Friday Findings – February 2nd, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
February 2, 2018
Thought for the week: “The Strong Economy Should Help Drive Enough Pricing To More Than Offset Any Costs Associated With Higher Crude Prices and Commodity Price Increases Driven By Shortages – DWDP Overly Cautious”
- Chart of the Week – Natural Gas Advantage Racing Back
- DowDuPont – Very Upbeat and Yet Disappointing At The Same Time – Concerns Over Cost Headwinds Likely Overblown
- SMG – Weeding Out The Opportunity
- Electronic Chemicals – A Sure Thing This Quarter?
- Weekly Winners & Losers
The chart shows the (fuel equivalent) ratio between Brent crude and US natural gas. It is a proxy for US competitiveness from a chemical feedstock and incremental electricity perspective. The rest of the world does not have the abundance of natural gas, and while we have seen international LNG prices drop from a Brent based pricing formula in periods of LNG surplus, it looks like LNG will be tight in 2018, and pricing will likely reflect the Brent crude oil marker of the past – new US LNG terminals do not come on line until very late 2018 and 2019, and demand in China and Southeast Asia has risen to absorb additional capacity from Russia and Australia.
While the US winter has been cold and inventories have been declining at a fast pace – chart – they have not been falling as quickly as historic “weather” models would have suggested because production is so high – second chart, which shows that the 12-month rolling production average has picked back up again. The market price for natural gas is already discounting what might happen to inventories if weather normalizes for the rest of the season. The US is running existing LNG facilities flat out, and with the Cove Point start-up imminent (press release on the 31st), but delayed a little further, the market has visibility around LNG demand for the rest of the year.
LNG spot prices are high because demand is high, in part because of a move to cleaner fuels in China, but also because economic growth is high. This is also driving crude oil in our view as much as production controls. The US surpassed 10 million barrels per day of oil production this week, for the first time since 1970, yet pricing remains robust, creating a widening value gap between what most petrochemicals producers and industrial companies outside the North America pay for feedstocks and power versus those within the US. The higher price of crude is encouraging US shale investment to produce more crude, but all meaningful US shale oil fields produce copious amounts of associated natural gas and NGLs. Consequently, additional oil investment, such as that suggested by Exxon this week, will add to natural gas supply.
While we are seeing some chemical companies disappoint, or give more cautious guidance because their raw material prices are rising – driven by global pricing and the crude oil pressure – chemical price increase announcements are widespread, and given global demand strength they should push through. Based on similar periods of history this environment makes us more bullish on chemicals rather than less. Furthermore, any price increase won by a US based producer comes at a time when US costs look like they might be falling.
LYB had an extremely strong quarter in the US, despite higher natural gas prices, but saw declines in Europe in part because of higher crude oil prices. LYB’s results bode very well for WLK, which remains our preferred way to play the commodity chemicals market – LYB and DWDP remain on our favorites list.
- DowDuPont – Very Upbeat and Yet Disappointing At The Same Time – Concerns Over Cost Headwinds Likely Overblown
To have such an upbeat view of the world and the business and then to disappoint so much on guidance, DowDuPont management have had an interesting week. To be upfront, our well above consensus earnings estimate for DWDP for 2018 is based on an annual model rather than a quarterly one and we can understand why estimates for Q1 2018 are likely a bit too optimistic and in need of a reset. The conservative guidance for the rest of the year, in the context of how well the company beat Q4 2017 expectations, is likely a function of three separate factors:
- Raw material headwinds (especially outside the US)– everyone is seeing them and they are prompting price increase announcements across the board from commodity to specialty chemical producers globally. The recent reversal in US natural gas is very recent, and would not be factored into DWDP’s thinking this week. Note that LYB results show a steep decline in European basic chemicals earnings in part because of higher feedstock costs. LYB is not showing the same caution for 2018 as DWDP.
- We would counter this caution and turn it around – the global economy is at the right point in its cycle to get price increases through and the raw material headwinds are an opportunity to raise prices. It is far easier to get a price rise out of customers when they are looking for more product than when they are looking for less.
- This headwind could become a substantial tailwind if prices increase and then US natural remains low and/or crude oil eases – especially if the demand environment remains strong.
- Years of over-promising and under-delivering at both DOW and DD is not lost on this management team and they will want to guide to something they can meet or beat in Q1 and for the balance of the year, in our view influenced by some of the concerns rather than opportunities that we raise in point 1.
- Ag – clearly worse than expected and taking another leg down in 2018 because of limited demand and increased competition. This is quite a negative sign for Ag as over the last several years, legacy DOW’s Ag business has fared better than legacy DD and MON in industry downturns. Given that a large piece of legacy DD’s crop protection portfolio has been divested, for DWDP to be this negative suggests a very poor environment – and possible concerns for FMC.
- If the companies were separated today we would have two businesses that investors would want to own and would command good multiples, and one that would likely be discounting more trouble – like the rest of the Ag sector.
With respect to our higher earnings expectation than consensus, items 1 and 2 above do not worry us that much – DWDP has commodity pricing leverage and operating leverage across the specialty and materials platforms. Ag is different, as the market is cyclically weak because of over production of food, and better food handling (packaging, which benefits DWDP). $5.00 per share is likely a stretch target for DWDP in 2018 if Ag remains a drag, but we would expect the momentum in the other businesses to continue and bring earnings surprises with them – chart. If Ag was a separately traded company today it would be cyclically cheap and we would probably be recommending it as a consequence! Right now, it is likely a drag on the overall multiple. DWDP will probably still make around $20bn of EBITDA in 2018 and on that basis, is trading at an enterprise value of roughly 10x EBITDA. The specialty business is likely worth 14-15x in the current market, the materials business likely 10x. Oddly the Ag business is probably also worth 14-15x based on trough EBITDA. This gets us to a target price in the $90-100 per share range. It all comes down to execution at this point – to deliver the synergies and the spin-off companies without adding costs. The trends look good before the synergies have kicked in materially.
DWDP beat Q4 2017 estimates by 23% on an “apples to apples” basis – if the same were to hold through 2018, the company would make roughly $5.00 per share.
Note: EMN produced very strong Q4 results and guided above consensus for 2018. EMN has been pushing price increases aggressively – reacting to higher costs, but also taking advantage of strong demand. DWDP should have the same opportunity and see the same benefits – adding to the synergy and volume opportunities. While we have not written recently on EMN, it has been on our preferred list for the last year, in part because of valuation, but also because of operating leverage.
While note yet a screaming buy, we think that the reaction in SMG this week has been an over-reaction and likely presents a buying opportunity – waiting for the stock to get even more attractive may work but we see a risk reward profile already biased to the upside.
“According to a recent survey from John Deere, Millennial homeowners covet nice lawns more than their elders. Specifically, they beat older generations by a margin of 44% to 37% in aspiring to have a lawn that’s the envy of the neighborhood — above even having a nice TV.” While this may sound like good news, we would probably temper the excitement with the caveat that the average Millennial likely wants less grass in total than prior generations! Regardless, the core business at SMG is not going away, and at current prices we are again looking at the cannabis market as upside.
Colorado tax revenues would suggest that the market is still growing at 20% after 4 years – with more (and larger) states having recently passed or proposed legislation to legalize. The market has not been the “moon shot” that some investors had been hoping for but it is still likely to grow faster than anything else in the SMG garden.
The stock is now well below a market multiple – chart:
Even with the recent reduced quarterly numbers SMG’s return on capital is not far from an improving trend. Our models suggest that normal value for SMG is $105 per share (16% upside) – higher if the hydroponics business can see accelerating growth in 2018.
History suggests that we should expect ENTG, KMG and VSM to show strong upside surprises over the next few weeks. The correlation is not great – it never is in this business – but there is information in the results of the chip makers that should not be ignored – chart.
Valuation would suggest that the most upside is in those less exposed, like Wacker and BASF, or DWDP if you buy into the story above. Note that DWDP reported improved results in its Electronics business and provided positive guidance (absent some portfolio changes). Of the smaller cap US names, valuations look hard to distinguish, but we would probably focus on VSM at the margin as we think 2018 estimates remain very conservative.
VSM and ENTG report on February 6th.
KMG reports on March 11th.
©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.