Friday Findings – March 23rd, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
March 23, 2018
- Chart of the Week – More Cash – Greater Investment Uncertainty
- No Benefit Of The DOW’t!
- Weekly Winners & Losers
At the IHS World Petrochemical Conference this week there was a great deal of confidence and many happy faces – the chart of the week shows why. The US chemicals industry currently has the highest net income margin since our detailed modeling began in 1970. With the higher margin comes higher cash flows and this is not isolated to the US – every company that I spoke with in Houston this week is talking about high margins and very high cash flows. In our ethylene piece last week, we concluded that, despite this cash flow, producers were not spending enough to keep up with demand – IHS has a higher rate of ethylene expansion than we are modeling (likely closer to our numbers if you factor in delays), but even without delays, not enough to keep pace with the demand growth generated by a global economy growing above 3.0% per annum. Given the cash, why the slower investment? It all comes down to risk and uncertainty around investing assumptions, which have never been higher.
- Can the economic expansion continue unabated – we are already close to the second longest period of expansion that the US has ever seen. A couple of years of lower growth could create over capacity quickly. Could a trade war do this – probably, if it gets out of hand.
- Construction costs – Dow quoted as saying US Gulf Coast construction costs are up 40% in the last 5 years – this statement is likely a bit self-serving (to discourage others), but costs are definitely higher than they were. Cost control and over-runs were repeated topics of discussion this week.
- But far more important is the feedstock landscape – not driven by availability of natural gas or crude projections – those are relatively easy to model – driven by changing patterns of fuel demand. This is all about EV penetration – the rate of decline in demand for gasoline and diesel – how refineries react and how crude oil prices react.
The chart below is taken from data presented by IHS this week and it shows an estimate of how vehicle sales COULD evolve. IHS has a more aggressive case and candidly we think their more aggressive case is more likely, if not conservative. But the uncertainty that this chart brings to forecasting petrochemical feedstock availability and relative pricing is a major curve ball for planners. Oil demand peaks at some point, maybe as early as 2020-2022, gasoline demand starts to fall – following diesel – chemicals become a more important customer for refiners – refiners run to make more chemicals – more aggressive FCC temperatures and catalyst choices to make more propylene and some ethylene. At the same time, while there appears to be abundant natural gas in the US, there seems to be almost endless potential demand for it as LNG.
In the past we have seen major swings in relative energy pricing but they have by and large been a surprise. Now we expect change but can’t quantify it. We would favor companies with balanced cash allocation strategies – shareholder return plus some new capex (de-risked through JVs for the big projects) and opportunistic M&A. Those experiencing significant free cash flow for the first time are the ones most likely to spend it with little discipline. See the piece below, but one of the factors that could be causing the wane in interest for DWDP is a lack of clarity of around use of cash, especially at what will be the new DOW.
Returning to the chart of the week – chemicals is not the only industry with peak net income margins – capital goods is in the same position – chart. The difference is that capital goods are expensive – chemical stocks are much cheaper. Ex-GE, the conglomerates group is also at peak.
DWDP is caught in a difficult dead spot. Despite handily beating Q4 estimates, talking about higher levels of synergies, giving clarity about the spin timing and now clarity about the leadership team of the new DOW, the stock is underperforming. Perhaps investors do not like the increase in goodwill on the balance sheet, perhaps they do not like the leadership change – but neither of these reasons seem logical to us. We think it is more likely that the stock is being largely ignored by the sell-side, pre-spins, from a modelling perspective – perhaps because it is viewed as not being worth the effort. In the first chart we show estimate revisions for DWDP and a variety of peers (some in only a few overlapping sectors) since the merger. Views on every other company have improved – DWDP’s have declined! The other companies are all in the same businesses as DWDP and so the chart makes little sense, suggesting that at a minimum DWDP is a glaring relative buy based on likely earnings trends. In the second chart we show revenue expectations. With the exception of Braskem (unclear what is going on there – maybe currency) it is the same picture – everyone else’s business is expected to improve but not DWDP’s.
DWDP is closing in on its 52-week low and is a glaring buying opportunity in our view, particularly given the strong demand and pricing environment that has been the central theme in Texas this week. We still believe that DWDP can earn $5.00 per share in 2018. DWDP has underperformed YTD, though no more than BASF and HUN – 3rd chart – and while it looks more expensive than the group – 4th chart – it is not if, as we expect, EBITDA estimates are low by more than 10%.
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