Friday Findings – February 16th, 2018

gcopley
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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 16, 2018

Friday Findings – February 16th, 2018

Thought for the week: “Multiples are Falling – Creating Opportunity – But Never For Value Dilutive Acquisitions”

Chart of the Week

  • Chart of the Week
  • Some Schizophrenic Analysis Of Commodity Chemicals
  • Semi Demand
  • Chemicals Earnings
  • LYB – Off Track and Inconsistent with Other Moves – Suggests Strategy is Drifting
  • Weekly Winners & Losers

  • Chart of the Week

The chart of the week shows how multiples have shrunk over the last few weeks, not so much because of the broader market correction but because of estimate increases. The consequence is that many stocks look much more interesting than they did at the beginning of the year. The earnings acceleration was possibly priced in to a degree in many companies, but at the extreme we have seen multiples of earnings come down by as much as 5x in only a few weeks. The estimate revisions for 2018 are a function of revised company guidance as we have worked our way through Q4 earnings. The guidance is generally up on expected lower taxes, but also because of the stronger economy we have been discussing for the better part of a year and the leverage that it brings. We have been fairly critical of the slow evolution of estimates and revisions over the last 10 to 15 years, where sell side analysts now essentially wait for corporate guidance before they make any moves. Only now are 2018 estimates reflecting the tax changes and some of the leverage gains that companies are seeing. The investment opportunity is to look for the companies that are looking inexpensive on a multiple basis but that likely have even more earnings upside – from leverage to volume growth or pricing that is not yet reflected in 2018 expectations.

DWDP remains our favorite idea in the large cap space and we do not see 2018 earnings potential remotely reflected in the current share price, and we have recently highlighted the electronic chemicals space as one with further demand growth leverage in 2018. This is important for DWDP, but the more levered names are discussed below.

Other companies that we would highlight, where valuation has been a deterrent from what is otherwise an interesting fundamental story, include: SMG (see prior commentary), VSM (see below and recent research highlighted above), PCAR, GNRC, FCX, PKG and IP.

On the other side of the table there are several companies that are off their multiple highs, but still look unattractive to us because we do not believe that earnings growth can support the multiples: MMM, GGG, IEX, DHR, ROP, AME.

  • Some Schizophrenic Analysis Of Commodity Chemicals

The sell side loves DWDP, HUN and increasingly Covestro but hates LYB – how does that make sense? For DWDP to work polyethylene needs to work and for HUN and Covestro to work – and to help DWDP – polyurethanes have to work. If they are going to work for DWDP and HUN – they are going to work for LYB also! In the table below, we show the current recommendation ranges for all of the larger commodity names – there is some consistency, but some interesting inconsistency. As we have written in prior research, you should sell stocks when everyone loves them and buy them when everyone hates them – and this is a major red flag with our DWDP and HUN preferences.

  • For DWDP we would be more concerned if we felt estimates for 2018 were accurate or aggressive – at this point, while recommendations may be positive, in our view estimates remain very low.
  • For HUN, we have not seen a positive cycle in any of HUN’s businesses since the company went public and as a consequence we think there is material earnings upside here also.

LYB is not that expensive, so the company has done something to reduce support – maybe the unpredictability of the current strategy, as seen by Thursday’s acquisition (see below), and the thought that more deals are on the table. SABIC is another story led by polyethylene, which is an either/or market – it works or it doesn’t – if it works everyone benefits; if oversupplied everyone fails.

Much as we like the DWDP story there is clearly a short DWDP/long LYB or SABIC thesis, just based on the long-term analysis of stock performance versus recommendation – summarized in the first chart below the table.

The better investments tend to be those where sentiment is improving and the stand-outs right now are BASF, Covestro and WLK. SABIC and LYB are the two languishing in the unloved category (at a cyclical recommendation low). BASF is an operating leverage play as the company operates in most economically sensitive segments and enjoys significant leverage. Covestro is moving in line with HUN on the basis that the polyurethane markets look stronger – another reason why the LYB recommendation looks inconsistent.

Our view is that all of the more commodity basic chemicals are going to have a good year – driven by demand.

We are positively inclined towards all the names on the list above, but have some questions about strategy and business quality at OLN, which have been evident from earnings misses since the Dow purchase.

  • Semi Demand

Following on from our commenrtary in a previous Friday Email and consistent with our overweight move in the SMID piece published on Monday, we see further upside in the names exposed to the semi-industry in 2018 because we believe that semi demand will continue to surprise on the upside and the material suppliers by and large have almost linear operating leverage with higher volumes. Early in 2017, semi demand was expected to be about the same as 2018 expectations are today. As seen in the second chart, demand well exceeded expectations – driven by everything from more smartphone sales to more elctronics in autos and appliances – plus Alexa, Siri, etc…

We still see upside to estimates for all of the chemcial exposed names in 2018 and see upside in CCMP, ENTG, KMG and VSM. KMG is the only stock discounting earnings revisions in our view today, but not much. VSM is the “value play” and could have some very good comps once we lap the 2017 NF3 price declines.

  • Chemicals Earnings

Q4 2017 earnings results in the Chemicals space have generally produced positive results with most companies beating beat top and bottom line estimates – summarized below in separate charts for the SMID and large cap groups. Leverage has been more noticeable in the SMID cap group, with several small revenue beats translating into significant EPS surprises, though the group had underperformed relative to the large caps over the past month as of our SMID report on Monday.

Weak results have generally been confined to cyclically struggling markets like ag (MON) and coatings – (FUL – adhesives) or idiosyncratic underperformers like OLN (see commentary above). AXTA’s result is an outlier in an otherwise lackluster reporting season for Coatings.

Looking at the large cap group, we are seeing improvement in industrial gas fundamentals as the economy continues to be generally strong. DWDP and EMN showed the operating leverage that makes them two of our favorites in the Chemicals space.

  • LYB – Off Track and Inconsistent with Other Moves – Suggests Strategy is Drifting

Investors have become increasingly concerned about the strategy at LYB and this is reflected in the depressed recommendation on the stock, as highlighted above. Rumors of deals – Braskem, Huntsman, Dow Material Science – have circulated since the company first discussed acquisitions at an analyst day last spring.

We are surprised that LYB would choose SHLM for three reasons:

  • Bulking up in more value added and (hopefully) stable businesses has never created shareholder value for primary commodity companies – LYB is paying for a business that trades at 2x multiple points of EBITDA higher than LYB. Charts below. While the company talks about EPS accretion because of synergies, it has created value destruction with SHLM earnings now trading at a lower multiple.
    • The right follow-on strategy would be to fully integrate the compounding businesses and then spin them off as a much larger much more profitable company that could get a SHLM or POL multiple.
  • SHLM has something of a checkered past, with some huge earnings misses and plenty of volatility as a consequence – shown in the relative multiple chart below and also in the third chart. Note that since 2012 SHLM has had some much more significant negative surprises than LYB.
  • The packaging piece of SHLM’s business could be at risk from a more aggressive global push to reduce packaging waste and increase recycling. Compounding packaging polymers to add properties or color or feel makes the polymer much harder to recycle – the additives are the problem.
    • Given LYB’s recent step into recycling (the timing of which looks very fortuitous) – buying a business with 25% of its revenues in harder to recycle packaging polymers looks like a tack to the left at a time when the company appeared to be ahead of public opinion and tacking to the right.

This move by LYB does cause us to question the strategy overall, and perhaps the recommendation sentiment is appropriate. While we like the commodity group because of pricing and volume leverage, and while LYB is the most levered way to play polyethylene, we maintain our preference for WLK and DWDP. LYB will work if polyethylene rallies.

  • Weekly Winners & Losers

©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.

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