Friday Findings – January 19th, 2018

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 19, 2018

Friday Findings – January 19th, 2018

Thought for the week: “Plastics Waste – A Long Road To A Better Place – Everyone Will Need To Compromise – Some Could Lose A Lot”

Chart of the Week

  • Chart of the Week
  • Plastics Recycling– Trouble For The Compounders!
  • PPG – 20x Earnings For A Company With 1% Earnings Growth!
  • Growing Economy Leaving GE Behind!
  • Weekly Winners & Losers

  • Chart of the Week

The chart of the week focuses on the subject du-jour – plastic waste. It shows global Google searches for the last 5 years indexed to 100 as the highest point – which is this week. While there has been an upward trend over the last 5 years, the last 5 days have shown a 33% increase to the trend prior to the last week.

The momentum has been driven by a couple of converging issues, the first being public sentiment surrounding the damage that a buildup of plastics is doing to the oceans of the world – highlighted in the BBC “Blue Planet” documentary. The coincident factor has been growing public awareness of a buildup of plastic waste in Europe and in some parts of the US as a consequence of China backing out of the recycling market and no longer taking shipments of waste plastic. China had been consuming millions of tons of waste plastic a year but the processing facilities have been closed because of pollution.

Social media is playing a large part in the groundswell of negative sentiment towards plastics and some of the most relevant recent articles are linked below. Plastic waste has been an issue for years, but it is interesting that it has gone from back burner to front burner so quickly. Searching Linked-In on Thursday we found an article or post related to plastic waste hitting the feed every 3-5 minutes!

Social media has become a very powerful tool in amplifying ideas and trends very quickly and the chemical/plastics industry needs a response to this specific issue now as their customers are quickly making statements about future use of packaging that while likely irrelevant for demand in 2018 could have significant repercussions in the years to come.

What surprise will rapidly changing public opinion bring us next?

  • Plastics Recycling – Trouble For The Compounders!

Addressing the issue of plastic waste has two components – use less or recycle more. The easy corporate or government approach is to declare or mandate lower use. But this can only go so far, as we have entire food supply chains all over the world that rely on plastic packaging to ensure food quality and safety. Moving away from these supply chains would likely result in more food waste, higher costs of food supply and higher food prices. Reduction in use is one way to limit plastic waste, but recycling has to be a much larger part of the longer-term solution.

Recycling is limited almost everywhere by the inefficiencies of separation and collection. LyondellBasell and Suez have recently acquired a business in the process of commercial completion in The Netherlands with the capacity to convert 30,000 tons of pure recycled polyethylene and polypropylene a year, that they believe can be sold as “food grade”. The limiting factor on capacity is the ability to source the pure streams – mostly from Germany, and if we assume that 20,000 tons of the output is polyethylene – the venture will have a 0.02% impact on a 100-million-ton global polyethylene market! It is a start, and LYB may get some very high prices for the product if it allows the consumer/customer to meet a stated recycle goal. We see this as an incremental positive for LYB, but no more than that unless they have some barrier to entry that allows the company to replicate the model elsewhere and grow the business.

To increase the useful nature of plastics recycling, i.e. increase the ability for recycled materials to replace new product (rather than being used to make mixed plastic road barriers or cheap outdoor furniture, or low quality, limited use packaging), requires the rest of the world (especially the US) to look at the German collection and segregation model.

It also requires more standardization of packaging and less “fooling around” with the base plastic. Additives are a significant obstacle to recycling as they cannot be removed from the material and contaminate the recycled product, making it unfit for most uses. Adding color, and materials to impact feel and aid marketing are all problems when it comes to recycling. Clear polyethylene, PET and polypropylene works well in the recycle process and social pressure is likely to persuade food and consumer products packagers to simplify in order to aid recycling.

We are a long way from this impacting base polymer markets materially, but we see three risks that will likely play out within 18-24 months:

  1. Reduction in use of unnecessary packaging – plastic bags – superfluous grocery packaging etc. This will impact polymer demand growth (especially polyethylene) but probably not significantly.
  2. More standardization – the market will gravitate towards polyethylene, polypropylene and PET – this will likely hurt polystyrene and at the margin PVC (there is little PVC in general packaging).
    1. Reduced polystyrene use will ultimately hurt TSE and CPChem and perhaps LYB and WLK because of their styrene sales.
  3. Less complexity in packaging – i.e. fewer additives – basic function (and good corporate PR) will win out over aesthetics.
    1. This is bad news for the compounders like POL and SHLM.

Public opinion pressure and mandated recycling behavior is key here as this is generally not a stand-alone profitable commercial opportunity. The world has seen a number of plastics recycling initiatives, but they have always been coincident with high oil prices and therefore a high margin umbrella to work with. As oil prices fall and the incremental cost of virgin polymer falls with it, recycling can become loss making very quickly.

  • PPG – 20x Earnings For A Company With 1% Earnings Growth!

As we have indicated in prior research, we do not think that the paint industry is necessarily a beneficiary of the better global economy, in part because of the raw material increases that PPG mentions, but also because the end markets are not growing quickly enough to prevent strong competition chipping away at pricing, especially in automotive OEM.

To clarify the title, PPG reported recurring EPS growth of 4% in 2017, but the company had a 3.5% decline in share count – recurring net income is summarized in the exhibit.

While there is an expectation for earnings growth in 2018, the absolute level of earnings has been revised down consistently, as were too bullish estimates for both 2016 and 2017.

We see the relative safety in the paint space from a volatility perspective, but we are unconvinced that 2018 will be a year where relative safety wins and expect investors to focus where there is either more economic leverage – higher incremental margins without raw material headwinds (such as Industrial Gases), or leverage to improving commodity prices as market demand improves and prices rise. Moreover, we are already overpaying for the paint space based on underlying organic earnings growth, with the expectation of further consolidation baked into valuations for PPG, SHW and AKZO. We would be short the coatings space in 2018 and long the more levered chemicals sectors – all but Ag today.

  • Growing Economy Leaving GE Behind!

The ISM new order index – chart – continues to show the underlying strength of the US economy and is accompanied by a whole host of improving trends in other countries as we enter 2018. This should be good for manufacturing companies, equipment and raw material suppliers alike, and data like this continues to propel the stock markets higher supported by corporate earnings.

As has been the case for most of the last 9 months, GE is missing out on all the good momentum and all the positive signs – the company has again this week upset the market with a huge GE capital write-down on insurance losses and the notion that Mr. Flannery might now be considering a break-up. The former piece of news begs multiple questions about the accounting at GE and why this loss was not identified or disclosed earlier and the notion that the company might be considering a break-up calls for questions on management fitness for the job, not because it is necessarily the wrong move, but because only two months ago the strong suggestion was that the core of the company was going to stick together.

Break-up has been our suggested solution for some time, but at the risk of sounding like we are talking out of both sides of our mouths there are problems with this direction also:

  • The company does not have any cash flow on a consolidated basis. Splitting or spinning out businesses would necessarily start with those that could stand alone, i.e. the Healthcare business, leaving a residual company with further restructuring costs and limited cash flow – possibly faced with another dividend cut decision.
  • It will be hard to find a value for the Power business in its current form – the business also requires write downs, lay-offs and facility closures if it is going to right size itself for the market of today and tomorrow. This is the next GE negative surprise in our view – perhaps as early as next week.
  • Equally important – THE PUCKS CONTINUE TO MOVE – while GE is reflecting inwards. GE’s competitors are gearing up for the fight – cutting costs, creating JV’s etc. and accepting that the world they had operated in has changed. By the time Mr. Flannery is ready to lift his head above the parapet, the landscape he saw when he went down will be different. There are dozens of questions that need to be addressed not least of which is around the development of LNG – from a GE perspective:
    • Will more abundant LNG impact power investment decisions around the world – how does GE win this business versus equally hungry developing market competitors?
    • What does more LNG do for the power cost curves around the world and what does that mean for the wind turbine business – if anything?
    • Does access to cheaper electricity and greater focus on the environment change developed and developing world attitudes towards rail electrifications – are the days of the diesel electric engine numbered?
  • We could go on….

Since we started the Friday Findings, only CLF has made into the weekly losers group as often as GE.

  • 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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