Friday Findings – March 9th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
March 9, 2018
- Chart of the Week
- The Lithium Swan Dive – The Drop May Be Over, But So Is The Love Affair
- The WLK/LYB Disconnect – Is Chlor-Alkali That Good?
- Weekly Winners & Losers
This week’s chart gets more stock specific than usual, but does not on its own constitute any specific recommendation. It does however illustrate one of SSR’s more powerful stock measurement tools and it gives investors, and ourselves, controversies to explore further. The X-axis is the current stock multiple of “normal earnings” divided by a long-term average. The Y-Axis is expected consensus EPS growth from 2017 to 2019. We drive our measure of normal earnings through long term average or trend return on capital (trend where there is a pronounced and consistent trend). The stocks to the left of the chart, with the exception of Eastman have made major acquisitions in 2017, adding substantial tangible and intangible assets to their capital base – suggesting higher normal earnings. These are the stocks to buy ONLY if the acquisitions were worth it and historic returns can be repeated.
For context, the second chart shows historic relative multiple versus the same expected growth rate. SHW, FUL and DWDP are clustered at the top of the chart because EPS growth reflects some benefit of the acquisitions made. However, when compared with the first chart, multiples do not reflect that this earnings growth is sufficient to justify the price paid for the assets (even if the deal is EPS accretive by virtue of borrowing rates or stock returns being significantly lower than historic returns on capital).
The question is whether a company like DWDP (same for SHW and FUL) can get back to trend – chart. If so the EPS and valuation upside is significant and this subject will be covered in more detail in future research. To get back to trend DWDP would need to earn almost $6.00 per share in 2018.
The stand-outs from the first two charts are EMN and WLK (see below). EMN has been on our preferred list for a couple of years – initially just because of valuation, but now because of what we think will be strong earnings momentum – the risk on EMN is a strategy that seems confused and the possibility that the company makes another poor acquisition with its increasing balance sheet flexibility. ECL is the only stock that looks expensive in both charts.
We have noted in prior Friday emails and prior research that a trade war could be bad for chemicals as one of the US’s most significant exports – 2nd after machinery, although energy is catching up. As we add new capacity in the US – reliance on export markets increases – chart – and any trade retaliation in chemicals might impact the ability to export and consequently operating rates. The most at risk is polyethylene, although chlor-alkali operating rates are high in the US because of chlorine derivate exports.
Lithium has been THE darling of the investment world for the last couple of years, but the exuberance – rational or irrational – has faded, as shown in the first chart. ALB is the most levered, with SQM producing other metals that are improving, and FMC now focused on its larger Ag portfolio and looking to separate its lithium business by year-end. Despite the share price corrections, none of the three stocks looks particularly cheap, but they should not, because Lithium remains in short supply and pricing remains high. What has disturbed investors has been the (not unsurprising) wave of lithium capacity announcements and related capital spending that have accompanied recent annual results and analyst updates.
But lithium is a rapidly moving target and it is highly unlikely that anyone has an inside track to estimating the market size ten years from now and maybe even five years from now. The automakers are sharing plans about EV models, production, and timing which may be too ambitious or too conservative – too ambitious because they are either overestimating the size of the EV opportunity, or their share within it, or conservative because they are underestimating consumer interest in EVs. Add to this a range of possible demand scenarios for electric trucks and utility storage and you have a demand range for Lithium that is wide enough to allow the bears to create a bear case and the bulls a bull case. What is undeniable, however, is that the capacity plans and capital available in the segment have been sufficient to take the hype out of the stocks and it is now time to look at them differently. Given that all free cash appears to be targeted for redeployment into capacity expansions, shareholders are not getting a better dividend or a buyback with what might be considered to be “windfall” profits.
Consequently, you have to take a view on lithium supply and demand, and whether you choose to take a 10-year DCF approach to potential earnings, or some other measure, lithium itself is guesswork. We would focus on how strategies at the lithium companies develop to reflect this greater uncertainty. The cash flows are high – note in the second chart that the decline in ALB has not been revisions driven. Simply plowing all of the cash flow back into new lithium capacity may be less popular with investors than it was – even if this is the right use of cash. (Note in the chart that both SQM and FMC estimates have been driven by other businesses during 2017.)
One of the standouts from the chart of the week is the very different expectations for WLK versus LYB in terms of 2-year earnings growth – something we have not seen historically – chart. This reflects to a small extent investors’ greater confidence in the strategy at WLK versus LYB, but it is more a reflection of the expected relative strength of chlor-alkali versus polyethylene and the second chart shows what we would expect – even more leverage for OLN (though part of the difference is the much lower denominator at OLN).
- WLK does not look expensive to us even with its recent rally – we would still be buyers.
- LYB does not have the EPS growth expectations but it still has the significant free cash flow – this used to be a positive and is now a negative because the company is spending on things that we don’t like and shareholders don’t like – new capacity for propylene oxide and tangential acquisitions.
- OLN does not make it into the chart of the week because of some very inconsistent history, but looks inexpensive and on paper the better bet, however:
- Execution has been very poor since the Dow acquisition and estimates have been wrong year after year despite the strong EPS growth.
- Also, Winchester remains a poison pill.
- We would focus on WLK and for those wanting to look outside the US in commodity chemicals we would look at Braskem.
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