Weekly Findings – December 2nd, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

December 2nd, 2018

Weekly Findings – December 2nd, 2018

Thought for the week: “Too Complex and you get a discount – Break-Up and you get another discount – go figure!”

  • Chart of The Week – Complexity: The Discount IS Real – So The Opportunity Must Be Also
  • Small Cap Discounts – Not Limited to Chemicals
  • HUN – Trapped and With A Hard Decision To Make
        • RPM – A Well-Articulated Plan and Achievable Goals – Upside If They Can Execute
  • Weekly Winners & Losers

Chart of the Week – Complexity

  • Chart of the Week – Complexity The Discount IS Real – So The Opportunity Must Be Also

With the news last week that UTX will split into three companies and the immediate negative reaction in the stock it seemed appropriate to revisit our work on complexity and the multiple discount that complexity brings. In the chart of the week we break a universe of 118 companies into three groups – highly complex, minimally complex and those in the middle – the middle group has 40 constituents and the other two have 39. We created our complexity index 6 years ago and we use two compounding measures – the number of reporting segments that a company has, which is then divided by its domestic exposure by revenue. Consequently, the more segments and the more sales offshore, the more complex. The more complex companies in the mix today should not be surprising – they include GE, DWDP, MMM and ITW, but also include companies that sell the majority of their products overseas, such as CBT and CCK. FCX makes the list because it reports in 9 segments. The multiple discounts that the more complex companies receive are significant and the analysis would suggest that there should be value creation in break-up or simplification.

Interestingly UTX does not make the highly complex list, but its proposed break up would take it from the middle group to three companies in the low group – most likely. DWDP would create two companies in the middle group and one in the low group unless Corteva chooses to increase its reporting segments. The market does not like the UTX move because it has learned from DWDP and to a lesser extent GE – the break-up is probably great – but the time taken to achieve it and the costs are not.DWDP – while no doubt working as diligently as possible is now three years from the merger announcement and while the initial excitement is shown in the stock chart (below), the lack of quantifiable catalysts has increased investor caution rather than enthusiasm – now made worse by the less certain economic backdrop. Today DWDP is at a 12.6x forward multiple – to get to 16x the stock has more than 25% upside. In the case of DWDP both the wait and most of the costs are now behind us. This would be our preferred way to play the multiple arbitrage of moving from high complexity to lower complexity right now – all else being equal. We are adding DWDP back to or preferred list.

For UTX and GE the wait and the costs are in front of us and maybe the chart above is something that UTX holders should consider. UTX is already at a forward earnings multiple of 16.7x – so not much upside from the break-up and perhaps downside from the uncertainty around the wait and the costs. The better strategy with UTX’s stock might be to wait on the sidelines for a while. Another troubling (sell) signal for the stock in sell side sentiment – which looks to have peaked (chart below) – in prior work we have shown that a peak in sell-side sentiment is often a sell indicator. We are taking UTX off our favored list for now. The stock was up marginally YTD prior to the announcement of the split. UTX remains attractively valued relative to MMM and HON, but as we have written in recent work these names look vulnerable – especially in a volatile or economic uncertain 2019.

With GE the potential from simplification is huge – and at a current forward PE of less than 10x it also looks like the potential upside is significant. HOWEVER, we don’t know the costs, or the timing, or whether GE can break the company up in a most logical way without leaving a piece that is insolvent. This lack of clarity is what is holding the stock back today as well as the fear that GE Capital in aggregate is insolvent. This statement itself is likely priced into the stock already – but the degree of insolvency and the required remedies create the uncertainty and the fear factor that has the stock price at current levels. GE’s break-up may have to wait until enough cash flow has been generated to make GE Capital a “going concern”, as any “post-split” GE Stub that drifted into insolvency would have ramifications for the spun out/separated businesses.

  • Small Cap Discounts – Not Limited to Chemicals

A couple of weeks ago we published a chart showing the performance disconnect between Small Cap Chemicals and the rest of the sector since September. We used the chart to support an idea that we are likely heading into a prolonged period of further industry consolidation or other M&A moves such as private equity investments. The chart below shows the same performance analysis, but this time for a broadly defined “Capital Goods” basket, including conglomerates, some electrical equipment and some Aerospace and Defense – the group constituents are listed in the table that follows the chart.

As with Chemicals, the smallest cap group has been severely punished relative to the rest. However, unlike Chemicals, it is the next cap group up that has done the best. Consequently, the companies that can move their own needle the most buy picking off some of the smaller companies have had the performance difference to make such a transaction more attractively valued. In the case of chemicals, the better performing group was the large cap group and while some of the cheaper small chemical companies might be of strategic interest to the larger companies they would not likely move the valuation needle.

There is a significant valuation gap between the small cap group and the rest within this capital goods grouping – chart below. Like Chemicals, unless we see some sort of economic catalyst that distracts investors from the idea that we are very late cycle in 2019, we expect the performance and valuation gap to continue and that this will stimulate M&A. We would own a basket of the smaller cap names. Given the pull back in valuations generally in this space, it is not obvious what to short, with the exception of WAB, which we have written about specifically in the recent past.

  • HUN – Trapped and With A Hard Decision To Make

Investors seem to hate two elements of the chemical business more than anything else right now – TiO2 and polyurethane. In the charts below, we show the YTD performance and valuations for both groups. HUN is stuck squarely in the middle penalized both from it polyurethane exposure and from its 53% ownership of Venator – the worst performing stock in our coverage group this year. HUN’s stock is being dragged down by the lack of interest in both TiO2 and polyurethanes.

The company has to make a choice with respect to Venator as the overhang is hurting both Venator and Huntsman, especially since Huntsman announced that it is looking for possible buyers for its stake – which is currently worth less than $300 million, 30% of what was realized with the initial sale of 47% of the company.

The way the market is treating both Covestro – a polyurethane competitor – and Olin – an epoxy competitor HUN might consider buying back VNTR, as selling its stake will raise minimal cash and may not impact valuation materially. From an accretion perspective it is a very cheap stream of cash flow and the better “value investors” buy at the bottom – which is where TiO2 sits today from a valuation perspective, even if not there from a cash flow perspective. There cannot be many other investment options open to HUN today that have the potential to payback in 4-5 years.

While HUN does not look as cheap as it has in the past – last chart – HUN was not public the last time polyurethanes and epoxies earned their cost of capital – which they are approximating today for the better products, of which HUN has many. We believe that our “normal” model has a negative bias for HUN because we do not include a positive cycle. HUN is still expected to generate $1.5bn of EBITDA in 2019 – even if this is too high and we cut it to $1.0bn, the stock would have an EV/EBITDA multiple of 7.7. At the current estimate the multiple is 5.3x

  • RPM – A Well-Articulated Plan and Achievable Goals – Upside If They Can Execute

Our move to a more positive stance on RPM post the Elliott involvement was based on the idea that Elliott was not in the stock for 15%, and with the announced changes in management structure, had a plan. Last week the company rolled out that plan – aimed at cutting costs by streamlining operations, combining businesses, rationalizing locations and systems and driving up free cash flow. The company has also indicated what it plans to do with the cash flows – heavily weighted to share buyback and dividends. The market has received the plan well and is clearly assuming that the new team can execute. We see two possible opportunities for further upside:

  1. The presentation showed a good plan, but it also showed how much low hanging fruit there was – how many facilities – how many different ERP systems, accounting locations etc. The company can do much better than this over time and it looks to us that target have been set that are both ambitious but very achievable (due partly to the inefficient starting point). Expect positive surprises – maybe not so many in 2019 but certainly beyond.
  2. The presentation also mapped out the opportunity for a potential acquirer – giving enough data for a good operator to do their own high level due diligence and look at what synergies could be achieved on top of the proposed cost rationalization.
    1. While RPM shareholders may now have stand-alone plan that could get the stock to $110-120 per share in 4 years, they might take a $90-100 offer today.

The company looks fairly valued on our normal framework (chart) and our return on capital based normal earnings is very similar to consensus today for 2019. Clearly the goals stated in the recent presentation are more focused on improving returns on existing capital than on adding to the capital base.

We continue to like the RPM story and see further upside. It is the most interesting stock in the coatings space unless Trian can make some headway with PPG and even if that happens it is unclear that PPG could offer a better investment risk/reward than RPM today. PPG could be a bidder for RPM – the company has the operational and business integration skills to do everything RPM has discussed this week.

  • 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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