The State of the US Chemical Industry – September 2013

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 23rd, 2013

The State of the US Chemical Industry – September 2013

  • US Chemical Industry profitability is doing well and the sector is highly valued, more so in both cases than the weak global economy would imply. An historic correlation of operating rates and margins would not support the levels of profitability that we see today.
  • The US natural gas advantage explains some of the apparent resilience in the US sector, and some of the rest can be explained by better market structure in more regional businesses. This has helped Coatings, Industrial Gas, and some businesses within both Specialties and Agriculture.
  • Some of the valuation red flags that we see today are explained by the factors above, but despite those factors there are sectors and stocks that we think will struggle to meet expectations – most notably Coatings.
  • At the other end of the scale we see real opportunity in the current TiO2 exposed companies, DD, HUN and ROC, in large part because of valuation, but also because all three are expected to divest the businesses, resulting in portfolio changes that will likely drive higher multiples.
  • Within industrials we would today be slightly underweight Chemicals, preferring Capital Goods for similar cyclical market and fundamental exposure and better value. Within Chemicals we would structure our position as below.

Exhibit 1

Source: SSR Analysis

Overview

The US Chemical sector is, in aggregate, expensive with most of the companies in our index trading well above what we would consider to be “normal’ value (Exhibit 2), and 7 trading within 10% of 10 year highs relative to the S&P500 (marked in red). By contrast, only one company is within 10% of a 10 year relative low (marked in green).

Exhibit 2

Source: Capital IQ and SSR Analysis

The Chemicals sector is not as expensive as some of the others within Industrials and Materials – see Exhibit 3 – but it is more expensive than others with meaningful exposure to China and a significant component of commodity exposure, such as Metals and Capital Goods.

Exhibit 3

Source: Capital IQ and SSR Analysis

For the most part, earnings have improved well above “normal”, and at a time when demand growth is generally weak and utilization rates for most products are not high. Earnings have improved in many cases without coincident increases in revenue, suggesting that significant cost reductions and controls are contributing to margin expansion. This is not a trend that can continue indefinitely.

The recent decision by the Fed to continue full on with its stimulus program has caused the sector to rally further, but we have to question whether valuations are now so stretched that fundamentals cannot meet expectations even in the most positive of economic scenarios.

In some of the better structured sectors we would not bet against continued earnings strength. What we would question in these cases is how much better things could get from current levels and this body of work does not make us any less cautious in viewing the coatings sector as a source of further appreciation. We would continue to highlight RPM as the company with the steepest hill to climb to meet expectations.

The most organic growth still exists in the Industrial Gas space and while ARG and PX have the added kicker of the consolidation in North American packaged gas, ARG is expensive and discounting faster growth than either PX or APD, both of which look more fairly valued and less risky.

We see limited fundamental upside in US commodity chemicals (margins unlikely to get better) and downside in European commodity chemicals – this leaves us firmly on the fence for this sub-sector. We like the US exposed names that will return cash to shareholders and we are concerned that the more global names use US cash flow to prop up European businesses and see overall returns dragged down as a result.

Ag looks attractively valued and is a better structured industry today that it was 10 years ago, but it is hard to fight the current weaker corn fundamentals and put an appropriate value on the recalibration of the potash market.

We continue to like the diversified restructuring stories, particularly for those companies looking to transform towards specialty portfolios in well structured markets where capital demands are moderate. This leads us towards DuPont, Huntsman, Rockwood and Eastman, with Eastman lacking the “value” attributes of the other three.

Combining our work on valuation and fundamentals we would look at sector and stock exposure as was illustrated in Exhibit 1.

Improving Margins and Operating Leverage

Companies are generally doing better than they have in the past with respect to return on capital – Exhibit 4. This is more impressive given the weaker demand environment and the fact that many companies are still operating at lower aggregate utilization rates than they were pre-financial crisis, suggesting significant further operating leverage is possible as economic growth recovers. Note that in this analysis “normal” refers to trend, where companies have a clear and consistent historic trend, and average where they do not. Four companies in our coverage group are at 10 year highs for returns on capital.

Exhibit 4

Source: Capital IQ, Annual Reports and SSR Analysis. Note: Where companies have made material portfolio changes we have on occasion manually changed trend or average assumptions to reflect that change:

Looking at Net Income Margin for the sector we see a very different picture for the recent economic downturn versus prior downturns. – Exhibit 5. There was a significant improving trend prior to the most recent recession and much better performance through the recession. If we deconstruct the chart and look at the sub-sectors we see the expected aggressive dip in margins in both the Commodity and Diversified groups, but a much faster recovery than in prior cycles. For Industrial Gas, Specialties and to an extent for Coatings we see higher lows and equally fast recoveries – Exhibit 6.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Some general points on margins:

  • The quick recovery of commodity margins has much more to do with the natural gas advantage in the US over the last three to four years – for many products the world is over-supplied and producers without the advantaged feedstock position of the US are operating today at margins well below prior down cycles.
  • This effect has some impact on the Diversified group also.
  • The stronger margins in Ag help both DOW and DD and, as these are large components of the Commodity and Diversified groups respectively, they impact the average.
  • The recent dip in the Diversified margin is a function of TiO2, which remains a global commodity.
  • Structural changes in the Industrial Gas, Coatings, Ag and some Specialty segments have had a recent positive impact and explain some of the better trends post the financial crisis.

Structure matters

In Praxair’s recent analyst day one statistic they shared was that the US packaged gas market has moved from 67% independent from the beginning of the century to 50% today. A similar and perhaps more dramatic change has taken place in the US architectural coatings sector. While it is difficult to get meaningful data on a broad industry basis – we include a couple of charts for illustration. The first (Exhibit 7) shows an estimate of the Herfindahl index for the global coatings market – while the numbers on the scale are pretty meaningless, the improvement over time is relevant. Contrast this with a recent example of an industry going in the opposite direction – Photovoltaic Cells (Exhibit 8).

Exhibit 7

Source: bccresearch.com, SSR Analysis

Exhibit 8

Source: energyandcapital.com, semiconportal.com, SSR Analysis

The five year chart in Exhibit 9 comparing First Solar and Sherwin Williams share prices illustrates how the two industries have fared as their market structures have deteriorated on the one hand and improved on the other.

Exhibit 9

Source: Capital IQ and SSR Analysis

One of the problems faced by all “global” markets is that regional consolidation does not make much of a difference if we continue to see new producers in other regions – China and PV Cells is the best recent example – but this problem plagues the commodity chemical segments in general. Where markets are regional, consolidation can make a difference, and the Coatings illustration understates the regional change in the US. Other sub-industries where we have seen positive structural changes include Flavors and Fragrances, Adhesives, Agricultural Chemicals and Lithium (to a lesser degree). A couple of sub-industries still appear to be going backwards, such as Fine Chemicals.

Where we see a better market structure we have more confidence that improved industry and company returns on capital are sustainable and possibly can be improved further. Without the structural improvement we expect to see more normal competitive forces drive returns down to levels that actively discourage investment.

How Appropriate is Valuation? Back to Skepticism

The third chart in the series – the one which naturally follows 2 and 4 – is our look at Skepticism. In Exhibit 10, we show the current Skepticism Indices for the chemical group. As a reminder, if the bar is above the line, valuation is lagging profitability and if the bar is below the line valuation is ahead of profitability. This analysis would raise some possible red flags about our more cautious selections above, as FUL, ARG and VAL have current returns on capital that more than support their current levels of valuation – our concerns with all three are that forward expectations suggest further return increases which seem unlikely. Conversely, this analysis would raise a negative flag for PPG also, but given its recent portfolio changes and very low comparative return on capital versus SHW, PPG has more chance of showing the improvement than others.

The analysis fully supports our positive views on DD, HUN, ROC, EMN, OLN and MON.

Exhibit 10

Source: Capital IQ and SSR Analysis

How Ambitious are Earnings Estimates

In the Exhibit below (Exhibit 11) we compare 2015 estimates and the growth implied therein with what the companies have achieved in the recent past and what a more normalized rate looks like for each based on return on capital growth over time. What we are looking for here are inconsistencies:

  • Do expectations look out of phase with the last couple of years and the longer-term average
  • If we have had a couple of years of growth well above trend – does consensus expect that to continue – unlikely in our view. FUL, SHW, VAL are examples where the last couple of years are probably the anomaly not the new rule.
  • NEU and MON look conservative.
  • DD only looks reasonable on the basis that there is some cyclical rebound from the low in 2012; same for APD.

Exhibit 11

Source: Capital IQ and SSR Analysis

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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.

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