Weekly Findings – August 26th, 2018 – Focus on LYB

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

August 26th, 2018

Weekly Findings – August 26th, 2018 – Focus on LYB

Thought for the week: “Peak of the cycle investing: Lyondell ahead of several others”

  • Chart of the Week – Overconfidence Creeping in.
  • LyondellBasell – Not expensive but has downside
  • RPM – Setting Up For A Sale
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Overconfidence Creeping In

Last week we questioned whether Q2 might turn out to the best it gets for Industrials and Materials, if not in terms of earnings and revenue growth, then in valuation and market outperformance. In the chart of the week we look at the companies that missed earnings expectations in Q2 – 17 companies out of 120 in our group. They fall into three categories:

    • Those exposed and very levered to commodity pricing swings and where it is very hard for analysts to get the swings right without very active guidance from the companies during the quarter – these are highlighted in red in the chart
    • Those where valuations are high, performance has been good, and expectations were forced higher by performance in order to maintain positive ratings – these companies are highlighted in green and that list could include MMM.
    • A few that got it wrong – either the quarter or communication – and…
    • SHLM – see LYB section below.

We want to focus on the second group as we think this could become a larger group over time. At the beginning of the year we did a piece on peak valuations and the summary table from that work – in January is included below. At the time we noted that a number of sectors we above prior peak valuations and others were close. The green highlighted companies in the chart of the week, have, for the most part seen significant share price appreciation without meaningful earnings growth – the value gain has come from multiple expansion as the market multiple has grown.

If you are evaluating stocks on a relative basis, which is our preferred methodology, then the moving market multiple gives you some recommendation latitude. If not, you are forced to keep raising target prices and earnings estimates (at a fixed multiple) in order to keep a positive or even neutral rating – and as such earnings can get ahead of what a company can achieve. In an inflationary commodity and labor environment in the US the number of companies that miss optimistic estimates may increase from here.

Chemicals, Metals and Packaging (so materials) continue to look more interesting sectors than the industrials groups, but they are also the most levered to economic weakness from a valuation and volatility perspective, while they may still show the greatest upside to past peak valuations. Since the work we did in January, Capital Goods has become marginally less over-valued, but otherwise the picture looks very similar.

  • LyondellBasell – Not expensive but has downside

In our opinion LYB is starting to make some considerable strategic errors, and while a recovery in the ethylene/polyethylene market would expose the relative attractiveness of the stock from a valuation perspective, without this there are risks.

  1. Polyethylene has drifted further in the US in August, while ethane prices have moved slightly higher. Integrated polyethylene margins could bas much as 7 cents per pound lower in the US in Q3 2018 versus Q2 if there is no recovery in September. First chart.
    1. LYB has around 12 billion pounds of ethylene capacity in the US and if the company saw this full decline across the entire US ethylene portfolio that could knock 50 cents per share from earnings sequentially.
      1. On the plus side, styrene has not seen the same decline as polyethylene as most is sold on a formula
      2. On the negative side – Europe will also most likely be weaker in Q2
      3. Currently Q3 estimates are 60 cents lower than Q2 – possibly conservative enough but it is unclear as refining margins look like they will be lower in Q3 versus Q2 without a recovery in September

  1. Q3 numbers will be confused by 6 weeks of ownership of SHLM, given that the deal closed this week. The company will likely take a charge for integration costs and one time deal related charges and consequently the LYB Q3 headline number will be much lower than consensus.
    1. We think this is bad deal for LYB, and while LYB talks about earnings accretion, the deal was very dilutive on a multiple basis, especially given the significant earnings miss in Q2 2018. This is not the first time that SHLM has surprised the market with very negative results – chart – and we wrote a piece in in 2016 where we debated whether SHLM was poorly run or just in some bad businesses – we concluded that it was a combination of both. LYB has overpaid for a portfolio that is poorly managed – presenting room for improvement, but at the same time in some bad markets – not easily fixed
    2. One of the concerns that we have is the packaging exposure the in the SHLM portfolio – given as 39% of sales in SHLM’s 2016 presentations and reduced to 25% in the LYB deal presentation – second chart
      1. With the mounting pressure on packing waste and the expectation that consumer products and food companies will want to be seen to do the right thing, we see a scenario where compounded packaging demand trends to zero as a compounded polymer cannot be easily recycled. We are especially interested in why LYB thought this was a good idea given its move in polyethylene and polypropylene recycling in Europe
      2. We understand the automotive appeal, given LYB’s existing polypropylene compounding business, but this and other segments are going to have to grow quickly to offset losses in packaging in our view.
    3. As long as LYB retains this business it will trade an appropriate commodity chemical multiple and if LYB manages to turn the business around and improve the profitability it will not impact the overall company multiple because it is too small.
      1. In 2001, Millennium Chemicals decided to focus on the “specialty” piece of its portfolio in an attempt to persuade investors that the company was undervalued. LYB is not making this claim (yet) and would be wise not to as the Millennium move cost the then CEO his job!
      2. The opportunity for LYB is to fix this business, integrate it with its own compounding business and then sell or spin it out – capturing the multiple arbitrage which exists today between LYB and POL – 5x on an EV/EBITDA basis.

  1. Spending at the peak – LYB broke ground this month on the long-debated PO/TBA facility in Texas. This is a $2.4 billion-dollar investment to add significant capacity to the slow growing, but currently profitable raw material market for polyurethanes.
    1. My now 35 years of association with the chemical industry tells me that it is generally not a good thing when a company announces something as the “single largest investment in the company’s history”. The value creators in this industry buy well and build cheap. Note that as DOW, CPChem and Exxon have brought on stream their new integrated ethylene complexes in the US they are seeing margins that are as much as 75% lower than they were when the decision to invest was made.
    2. LYB is not the only chemical company investing today, as costs rise and margins for some products fall, but it is the first of the new group to break ground. As we have written previously, we would expect others – mostly looking to invest in ethylene – to be reviewing plans based on current margins and re-working forecasts to reassure that planning assumptions have not changed.

But, Lyondell is not expensive, and trough valuation work that we did in early 2017, to support a buy recommendation at the time, derived a value of $106 per share – lower than today’s price but a 20% premium at the time. On this basis the downside is not that great, but in the work in 2017 we had assumed that European profitability fell to zero and the US “shale advantage” remained in place. The US shale advantage is looking less robust today, but Europe has not seen a collapse in ethylene margins. At less than 7x EV/EBITDA, LYB is not expensive, but if EBITDA falls by 25%, as it could in a weak ethylene market, the stock would likely test its 2017 lows again.

  • RPM – Setting Up For A Sale

Despite appearing in the chart of the week as one of the few EPS misses in Q2 without a real excuse for it, RPM is in the “winners” category for last week and is now up 28% year to date, despite negative revisions. The march higher, which began when Elliott announced its agreement with the company around management and governance changes in July – chart – was helped this week by the company removing a “Poison Pill” provision, effectively opening the door for a bid.

The question now is how much further upside there could be in a bid – as the stock is no longer cheap – second chart.

    • There are no pure play comps, as this is not a “coatings company” like SHW and PPG. The company has far more products and is much more focused on the big box retailers and other specialty sellers to get to market. From a raw material and process perspective, it does look like PPG or SHW (more the VAL piece), but from a marketing perspective it looks more like Masco, SWK or the Buffett building products businesses or perhaps OI.
    • Anyone buying the company is going somewhat off-piste, and a Private Equity bidder would have to see either significant cost opportunities or a break-up.
    • The opportunity is the SG&A, which at $1.65 billion is 2.4x EBITDA. If you were to assume that you could run the company with half the current SG&A. EBIDA could increase to $1.5bn – the stock could have 40% further upside and still sell for 10x potential EBITDA
      • Even if we are off by 50% in terms of upside, it is likely that you get the return by year-end – which looks good on an annualized basis

  • Weekly Winners and Losers

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