Friday Findings – January 12th, 2018

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 12, 2018

Friday Findings – January 12th, 2018

Thought for the week: “Oil’s strength is a symptom of an economy that is heating up”

Chart of the Week – The Risk of “Now” Based Investing – Do We Go Again?

  • Chart of the Week – The Risk of “Now” Based Investing – Do We Go Again?
  • Is BCPC Too Good To Be True?
  • Is 2018 Going to be Another Disappointing Year for the Farmer and for Ag in General? – Initial Data Says Yes
  • Weekly Winners & Losers

  • Chart of the Week – The Risk of “Now” Based Investing – Do We Go Again?

The chart shows the difference between the price of oil in the year shown with the price of oil 5 years later – yes oil prices were $50 per barrel higher in 2012 than in 2017! We chose 5 years to show the extreme variability in oil pricing – except for period from 1986 to 1997 – but also because that is roughly how long it takes from conception to product flow in any large new energy or chemical investment. The chart shows that the environment in which you start-up is highly unlikely to resemble the one in which you made the investment decision. Oil is an extreme, but we could chart natural gas, industrial production and GDP growth and get volatile pictures with major differences between the environment at the point decisions are made and when projects come to fruition.

This factor faces all companies looking to invest in major energy or chemical projects anywhere in the world and it is natural human behavior to be overly influenced by your current conditions. “We cannot invest now because the business stinks – and it might always stink”. “We must invest now because margins are great and they should stay that way”. The peak oil prices of 2011 through 2014 drove a wave of investment decisions around chemicals and LNG in the US. Interestingly, some of these investments have seen delays that now have start-ups in 2018 and 2019, at a time when oil prices are rising again and some of the margin protection that the US investments were supposed to have is returning.

The second chart shows the Oil/US Natural Gas ratio and the recovery of the last few months is evident.

  • Oil is not yet high enough to provide the margin umbrella that US ethylene producers need to spark a further wave of investment, particularly given that it would be appropriate to question whether the US has enough annual NGL production to support a major new wave.
  • However, it does improve the margin umbrella for current production and anyone expecting polyethylene pricing to weaken in 2018 is likely to be disappointed as long as oil stays at current levels.
    • While many ethylene producers around the world have improved their economics by finding ways to consume US surplus NGLs the marginal ton of polyethylene is still made by someone in Europe or Asia with an oil based feedstock.
    • Many of the Asian and European producers were very profitable during 2017 but this was because product demand was high and markets were balanced – this will likely be a worst case for 2018 – with product shortages likely to put upward pressure on many products.

With the highest percentage of ethylene made from ethane feed, WLK is the most levered to the widening oil/natural gas ratio, but both LYB and DWDP also benefit. We continue to like all three names. Both WLK and LYB have seen recent positive revisions for 2018 (WLK more so than LYB), but DWDP has seen no revisions recently, which is inconsistent. We maintain our view that estimates for DWDP are too low (by as much as 25% for 2018) and it remains one of our best ideas for 2018.

  • Is BCPC Too Good To Be True?

BCPC (Balchem) has figured prominently in a couple of pieces of research we have written recently: it has been the definition of a “Good Company” in the work we published in November, surpassing everyone in the number of years of EBITDA growth and the number of years of out-performance over the last 20. Separately, in our first Chemicals SMID piece this week we highlighted the company as one we would be cautious on because of the very high valuation relative to expected growth – chart.

The multiple is a result of the history and the consistent growth, but:

  • Revisions have most recently been negative for 2017 and 2018 (with the caveat that only 4 firms cover the company)
  • The growth story has been driven by acquisitions which were well integrated, but as the company grows it is hard to find large enough deals to keep moving the needle
    • Plus, nothing is cheap right now as the improving global economy has floated most boats
  • The end markets, while relatively safe and high quality, don’t offer the juice that those with more commodity exposure and economic growth leverage do
  • Plus – no company can grow forever!!
  • The shareholder base has been very stable, but it is hard to see how to get outperformance for 2018 unless the estimates are far too low, which was not the case in 2017.
  • Is 2018 Going to be Another Disappointing Year for the Farmer and for Ag in General? – Initial Data Says Yes

The 100 day moving average of both corn and soy prices in the US has turned down in recent months, more pronounced for corn than for soy – chart. But the average has turned down from what were already low numbers. This does not bode well for farm economies in 2018, following a poor year in 2017. It also does not bode well for Ag suppliers, especially those supplying elective rather than essential products.

Conventional wisdom would suggest caution on the equipment makers as those most at risk, but the last equipment cycle was several years ago and farmers are likely to have no choice but to increase spending. Despite its significant run in 2017, in part supported by significant estimate increases, DE is not expensive if we assume that the company can return to historic levels of profitability – chart. However, in our view the farm economy is likely to be too weak to drive further surprises, or further upside for DE in 2018, and the stock will likely only work from here with the promise of increased infrastructure/construction spending in the US. This is in part behind the enthusiasm for CAT and the high price, but CAT may benefit from increased mining spending – because of some of the commodity shortages that we discuss at the beginning of this report

Valuations for all of the major Ag related players are summarized in the last chart. Nitrogen has its own cycle and is a product that farmers need every year. Pricing is higher than we had expected at this time and we still see the risk of some oversupply in 2018, but we think the set-up for 2019 is good and this could drive the stocks higher in 2019. CF has the most leverage and while the stock looks expensive on current earnings it remains attractive based on more normalized urea pricing. We remain cautious on the Potash names, despite consolidation and valuation – the market structure here is still unstable and in a weak farm year, potash sales could disappoint.

Note that we have not included any of the Ag Chemical stocks in the chart – there is so much portfolio change in play right now that we do not believe that any stock valuation fully reflects the likely fortunes of the underlying business today

  • FMC looks expensive, but we have yet to see pro-forma data from the DWDP transaction and Lithium is a distortion.
  • The Bayer/MON deal is not yet closed – MON looks expensive because of the premium in the deal price.
  • DWDP is in the midst of reorganization – cost cutting and spin company capital structure determination so it is impossible to take a view in the stand-alone business at this time.
  • Syngenta is moments from de-listing.
  • There is nothing that can act as a proxy in the SMID space as most of the names are fertilizer producers.

  • 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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