual businesses are all doing well. The other concern we have is with respect to Chemours as the liability risk is unquantifiable. Chemours’ businesses are in great shape, but the drag on valuation is driven by the litigation and likely settlement uncertainty. The more money Chemours makes the deeper the pockets appear to the class action lawyers and the plaintiffs.
In summary, the better ideas are still grouped in Chemicals, Metals, and Paper and Packaging. The highly priced Industrial/Conglomerate names looks safe and stable, but too expensive in our view.
©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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. Sources: Capital IQ, Bloomberg, Government Publications.