Weekly Findings – December 9th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

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gcopley@ / asalzillo@ssrllc.com

December 9th, 2018

Weekly Findings – December 9th, 2018

Thought for the week: “BASF – The negative of high incremental margins”

Chart of the Week – Chemical Collapse

  • Chart of the Week – Chemical Collapse – BASF – The negative of high incremental margins

Last week’s negative guidance from BASF seems very significant given how late in the year it is and the implication for Q4 to get to the revised annual numbers. However, it is a clear reminder of operating leverage in the chemical industry and the negative side of the cycle. BASF has more than just volume problems, as the company is also seeing reduced commodity margins in olefins in Europe, which fits with the direction of ethylene prices – chart below – but is still disturbing in a market that has also seen crude oil fall from the 80s to the 50s over the last 4 months, which should have lowered input costs. Olefin prices in Europe have clearly fallen faster than quickly declining feedstocks. This is part a function of slowing demand in Europe – BASF mentions automotive demand slowdowns, but the focus in its business problems is China – and partly a function of increased imports from the US depressing both demand for local product and in some cases pricing.

As shown in the second chart, while the gap between European and Asian ethylene prices and prices in the US has fallen meaningfully, there is still an arbitrage to move ethylene and derivatives – it is smaller than it was, and incremental ethylene exports from the US – using the ethylene spot price as a proxy are at break-even economics. Higher crude prices, should the OPEC move work, might give some support to European and Asian ethylene pricing, but if we are in an oversupplied market – which appears to be the case – it won’t matter.

There are many possible readthroughs for the rest of the group. BASF mentioned weak isocyanate markets specifically and both LYB, HUN and DWDP all traded off after the announcement from BASF on Friday. Automotive is another area of weakness cited by BASF, with a particular focus on China. This has implications for DWDP again, but also the coatings companies, AXTA and PPG.

DWDP has some significant synergy goals for the fourth quarter and may be able to offset any weakness, but like BASF, operating leverage is high and in some end markets incremental margins can be as high as 50%. As usual the second derivative plays – TiO2 into paints – continue to be taken to the woodshed – see below and the chart of the week. All the stocks except RPM have underperformed materially this year. But only a few are cheap enough on a “normalized basis” too look interesting today (WLK, OLN and FUL) and the rest have further downside to hit prior cyclical lows. The unknown is TiO2 as we do not have a good cyclical proxy for the sector – again see below.

We would buy WLK and FUL today – WLK has balance sheet flexibility and a strong track record of making very good M&A moves in cyclical lows. FUL will either get the Royal acquisition right and EPS will start surprising to the upside or someone will buy FUL and get the gains themselves. OLN is a different story, as there needs to be a strategy rethink and directional shift before the stock can work. We would be buyers the day the company admits that it paid too much for Dow Chlorine Products and present a plan to fix it.

  • TiO2 – Out Of (Conventional) Options

Four of five the worst performing stocks in the sector this year have TiO2 related problems. This is a sector that is now very much in need of some unconventional thinking.

  • Public investors are not interested because even though pricing remains well above historic lows, they are weakening and with companies like PPG and BASF pointing to slower coatings demand, TiO2 is the clear raw material loser and so expectations remain pessimistic. This is not a late cycle business.
  • The companies are also out of consolidation options, with TROX dropping precipitously this week having made an expensive last-ditch attempt to get its Cristal deal approved. The 30% stock move was in part precipitated by an indication that 23% of the company was up for sale but also suggests that investors think this is either too steep a price to pay to get the deal done – selling one of the best assets – or they think the deal will not get done at all.
  • None of the companies look like interesting acquisition targets, in part because of the cyclicality of the business and the data points that suggest earnings are not yet reflecting an economic low – because we do not have an economic low yet
    • As we have wrote last week – the obvious buyer for VNTR is HUN – this would be the right financial option even if it might not fit with stated strategies – but things have changed, and strategies should be revisited
    • CC looks like a steal at this price, given the strength of Opteon and the cost advantage in TiO2. However, the possible poison pill at CC is the environmental liability – which is hard to quantify. The company is spending money to control its major emission issues, but it is always past liabilities that are the concern as we have seen with the C8 issues and others. Opteon alone is likely worth more than the company overall today!
  • Private equity has plenty of cash and the cash returns from these businesses is very high. It is unclear whether there are any willing sellers in the group.

Despite all this negativity we would buy a couple of the names today – despite the continuous collapse of the last 4 months. VNTR is now so cheap that either HUN will find a PE buyer for its stake or it will buy the business back. Taking out the uncertainty either way will likely help the valuation at HUN. CC is also looking too cheap to ignore and will likely do something to boost interest in the stock given cash flows and the balance sheet – either higher dividends or a major buyback. Take private options look like possible strategies for all.

  • Weekly Winners and Losers

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