Peak Valuation in Some Commodity Chemicals – Something to Watch

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 19th, 2014

Peak Valuation in Some Commodity Chemicals – Something to Watch

  • A couple of US commodity companies are reaching earnings peaks (relative to normal) at which point historically we have seen multiples decline to offset any further earnings growth – so a valuation peak. WLK is already at that point and LYB is approaching that point. DOW’s US business is over-earning, but the rest of the world is holding them back.
  • DOW and LYB are unlikely to get to an earnings peak like WLK because of their non US exposure. AXLL is a long way away from peak earnings and peak multiples, but earnings should see further improvements.
  • However, we are not at a peak. Current high earnings for WLK and others are the result of a feedstock advantage, not a structural shortage of product. If you believe that a commodity peak is likely – a scenario supported by DOW in its presentation today – there is further upside.
  • We do not believe that a peak is likely, given high polymer prices and slow demand growth. We think that the global market for ethylene and derivatives will only grow slowly and could be oversupplied as early as next year.
  • The only reason to stay in WLK and LYB today is the medium term nature of the US margin advantage and a high level of conviction that companies will return the cash to shareholders. WLK is not expensive if you are sure that forward dividends will approximate forward earnings, for example.
  • As indicated in recent research, we believe that DOW has upside if restructured appropriately, and the stock is not at a peak valuation yet. Today’s presentation in Saudi Arabia suggests some further (but not enough in our view) radical thinking!
  • There is a possible “long chlorine – short ethylene” trade, based on valuations today (so Long AXLL and OLN and short WLK and LYB).

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

In our recent
chemicals monthly
we talked about peak valuation in the commodity subsector and we have had more comments, feedback and questions than we expected – so here we elaborate a bit.

Commodity cycles have historically driven earnings from peak to trough in basic chemicals and other commodities and in general the market discounts the peak with a low multiple and the trough with a high one. This is perhaps best illustrated in Exhibit 2, which shows Dow Chemical’s 12 month forward PE against earnings relative to “normal” or mid-cycle. When earnings are well above normal the multiple is low and when they are well below normal the multiple is high. We have excluded all data points where earnings were negative and any very high multiples caused by earnings which were only incrementally positive.

Exhibit 2

Source: Capital IQ and SSR Analysis

Note that for DOW we have 43 years of monthly data in the chart, so we pick up several cycles. None of the other publicly traded commodity chemical companies today have enough historical data to do the same analysis, but we also looked at Georgia Gulf – prior to their near death experience and the reverse stock split, and we got the results shown in Exhibit 3, which are very consistent with the data for DOW.

Exhibit 3

Source: Capital IQ and SSR Analysis

What both charts show is that once earnings get close to or above 2x normal, valuation effectively flat lines and even declines slightly as multiples fall faster than earnings rise.

Looking back at Exhibit 1, Westlake appears to be in that danger zone, with LYB getting closer. In Exhibit 1 our “normal” earning assumes a return to a more normal US ethylene margin structure – i.e. a closure of the gap between oil and natural gas prices.

However, this time it is different as we are not at what would be considered a normal peak – tight markets and prices rising well above marginal costs – and the current situation is expected to endure, rather than peak and then fall.

The reasons to own LYB and WLK today are two-fold:

  • A belief that we are going to get a cyclical peak – i.e. a global product shortage which will lift prices higher and further expand US margins
  • And/or the cash generated over the next few years will be returned to shareholders rather than spent on expensive acquisitions or new capacity.
  • For Dow we would add positive restructuring moves as another potential catalyst for upside.

For example, addressing the second point; Westlake, which today looks like it is expensive on the basis of the analysis above, could choose to pay more than $9.00 per share in dividends over the next three years if we believe consensus earnings estimates. On that basis the stock would have a current dividend yield of around 7%, which should support current values.

On the issue of a cyclical peak still to come, near-term, we have a high degree of skepticism. We have well
documented our position
on this subject and our view that a traditional “peak” is unlikely given slow levels of global growth, in part because of the slower economies, but more because of the high absolute price of chemicals and plastics which we think adds an additional constraint to growth.

It is worth noting the price of polyethylene in prior peaks – Exhibit 4. On an inflation adjusted basis, polyethylene has peaked at current prices a couple of times in the past. At these historic peaks, prices have reached a point at which people make substitutions or reduction decisions – thus balancing the market. We are at that level of pricing now – which, in our view, is why growth is slow and why a further escalation of pricing, beyond normal seasonal volatility, is unlikely.

Exhibit 4

Source: Wood Mackenzie and SSR Analysis

Investment Conclusions

  • Do not buy any of these companies based on the hope of a “peak”.
  • WLK – can only support current value and any incremental upside, in our view, by almost guaranteeing cash return to shareholders – without that guarantee there is a risk of reinvestment at high prices and the stock is too expensive on that basis. Earnings support valuation.
  • LYB – doing as well as it can without help from Europe – but valuation is discounting further earnings improvements, which will be hard without margin improvement. Current price only supported by continued and almost guaranteed return of cash to shareholders.
  • AXLL – Under earning – after some severe negative revisions this year, but undervalued also – probably more interesting than OLN as an investment today.
  • OLN – stock cheap but earnings poor – need to see an improvement in earnings. However, in general the chlorine names are much more interesting than the ethylene names today.
  • DOW – upside with restructuring – see recent research – but core businesses need more meaningful cost reduction as earnings are not high enough to support valuation.

Exhibit 5

Source: Capital IQ and SSR Analysis
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