Polyurethanes: a poorly understood opportunity Positive for HUN, 1COV, BASF and DOW – less so for LYB

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 11th, 2018

Polyurethanes: a poorly understood opportunity

Positive for HUN, 1COV, BASF and DOW – less so for LYB

  • Polyurethanes have not been an investor focus for decades, with the segment buried in much larger companies for the most part, and HUN having the greatest focus per share before Covestro was spun out of Bayer.
    • Polyurethanes will be a larger part of the new DOW than the old DOW and are more significant as a proportion of total business for LYB than for BASF.
  • The polyurethane market is complex, with multiple uses and chemistries. Some parts of the value chain are more commoditized than others – but overall growth is GDP driven and the sector has for the most part been underinvested in for many years.
    • Commodity isocyanates and propylene oxide ingredients get the attention, and pricing for these components does impact the price of the finished products for large customers.
    • Investor concern today is focused on the risk of oversupply in the commodities and not enough attention is being placed, in our view, on the robustness of the end markets and the lack of fungibility and logistic constraints at the customer end of the business.
  • Both HUN and 1COV have rising estimates for 2018 and 2019 and yet declining valuations, and multiples of EBITDA (Exhibit 1) that are small compared to other commodity biased companies that have the potential for greater earnings volatility.
    • Much of HUN’s recent historic volatility has come from the TiO2 business which was spun off last year. Ex-TiO2 the operating income has been relatively stable. There is not enough history on Covestro to do the same analysis.
  • Both HUN and 1COV are widely loved by the sell-side, which is a negative based on past analysis – Covestro has an industry high range of price targets – HUN narrower.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

The investment community has no love for the polyurethane markets, punishing both Huntsman and Covestro (those with the largest proportional exposure) year to date despite extremely low valuations and positive revisions – Exhibits 2 and 3.

The polyurethane market is complex with a variety of end markets, wide variety of products, and an equally wide variety of chemistries. It is nothing like the simplicity of polyethylene and polypropylene. We have borrowed a couple of charts from Huntsman to attempt to show the complexity of the market – Exhibits 4 and 5.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Huntsman

Exhibit 5

Source: Huntsman

Both HUN and 1COV are on our favored list (and have been for a while), because they operate in business segments that have not seen over-investment in recent years and have strong exposure to improving economic growth and some pricing power. BASF and DWDP are significant participants in the polyurethane markets, but the businesses are a little lost in much larger portfolios – will be much less lost in the new DOW. LYB is a significant polyurethane ingredients producer. The market seems to be focused on expected oversupply in 2019 of isocyanates (MDI and to a lesser extent TDI) – both ingredients in polyurethane manufacturing, but all participants are showing strong growth in 2018 and it is likely that the impact of new capacity is significantly overblown in stock valuations – especially for HUN and Covestro. These companies are throwing off mountains of free cash and we struggle with the idea that private equity is willing to look at ARNC at 8.3x EBITDA in preference to either HUN or 1COV (notwithstanding the issues of trying to take a company private in Germany without strong corporate support).

Other observations from the charts above:

  • Given the discount in HUN and 1COV versus the others (1COV especially), why is LYB not looking to buy HUN or 1COV to create an integrated polyurethane business – much higher valued within DWDP
  • Contrary to the above – if polyurethanes are so unloved, why is LYB getting bigger in the intermediates segment.
  • Dow Materials (new DOW), when spun out, is going to look like LYB with a bit more HUN and 1COV in the portfolio than LYB – this does not bode well for Dow Materials valuation – DWDP is 2.5 multiple points higher than LYB and 4.5 multiple points higher than 1COV today.
    • If polyethylene continues to weaken, and polyurethane valuations do not improve, market conditions will not be that attractive for a spin out of Dow Materials in the next 6 months.
  • Is DWDP really worth 2.7x EBITDA more than BASF?

Looking at HUN and 1COV specifically, earnings revisions for 2018 and 2019 have been particularly strong – Exhibits 6 and 7.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

While we have limited history on Covestro, the current EV/forward EBITDA multiple is probably all that you need to know. For HUN we have more data, though not enough, as the company has only been public for 13 years and has changed its portfolio significantly over that period. We cannot find a proxy for a cyclical norm or an up-cycle in polyurethanes but note that the industry has been earning well below its cost of replacement capital for the entire time that HUN has owned the business (HUN did not pay replacement cost for any of the pieces it acquired). History is a poor guide for HUN, in part because of the lack of complete cycles but also because of the portfolio changes. The step up in return on capital – Exhibit 8 – coincides with the spin-off of Venator, but it also coincides with improved (likely cyclical – though where on the cyclical spectrum is unclear) margins in both polyurethanes and epoxies. As the stock has underperformed and as returns have improved, HUN’s SI has hit a peak – Exhibit 9.

With the trend return on capital we have in Exhibit 8 (7.5%), HUN would be fairly valued today – almost all of the SI is driven by over-earnings versus that trend. If the new right mid-cycle return on capital for HUN is 10% – normal value is around $40 per share (the consensus median). If the new normal is 12.5% – normal value is $50 per share. $40 would be 37% upside from today’s price

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

We like every stock on this list except LYB which we have written about recently. It is hard to ignore the attractive valuation of the European names – more beaten down by higher oil and trade concerns than the US names so far this year – despite strong revisions. We see another great entry point for HUN.

The risk is that the sell side loves HUN (Exhibit 10) and history shows that this is quite a strong counter-indicator. One standout anomaly is the bizarre range of target prices for Covestro. Exhibit 11 shows current prices and highs, lows and mean target prices. Today both HUN and WLK are below the low end of the ranges. The range for Covestro is remarkable – the data in the chart is in US dollar but the range is more than €100. There are 23 analysts covering the stock and providing target prices and estimates – the Covestro data shows how hard it is to model the polyurethane business.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibt 11

Source: Capital IQ and SSR Analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Sources: Capital IQ, Bloomberg, Government Publications.

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