Friday Findings – April 13th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
April 13, 2018
- Chart of the Week
- Covestro – Back To Bargain Status
- Aluminum Upside – Short Squeeze – Rusal May Just Be A Catalyst
- DWDP – Trust-Ed: Breen WILL Depart, But That Will Be A Good Thing
- Bayer/Monsanto – Close To The Finish Line – What Does It Mean?
- Weekly Winners & Losers
In the chart of the week we show again the US gas advantage versus global oil and how we have seen steady improvements through the last 6-9 months, mostly because oil has risen, but also because natural gas has remained very cheap in the US, despite the very cold winter. With no new LNG capacity expected on-line in the US until the end of 2018 at the very earliest, we could see quite weak natural gas pricing through the summer, likely lowering US chemical feedstock costs at a time when international costs are rising because of crude.
The short-term data in the US looks poor for ethylene/polyethylene with ethylene margins weak and polyethylene pricing now also weaker, in part because of cheap ethylene but also because we are adding supply that needs to find a home – chart below. But the oil/gas gap should still work, with polymer pricing needing to rise in the rest of the world, because of higher costs, making it easier for the US to export more of the new production and ultimately leading to higher polymer spot pricing. It is possible that Q2 guidance from LYB, WLK, DWDP will be tempered by the current weak signals and possibly a worse than expected March in an overall good first quarter. We still expect 2018 to end strong for polyethylene and would be buyers on any Q1 news/Q2 guidance related weakness. Outside ethylene/polyethylene most other chemical segments look very strong as we head into earnings.
At its AGM today Covestro has guided to much higher Q1 EBIDTA than a year ago, mostly reflected in consensus in our view, but has been conservative about the full year and expects a year flat with 2017. A couple of points are worth noting:
- The conservative guidance is partly disbelief that current market strength can continue – we believe that it can – and partly concern about new TDI capacity coming on line in Asia, which we think the market actually needs.
- Demand is very robust for all of Covestro’s products and while there is raw material price pressure in polycarbonates and other areas because of higher oil, the market is strong enough to allow for these costs to be passed through.
- Even if 2018 EBITDA guidance is correct, the stock is trading at 5x EBITDA, making it one of the most attractive companies in a group that all have strong momentum in our view. All should have the demand from customers to more than push through any raw material cost increases and all look cheap.
In recent research we have predicted a trend towards M&A and away from capex for the chemical space over the next couple of years and everyone in the chart below looks like possible acquisition or merger targets to us, with Covestro the most interesting.
The Russian sanctions and the impact on Rusal has caused concern in the aluminum market and a spike in aluminum prices and stocks. This has had more of an impact on AA than the trade debate, in part because AA has much of its aluminum capacity outside the US, but mostly because this is a commodity market and cyclical tightness is more important than tariffs. The jump in metal pricing Thursday and again today, is more of a reflex than anything else – first chart – but the reflex may be directionally correct and sustainable given other factors. Aluminum inventories are low – second chart – and a report today suggests that demand for LME inventories has jumped sharply. This lower level of inventory cushion will support prices but could lead to more price volatility given the lower cushion and the impact that small swings in inventory could have on sentiment. In addition, we have clearly seen a flattening of Chinese exports (despite today news that exports have peaked in response to the recent price change). This flattening is in part because of Chinese demand growth and in part because of curtailed production on those facilities with a poor environmental footprint – just as we have seen in other industries – Chinese exports have now been essentially flat for the last three years – third chart. It is likely that the rise in recent exports, not reflected in the data in the chart, is a draw on Chinese inventory, which in itself will have a further tightening impact on the market.
Alcoa remains very attractively valued in our view and does not discount the already improved aluminum market – prior to any recent and further gains. The company is already back to a normal return on capital, with expectations for 2018 close to the ROC based norm outlined in the chart below. The question is then what multiple do you pay for that. Like Dow and DuPont, Alcoa’s history suggests that on average you get a market multiple of earnings for the stock – today that shows the company as extremely cheap – with a target of $90 per share – second chart. However, like Dow and DuPont, you do not get a market multiple when the market itself is at peak multiples. There are two ways to think about this:
- What is an appropriate relative multiple at a market peak – probably around 0.8. That would be around 15x today – so $10 to $12 per share upside from today’s close.
- What if prices keep rising and earnings are far too low – peak earnings could drive the stock much closer to the $90 normal relative value – a lower multiple of much higher earnings.
- A 10% return on capital is $7.30 per share at a relative multiple of 0.6 (discounting a peak) and generates an $85-90 price target.
The weakness in DWDP has been blamed on a variety of things, ranging from trade war fears, to lack of news, to the ethylene worries (see above) and to fears that Ed Breen will depart early. We do not think that Ed is leaving any time soon, simply because the job is not done yet. However, we think that it is entirely likely that he manages himself out of a job within 12 months, possibly taking a non-Executive Chairman role at one or more of the spin-off companies. Ed’s day job is to get the Ag business (Corteva Agriscience) and the Specialty business (DuPont) in the right shape to separate and stand alone, with appropriate capital structures, strategies and, most important, management teams, capable of executing the strategies.
For Ag it is fairly straightforward – either Jim Collins is the right guy or he isn’t! The goal is to integrate the Dow and DuPont businesses and drive cost effective innovation and lower costs. There is no real secondary agenda – you need a good operations, brand and cost management strategy and the right person to oversee it. If Jim is the wrong guy, a consolidating industry (Bayer/Monsanto finally in the last stages) should throw out some alternates.
For the new DuPont, the challenges are more significant and this is where we expect Ed to add the most value. The new DuPont is four very different businesses that don’t necessarily have any real strategic synergies – maybe in Transport and Safety and Protection as they are both largely polymer businesses. Old DuPont always struggled to get value for the “conglomerate” structure and new DuPont will still be a conglomerate of sorts, and while this may be harsh, currently staffed with the same senior management that could not get value and drive costs low enough previously. Regardless of what might have been suggested previously by DWDP, Ed still has the latitude to break this business up if he sees more value, or cannot find leadership that he thinks can extract value from keeping it together. We do not think that he has any intention of running new DuPont unless it is to break it up. With Tyco, Ed effectively managed himself out of a job, much to the benefit of the Tyco shareholders who placed their faith in him. If he cannot find the industrial or leadership logic to keep new DuPont together we may see the same playbook.
We want Ed to leave DWDP, but only when he is finished We see significant value in DWDP, likely catalyzed by strong earnings (polyethylene may have some near-term weakness but the rest of the portfolio looks good), better guidance, some reassurance that Ed is going nowhere, yet, and possibly further share buy-back at current low values – we would want to own the stock before the quarterly call on May 3rd.
With news that the Justice Department has approved the Bayer/Monsanto deal, we move closer to a very consolidated crop chemicals world. Divestments have for the most part gone to existing smaller players, BASF and FMC and while the chart below draws you to the influence of the top three, the top 6 now have more than 97% of the market. In the seed business the various competition authorities have been quite strict and while there has been some consolidation around the edges, BASF becomes a new player and the competitive landscape is not changed that much. The only real change here is a risk – a risk that Syngenta seed technology is now widely deployed in China – probably good for Chem China earnings but not good for corn and soy supply/demand.
Fundamental data points vary right now with FMC habitually guiding up estimates – good sign for crop protection chemicals and MON missing recently on disappointing corn prices.
We remain cautious on the Ag space, with the exception of fertilizers, as despite the consolidating moves we do not see much of a change in farming fundamentals, which remain generally weak. The driver is still seed productivity, which is running well ahead of demand growth, keeping pricing pressure on the major crops. Pesticide demand should be ok, but the mergers probably do not generate any pricing power in our view and are more likely to create companies keen to take share to meet some of the objectives they presented while justifying the deals. FMC may be an isolated case because of poor guidance or poor modeling post the DuPont deal in November 2017. The company specific upside from the Bayer/Monsanto deal and from DowDuPont’s ag spin will likely come from synergies not from better business fundamentals – synergies lower costs and in a competitive world those cost reductions could be competed away. We would steer clear of the group, preferring the fertilizer names, MOS and CF, but especially CF as corn production is growing (even if pricing and seed pricing is weak) and the nitrogen need is growing with it.
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