Weekly Findings – August 19th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley

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gcopley@ssrllc.com

August 19th, 2018

Weekly Findings – August 19th, 2018

Thought for the week: “Is Earnings Growth As Good As Its Going To Get”

  • Chart of the Week – Was This The Last Good Quarter
  • Ethylene/Polyethylene – No Recovery In August
  • APD – The Inevitable March Towards Multiple Contraction Continues
  • Steel and Aluminum Tariffs – Pleasing a Few At The Expense of Many
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Was This The Last Good Quarter

In Q2 we have seen a further improvement in the number of companies in our Industrials and Materials universe growing revenues and earnings – chart of the week. In the case of revenues. 102 out of 104 companies grew revenues in Q2 – the highest percentage this decade. Earnings growth was also a high for the decade. But is this the best it gets? Possibly, and even if it is not the peak and we can push through the balance of 2018 at similar levels, will anyone care from an investment perspective?

On the positive side, EBITDA growth remains strong – first chart below – with most sectors at or above median levels – peaks and troughs defined by economic troughs and recoveries not the steady and strong growth we see today. As the sectors have generally underperformed this year, stocks are on average getting cheaper as EBITDA grows. But there are negatives also:

  • In the chart of the week, the growth in the number of companies showing earnings growth, while still strong, is decelerating. This is largely because of the challenging backdrop of rising raw materials costs – higher energy (see section on US ethylene below) and higher metals pricing because of tariffs (note DE’s earnings last week). Companies are pushing through pricing because of the strong economy – driving revenue growth, which is just keeping pace with costs. Median EPS growth in Q2 was no better than Q1.
  • In the second chart below we show revenue and EPS surprises for the same group of companies. This chart looks good, but not as good as it did for Q1 2018 or for Q4 2017 – expectations are catching up with the stronger market and if history is a guide they will start to run ahead and the shape of the second chart below could change meaningfully by the end of the year.
  • Costs are ramping up quickly in the Chemicals space with US ethane prices hitting a high in August – see section below – LYB looks most exposed with Q3 estimates off their peak but still higher than they were a month ago.
  • All of the things that DE talked about – higher metals prices and higher transportation costs. The US is seeing some pockets of inflation outside what has been driven by tariffs
  • Hubris – history shows us that management teams and analysts always miss a point of inflection in business dynamics. We suspect that Q2 2018 might be as good as it gets for earnings growth for a while – the bulls are focused on growth (which is strong) but costs and optimism could be the spoilers.

  • Ethylene/Polyethylene – No Recovery In August

Ethane pricing remains a problem in the US Gulf – hovering around 39 cents per gallon in August. From a raw material cost alone, this is more than 16 cents per pound for ethylene – the most recent spot price is 15.25 cents! The economics make no sense, but the spot price is being fed into formulae for the sale of ethylene and for the sale of polyethylene for much of the market.

Ethane is steeply higher relative to Brent crude – first chart – and while still much lower than history, this directly impacts the economics of exporting US produced ethylene-based derivatives. Polyethylene pricing is sliding – as shown in the second chart – but margins are collapsing on an integrated basis because of the increase in ethane – all US polyethylene producers have integration back through ethylene.

We have discussed in prior work the challenges of investing in ethylene and we expect that there are some tense meeting going on between potential JV partners for new US facilities, and that both Shintech and Formosa are regrouping, as it is almost impossible to ignore the current situation when looking at a long-term investment.

Near-term we still think that Q3 estimates do not reflect the turndown in margins – especially for LYB. DWDP had some implicit negative guidance its Q3 and full year forecast if you believe that the synergy numbers that the company discussed are possible for Q3 and Q4. However, the reduction in estimates may not be enough. The same is probably not true for WLK – strong PVC and significant spot ethylene purchases could help WLK in Q3.

  • APD – The Inevitable March Towards Multiple Contraction Continues

APD is one of our weekly winners, with the stock responding well to news that the company will invest heavily in a gasification and energy complex in the Southwest of Saudi Arabia – effectively acquiring 55-65% of the complex from Saudi Aramco and committing roughly $2.0 billion of capital, plus taking on a similar percentage of project-based finance.

While fixed fee-based contracts are never risk free, it sounds as if APD has struck the best deal possible, even if the deployment of the capital is likely to return less than the current company average. This adds to our concern that the company is back in a “dilutive capex” cycle when it comes to capital deployment. The bull case focuses on earnings growth – if the investment goes ahead as planned APD will see a step up in EPS in 2020 to reflect the capital that has been deployed and capital will step up also – second chart.

The company is doing a very good job of finding ways to spend free cash flow on projects that return more than their cost of capital and (in theory) present a better return than buying back stock. EPS will grow as a function of this move and moves like this – but the shape of APD is changing and that has always been our concern.

  • This project alone will account for more than 10% of APD’s deployed capital in 2020
  • The China gasification project is another significant deployment of capital – more than 5% on one venture.
  • Neither of these ventures are without country/political risk
  • APD does not want to be compared to a utility company as even the best trade at significant multiple discounts to APD
  • Nor does APD want to be labeled as an oil service company – volatile and lower multiples.
  • If this project boosts APD’s earnings in 2020 by 8 or 9% as suggested, but the company loses 2x multiple points of earnings because of the changing nature of the business and the risk profile associated with it, there is no gain in value.

To be fair to a very talented management team at APD, we cannot think of a better strategy today, but while the changing regulations for shipping fuel may provide a boost longer term to APD’s gasification opportunities, beyond the Jazan project, we do not see this business being valued as highly by investors as the traditional industrial gas model.

Consequently, we continue to favor PX over APD. APD is not expensive as long as it can hold on to its historic multiples.

  • Steel and Aluminum Tariffs – Pleasing a Few At The Expense of Many

Critics of increasing tariffs, and there are many, point to net negative impact it may have on the broader economy, while only potentially benefitting a few. Raising tariffs on Steel and Aluminum may help the sellers, but only if demand remains robust and consumers in the US are not rendered uncompetitive as a consequence. Equally if some other secondary or tertiary effect impacts demand growth or perceived demand growth, global pricing may fall – leaving US based producers with the benefit of a tariff but off a lower base price. This is clearly the case for Aluminum – chart below – but even US steel prices are off their highs. As can be seen in the second chart – which shows all the major metal producers and consumers in our universe, the losers outweigh the winners significantly – producer and consumer. If you ignore CLF (which is a very focused beneficiary of steel tariffs), only DHR and IR have beaten the S&P 500 YTD.

Clearly the investment community is not a fan of tariffs. In this group we would focus on SWK, AA, FCX, TRN, and UTX, although OSK is looking very interesting from a valuation perspective. We would stay away from GE and ANRC (despite the PE rumors).

  • Weekly Winners and Losers

©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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