The Friday Findings – December 8th 2017
The Friday Findings – December 8th, 2017
Chart Of the Week – The Key to Matching Operating Leverage to Value
- Chart Of The Week
- GE – More Power Struggles
- TROX – Almost Saw The Whites of Their Eyes!
- PX – Momentum, But Miles Of Road Ahead
- Weekly Winners & Losers
From an investment perspective, the leverage opportunity in the transport space looks like it is largely discounted in stock prices, with KSU the only rail company with attractive value today (plagued by news flow on US/Mexico politics). ODFL looks like the most expensive stock in an expensive sector. On the other side, IP and OI look like the most interesting undervalued names in a sector that does not reflect the leverage opportunity. IP has performed horribly in 2017, but has executed poorly also – the significant potential upside in the name relies on better execution in 2018.
Beginning this week – we are starting the Friday Email with a “Chart of the Week”. (As we drag ourselves into the 21st Century we will also be including this chart and some commentary in both a LinkedIn and Twitter feed – SSR LLC on LinkedIn and @SSRIndustrials on Twitter)
This week we are using our long-tested skepticism analysis to think about leverage to an improving economy. The reality is that all of the sectors in I&M have high incremental operating leverage (except E&C where incremental demand can be bad if the companies do not have adequate human capital to meet higher demand). As demand grows earnings should grow more quickly. The sectors to the right in the chart show skepticism – they have aggregate share price values that do not adequately discount current earnings (the market is skeptical!). If these sectors also have high operating leverage – which they do – better economic growth will drive higher demand and either a greater disconnect, or improving valuation to close the gap. On the other side of the chart, valuations already anticipate operating leverage and the aggregate share price upside is more limited. For more detail see our most recent Industrials Monthly or our more focused work on Skepticism.
While the stock looks interesting at current values, we remain concerned that there is another round of bad data coming – we would certainly not buy before the end of 2017 for the technical reasons we have discussed previously.
The market has reacted indifferently (appropriately so in our view) to the news that GE is cutting (a lot) of heads in its power business in an attempt to lower the cost base. This is a necessary step for GE, but it falls very short of what will likely ultimately be required to either create shareholder value from the business or minimize value destruction:
- This is a new build industry with 300% overcapacity!! According to Siemens there is capacity to build 400 large combined cycle power plants globally per annum and demand this year is slightly more than 100.
- No industry operating at 25% of capacity makes money – but everyone tries to cut costs – Siemens announced job cuts last month, this week – the rest will follow. If everyone cuts costs the cost curve simply moves down, pricing moves down and no-one makes any more money – no different than any commodity, or any other industry.
- Demand is not going to save this business – solar and wind and batteries are here to stay – there is no scenario where demand goes back to 200 units – let alone any closer to capacity.
- Demand is predominantly in the emerging markets – home turf for a couple of larger power plant builders and designers – they will fight hard to keep or build share despite GE and Siemens’ better technologies.
We see Thursday’s news from GE as a negative rather than a positive as it is further confirmation that the Power business is in real trouble, and likely more trouble than cost cutting alone can solve. The industry needs to restructure or it will be a competitive death spiral to the bottom. GE Power is likely worth more today than it will be tomorrow and tomorrow it will be worth more than the next day, etc. If there is a way to sell or exit it – together or in pieces – GE should have this as a high priority.
The business has a strong maintenance and repair footprint and some unique technology – the maintenance business should drive cash flows, but not growth – of more interest to some possible buyers than others. The technology might be the hook that could get a buyer over the line.
The table below is a start at a snap shot of the Power business and our initial thoughts on direction. As we run through each business, the problem that we find is that every competitor of GE feeling the negative pressure in the top two businesses is likely to chase opportunities in the rest of the table, where they operate, to offset the losses – increasing competition and lowering price and margins. In other words the negative pressure in the larger business may limit the opportunity in the others, or worse, drive margin declines.
While there is a price for any commodity company, today the TiO2 stocks are too expensive in our view and there remain deal specific risks to TROX. Chemours, while the largest player, has other positives and other negatives creating a more complex investment opportunity/risk. Opteon is a blockbuster “home run” for Chemours and likely the reason why most investors own it. The downside will always be legacy DuPont and Chemours specific litigation risk. We are the wrong people to opine on this, having been ensnared in the asbestos debacle of the late 1990s and early 2000s. We feel you cannot be TOO cautious when it comes to litigation risk. We would rather own Venator for TiO2 exposure and HON for the refrigerant opportunity.
Sometimes the FTC just says no! Generally, there is a negotiation, for weeks, behind closed doors and generally there is a settlement, sometimes a settlement where the companies looking to combine businesses are very unhappy with the FTC. However, when the FTC says no – that is generally the end point.
TROX is going to fight the decision and is willing to make concessions to get the deal done – that will likely mean the sale of chlorine based capacity in the US, in order to maintain the competitive dynamic that the FTC is looking for. Maybe Venator is the buyer – that would keep things neat – but what if the higher bid comes from a major Chinese producer looking to get both a foothold in the US market and access to chlorine based technology. In the long run, that would likely be bad for TROX and the other US and European producers.
However, it is unclear that there is any good outcome for TROX or the industry now, as walking away from the deal leaves Cristal in play and available to one of the Chinese companies, like Lomon.
We do not like the TiO2 business because:
- It is cyclical and not cheap enough;
- It is only a matter of time before one or more of the major Chinese players gets into the chlorine based side of the business – dropping the top end of the cost curve;
- and because the major buyers are large and powerful – and always focused on lowering their reliance on TiO2 because it is such a significant cost for them.
- Pricing has lost momentum.
PX (and Linde) remain our single favorite idea in the Industrial and Materials space (ahead of DWDP) and if the deal is approved we believe that there is still as much as 90% upside.
Since the beginning of May we have seen a steady increase in target price expectations for PX, with some implied upside through the summer, but more recently target prices that are chasing the share price. Assuming that the deal with Linde can be completed, and the TROX news is obviously some cause for concern for PX holders, our view is that the upside remains substantial – almost 100% through 2022 and it is likely that “target prices” will chase the stock rather than predict the stock from here.
The stock is likely to move on a multiple expansion, discounting the benefits of the Linde deal from a synergy and growth perspective – see prior work. Near-term, prior to the deal closing, PX’s earnings may do well in light of better global industrial and consumer growth, but not enough on their own to keep the momentum in the stock. Analysts are going to have no choice but to predict 2021/2022 earnings, as we did; generate a value from those projections and discount that that back to today. This should adequately support (from a regulatory perspective) lifting target prices meaningfully from here, without the immediate PE support. PX is up and should continue to go higher, in our view, not because we have a little bit more operating leverage today than we expected, but because of the merger “prize”.
©2017, 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.