Friday Findings – January 26th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
January 26, 2018
- Chart of the Week
- GE – How Did The Golden Rule Get Broken
- PX – Adding Operating Leverage To What Is Already the Best Story
- APD – A Mix of Good and Bad Strategies – Concerned that “Bad” Wins
- What is SABIC Thinking? Covestro The Better Bet In Europe
- Weekly Winners & Losers
The chart shows the winners and losers in what has been a spectacular start for the market in 2018, with the S&P 500 up 6.2% already this year. The tax plan, the stronger economy and general confidence is lifting most ships but not all. Despite the better markets and the money pouring in to equities, some things are not working and in the chart we show the ten best performing stocks and the ten worst – year-to date.
- GE is perhaps a story on its own, but it does suffer from being in a few markets that are not really participating in the global industrial rally, such as power generation, where investment has slowed but also moved, away from large scale generators to renewables and smaller “top-up” generators. The increased use of large scale batteries has also made existing power infrastructure more efficient. Others in this space are also feeling the pain. Rail is also a problem for GE as demand for new equipment has slowed generally and this concern may also be impacting TRN.
- Lithium is another story that is not working – for now – as the premiums paid for lithium levered stocks in the first half of 2017 are shrinking as new capacity is announced. Lithium demand continues to grow very quickly and we are likely to see significant supply/demand and pricing volatility for years.
- A little surprised that only BMS made the negative list among the plastic packagers as there are two forces at work against this group, despite the stronger economy: the first being higher crude pricing and its likely impact on global polyethylene and polypropylene prices. The second is greater public and corporate reaction to plastic waste, with all plastic packaging makers at risk if food retailers, packagers and consumer products companies elect to make changes. This is unlikely to be material in 2018 in our view.
Otherwise the negative group is comprised of companies giving back some strong 2017 gains and others reacting to short term commodity pricing noise. We would be interested in CF, TROX, ASIX and TRN on current weakness. Lithium stocks and GE are not cheap enough for us yet.
Note that the chart does not contain any of what we would call the expensive industrial names already trading at multiple highs and discounting significant further EPS growth, such as CAT, MMM, DE, HON, etc. These companies continue to show their strong operating leverage with Q4 results and the stocks continue to react positively, despite valuations that appear to be pricing everything in. We continue to believe that these names will not outperform the more commodity levered names as demand growth in 2018 drives positive commodity pricing.
GE only missed Q4 earnings by a couple of cents, which in the context of the last couple of years is not that bad. However, given the opportunity to “reset” expectations in November 2017 and the need for the new CEO to gain some credibility with investors, this miss is inexcusable and suggests possible problems yet to bubble to the surface.
The market is focused on the SEC investigation, as it should be, and it is also appropriate to worry about shareholder lawsuits on the back of this and the expected restatements. But, the earnings miss suggests one or both of two other, potentially quite serious, issues:
- A new CEO that is overly confident and too optimistic. If Q4 guidance was a “stretch goal” rather than a sure thing, Mr. Flannery starts to look like his predecessor and that is not a good thing.
- Business leaders that are feeding Mr. Flannery too bullish guidance, either because they have the Immelt optimism bug or because they don’t have the necessary business “self-awareness” that we have discussed in prior research.
If it is the first reason, Mr. Flannery’s days are numbered. However, we suspect that it is likely more the second reason, which means that:
- Some or all of the businesses are in worse shape than anticipated in the November “report back” – we would expect Power to be in this bucket, but others could be also.
- We still think a significant Power related write-down is inevitable.
- Mr. Flannery has some further management changes to make and he needs to make them quickly.
All of this suggests that a break-up strategy is more likely, as it seems impossible to get one’s hands around all of the challenges and because it is probably the only way to stop the negative surprises – charts below. Investors should at this point put zero faith in the guidance for 2018.
The big opportunity – take the break-up path quickly and bring someone like Ed Breen onto the board to give investors confidence that it can be done well.
The big risk – a large Power write down compounds the Insurance write down and the SEC investigation and class action shareholder lawsuits begin – note that GE is largely held by individuals rather than institutions.
PX (and by association Linde) remains our favorite story for 2018/19, based on the earnings growth that the combination can bring from synergies, share buy-back and market share gains for new industrial gas business (see prior research referenced below).
Now we get the added benefit of operating leverage – something that deserted the industry for several years and its absence may have been one of the driving factors to cause PX and Linde to talk. Operating leverage is extremely high for an underutilized installed air separation or hydrogen or syngas facility. Several years ago, we estimated that PX probably had as much as $500m of potential EBITDA sitting in underutilized North American assets alone – we don’t think that has changed. The problem at the time was that with no real demand growth there was no opportunity to get to the EBITDA. What we have seen – especially in the second half of 2017 – is a return to manufacturing growth rates that are high enough to pull through more industrial gas demand. A couple of good years of North American growth could probably add 10% to legacy PX EBITDA, but the rising tide would help all; Air Liquide more levered than Air Products or Linde, but APD has also produced some very strong numbers today with volume gains a primary driver.
We had not factored stronger North American economic and manufacturing growth into our model when we first published our thoughts on what a combined PX/LIN could earn in 2020/2021. We could add as much as a further $1.00 per share to pro-forma earnings in 2021 which, assuming a 24% tax rate, gets us to $15 per share in 2021 – chart. While there are only 2 estimates for PX for 2020 today and none for 2021, our model has a 2020 estimate that is 60% higher than consensus.
In the space of a week, APD has announced strong earnings, increased its dividend by 15%, renewed its large supply contract with Samsung in Korea and announced another gasification project. Our thematic thinking on APD is that the company is the big loser in a merged PX/LIN world, with PX/LIN and Air Liquide taking most, if not all of the traditional Industrial Gas growth and APD limited to the periphery – see research. Since we expressed that view we have seen APD increase investments in “off-piste” projects, focusing on coal gasification and syngas production. The company has plenty of cash, and while raising the dividend was the right move in our view, we expect to see more of these (large capital increment) investments around the periphery of the core Industrial Gas market. Our worries are unchanged:
- Large capital allocations to single projects – increasing the dependence of the company on the performance of a few major investments rather than many smaller ones (the more traditional industrial gas model).
- Could result in greater earnings volatility as there is more execution risk with these larger projects and shutdowns could have an impact on quarterly EPS.
- Take-or-pay likely harder to enforce in places like China, compounded by APD taking equity in the gas consumer.
- Lower possible returns than the core business – declining returns caused the loss of investor confidence in APD in 2012. The company was growing earnings, but each increment of new earnings was more expensive in terms of the capital required to create it. Many of the moves made by the company at the time resulted in substantial subsequent write downs.
- Coal as a long-term source of chemicals – increased LNG may make coal cheaper as it is replaced as a source of fuel for power generation, but “peak-oil” at some point drives oil more in line with LNG – coal possibly becomes uncompetitive.
While not much of this is likely to play out in 2018, APD has only really adjusted its earnings outlook for 2018 by the expected gains from the Tax Act, despite the better economy. With the revised guidance, APD is trading at 24x 2018 earnings, and while on a relative basis the stock is not as expensive as it was – chart – PX looks significantly more interesting, not just on valuation, but on its likely opportunity to grow stable earnings more quickly without taking outsized bets on less predictable capital projects. Note that APD’s fiscal Q1 2018 earnings were helped by a contract termination in China and the sale of the associated assets to that customer – boosting both revenue and EBITDA and accounted for as part of recurring earnings.
The announcement this week that SABIC has acquired a 24.9% stake in Clariant, but has no intention of buying more, makes little sense. It is possible that SABIC took the opportunity of a block trade to get a large piece of Clariant on the cheap, but this is inevitably a path to something else – either a bid for the whole company, or a move to create some sort of JV – part of Clariant’s business with part of SABIC, or a swap of some sort – SABIC gives the shares back to Clariant in exchange for one or more of Clariant’s businesses.
The move does not leave Clariant management in a particularly strong position – the activist investors may be out, but they have handed a significant negotiating platform to SABIC, especially if SABIC just wants a piece and not the whole thing.
Ultimately, selling a piece or pieces to SABIC might make some sense for Clariant if by doing so the residual becomes more interesting to a third party – clearly no one has been interested in buying the whole thing as the activists had wanted. The stock has pulled back significantly on the news but still looks quite expensive on a stand-alone basis, maybe less so if it can be sold in pieces.
We would rather play companies in Europe that are levered to some of the commodities we think will see tightness in 2018 – with Covestro still our favorite idea, but BASF also looking more interesting. Note that HUN has just raised Q4 2017 expectations based on substantially better results in its MDI and Urethanes intermediates business (more than offsetting business interruptions elsewhere). We expect 2018 to be a very strong year for Urethanes with Covestro the most attractively valued way to play this today – we continue to like both HUN and DWDP in the US.
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