Weekly Findings – August 5th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley

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gcopley@ssrllc.com

August 5th, 2018

Weekly Findings – August 5th, 2018

Thought for the week: “Ethylene and Polyethylene Producers – Skirting Around Guidance – Historically a Dangerous Tactic”

  • Chart of the Week – Hedging the Guidance?
  • SMID Chemicals – Plenty Of Cheap Stocks
  • LYB – The Scary Data
  • LIN/PX – A Bigger Ask from The FTC – not much priced in anyway
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Hedging The Guidance

July looks to have been a terrible month for US ethylene and ended the month as badly as it began. Spot margins have collapsed and while not everyone is exposed to the spot market some points are worthy of note:

  • Most US ethylene contract prices are formulaic in nature encompassing the negotiated contract price – currently sitting just above cash cost of production, the spot price, well below production costs, and some “cost plus” element, which may be the bright spot today.
  • The low spot price reflects what someone is willing to pay to move a marginal ton of an ethylene derivative into the spot export market, or export ethylene itself – current levels suggest that these incremental export markets also look quite poor.
  • While polyethylene producers point to price stability, the reality is that much of the polyethylene that sells in the US does so on a cost-plus basis, so falling with a falling cost for ethylene (except in those instances where ethylene pricing is on a cost formula and may actually be rising with ethane).
  • There is more polyethylene capacity to come on in the US this year and unless 1H growth rates can continue – see LYB section below – weakness could continue

Given this backdrop the three major ethylene players in the US, WLK, LYB and DWDP are playing down the July issue specifically, though all talk of rising raw materials as a headwind. LYB has the most levered risk and probably avoided the issue more than the other two. Westlake tends to put pricing data in its release and there is no avoiding the spot ethylene price – a benefit for WLK.

DWDP probably gave the most significant quantitative negative guidance – suggesting that Q3 EBITDA would only grow by 12% year on year, versus the 20% average of the three quarters since the merger. If we were to attribute all of this to ethylene it is still only a margin decline of 4 cents per pound. We would guess that DWDP expects stronger growth in other areas (perhaps ex Ag) and that maybe the company is factoring 5-6 cents a pound of margin decline on an ethylene equivalent. The negative guidance upset what has been a good trend for DOW since the merger – chart – although the company has given disappointing and sometimes confusing guidance every quarter since the merger.

Since the earnings reports LYB and DWDP have seen incrementally higher revisions to estimates for the year and Westlake has seen cuts to estimates, as has the Westlake LLP (although there is only one active estimate today). It makes sense that the Westlake Partners LLP should see negative revisions as ethylene is getting worse – but if it is getting worse LYB estimates should be falling also as should those for DWDP.

We see three possible outcomes:

  1. A sudden recovery in ethylene profitability in the US and a reversal in recent trends in other parts of the world – in which case estimates might be fine; or,
  2. Frantic negative revisions as we head into early September when everyone has two poor months under their belt (and a negative trend) and IR teams start reaching out to the sell-side to help guide for the quarter
  3. Or pre-released bad numbers in early October or earnings misses in late October.

We think case one is unlikely and cases 2 and 3 fare more likely – see Lyondell commentary below.

Our base case is intact – that all things being equal the industry is only adding enough ethylene and derivative capacity to keep up with demand in 2018 and 2019 – just mostly in the US – which is where all the trouble is today. We see a strengthening trend once the dust settles. The problem is that the dust may settle hard in Q3 2018 and that estimates for 2H 2018 may be quite a bit to high – especially for LYB and DWDP – we still see WLK as a relative safe haven and would hedge with a long WLK short LYB trade for the near-term given recent performance if that was our investment style. Long term we like all three, but…

  • LYB has real transaction risk if it buys Braskem for a high value (in terms of asset replacement cost) and we hit a prolonged trough. Note that currently Nova is barely covering cash costs on the unit it acquired at full replacement cost from Williams last year.
  • If the margin pressure continues, DWDP may be trying to spin off DOW into a market that has little immediate interest
  • SMID Chemicals – Plenty Of Cheap Stocks

As the reporting season progresses we are seeing some significant inconsistencies between results and valuation/performance. Many of the companies with the largest revenue and earnings surprises thus far sit at the low end of the valuation range while some expensive names have produced results that have shown nothing spectacular

  • Our electronics thesis is largely intact with the companies reporting earnings beats and seeing the performance to support the strong earnings growth – in the chart below we show CCMP and ENTG (VSM and KMG have yet to report).
  • The Ag story is also working – better numbers and better performance and we probably should have focused on UAN as the more levered name as well as CF and MOS
  • But that is about where it ends!
    • BPCP remains one of the best performers of the year despite disappointing numbers and ridiculous valuation – see second chart. The stock has weakened since the earnings reports, but this has happened before only for the rally to continue.
      • We still like the BCPC short, IPHS long idea – IPHS missed expatiations largely because of a plant turnaround.
    • TSE and HUN continue to throw out positive surprises, but the market does not seem to care – both are now trading at low enough multiples of EBITDA to be interesting “take private” ideas – as is 1COV in Europe – share buybacks should be a priority for these companies.
      • If private equity is willing to look at ARNC, which is trading at 9x EBITDA and has commodity risk, TSEat 5.5x looks much more interesting in our view.
    • SMG is not yet showing the earnings trough that we anticipated and while you are getting the hydroponics business for free at this level of valuation, it looks like it is not worth much right now – we would buy on any further weakness
    • RPM put up some very poor numbers for the quarter, but we believe that the Elliott led restructuring will deliver either better results or a sale – so we would stick with it.
    • LYB is not getting a great deal with SHLM in our view, despite the way the company discusses the opportunity.
    • Despite its attractive valuation and TiO2 pure play nature, VNTR cannot seem to get out of its own way – it is the worst performer in the SMID group this year and this week – perhaps it is better off in private hands.
      • The market appears to have given up on TiO2 despite reasonable industry cash flows. The third chart shows performance from the beginning of July and both VNTR and TROX appear at the very low end with KRO also underperforming. CC is riding on the success of Opteon, not TiO2, although CCs TiO2 business continues to perform well.

  • LYB – The Scary Data

LYB and WLK provide a lot of data with their quarterly reports – LYB providing margin data and WLK providing some industry pricing data. Most of what they produced shows some of the issues that we discussed earlier with respect to July profitability, but LYB showed some data that has us far more concerned

The company showed a table that suggested first half 2018 polyethylene demand was up 4.6% in the US and Canada and 6.6% in Northeast Asia. Even with the strong economic growth in both regions, these numbers appear to high and well of historic trend – by at least 100 basis points. The cause may be a consequence of the trend in the chart below – oil has strengthened significantly over the last year and meaningfully in 1H 2018. Oil is perceived to have an inflationary impact on plastic prices as the marginal supplier is oil based – rising energy prices generally leads to an over-buying of plastics as consumers try to get ahead of future price increases.

Oil weakened in July – but is sufficiently volatile that one month would be unlikely to change market perception. If oil were to see a steady decline – even only back to the mid-$60s, with some certainty about that direction, we could see a switch in polymer buying patterns and some polyethylene pricing weakness – which on top of the current US ethylene cost issues, could cause an even sharper drop in profitability in Q3 2018.

  • LIN/PX – A Bigger Ask from The FTC – not much priced in anyway

Linde (LIN) was in the news yesterday, suggesting that the FTC was asking for a larger divestment package from LIN to approve the deal in the US and that the divestments in total may exceed the threshold agreed by the companies, allowing either to pull out of the deal.

We do not believe that the deal will fall apart and that if the threshold is broken the parties will likely agree to go ahead anyway. However, should the deal fail we do not see much downside in either LIN or PX – with business improvements since the deal was announced justifying current prices – see the return on capital charts below and our recent work on PX. LIN has not seen the earnings growth that PX has experienced over the last 18 months but has seen a significant step in return on capital, partly because returns were very low and any increment in income makes for a big change, but also because its capital base has fallen since 2016. Returns remain well below those of PX, at around 7% but have recovered by 200 basis points in 2 years.

LIN is trading at 10.7x last twelve months EBITDA, compared with 12.2 for APD and 14.1 for PX. Both of the US companies have substantially higher returns on capital – but Linde, like PX has a very positive slope to its recent return on capital spend

We like both PX and LIN because of the deal – more scrutiny from the FTC certainly increases the risk that the deal is not done, but neither PX nor LIN appears to be pricing much in at this time and current business trends are supporting of current valuation.

  • Weekly Winners and Losers

Despite tariffs and better earnings, uncertainty around trade and commodity price volatility is having exaggerated impacts on stock prices, with both X and STLD impacted by a recent fall in US steel pricing as well as a pessimistic futures market. VNTR missed earnings significantly; TROX beat expectations but was likely dragged down by VNTR and a general lack of TiO2 interest. IIVI reports on the 7th but has been hit by tariff concerns.

Both FLR and KBR had strong revenue surprises, as did CF, BMS and BDC. BDC is a very inexpensive stock based on our normalized models.

©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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