Weekly Findings – January 13th, 2019

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

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gcopley@ / asalzillo@ssrllc.com

January 13th, 2019

Weekly Findings – January 13th, 2019

Thought for the week: “An OK Year For Our Optimist Methodology, Despite the Volatility”

  • Chart of The Week – Optimists (generally) Fail
  • Is VSM the Chemours of the Semi-industry
  • Q4 Revisions – Some Correlation With Performance – Not Much With Value
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – A Rare Poor Year For Our Optimist Methodology

In the chart of the week we show the 2018 performance of what would have been the top optimists and most conservative companies at the beginning of 2018. Those companies are listed in the first table below. While the broader industrials group showed what we would expect – outperformance from the conservative group relative to the optimists, the smaller group “Chemicals Only” analysis did not show the expected results. Our work has shown that – with a very high correlation, and over almost any time period, optimists underperform – chart below the first table.

What is an optimist? For those that have not followed our work closely over the last 6 years, an optimist is defined as a company who habitually fails to meet January 1st earnings estimates for that year. The worst optimist has the largest aggregate miss and the most conservative has the largest aggregate earnings beat over time. In the first table, the 15-year sample set (ten years for chemical companies because we do not have a large enough sample set without) is more statistically significant in terms of identifying the optimistic DNA of a company. We show the 5-year analysis to see if there has been short term change and you will note that when we show the optimist and conservative groups for January 2019, there are more changes to the 5-year list as you would expect.

The chemicals segment failed to give the right results because several historically conservative companies were caught up in the commodity sell off – most notably Westlake and Eastman. At the same time the improved sentiment in fertilizers cause a historically optimistic CF Industries to outperform meaningfully. With analysis like this you will not get it right every year, and the makeup of the groups is based on averages over time. However, the methodology did work for the broader Industrials and Materials group in a very unpredictable market in 2018 and has worked well for Chemicals in the past. As of January 10, 2019, the optimist and conservative groups that we should be avoiding and buying for 2019 are shown in the next table – the highlighted names are not on the end 2017 list. For 2018, we are using current 2018 estimates versus January 1, 2018 estimates as we do not have full year reports for anyone yet.

Of course, we should just stop here and say that the analysis is what it is and does not require any further qualification, but where would be the fun in that!

In the table below, we broaden our chemicals universe to include smaller cap names and companies with at least 5 years of history – the table shows the top 10 optimists and top 10 most conservative TODAY (labeled as 2018) on that basis as well as the groups as they would have looked last year. One year of incremental data has fairly limited information as many of the 2017 optimists for were caught up in energy, commodity, trade and economic uncertainty in 2018 that none could have accounted for at the beginning of 2018, and consequently there are some very big differences in the groups that looked bad or good based on 2017 versus those that looked good or bad based on including 2018 and excluding 2013 for example (in the case of the 5 year analysis).

Separately some company specific comments where we have a view:

  • We have no strong opinion on any of the 15 year I&M conservative names other than that we have highlighted OSK a couple of times as a stock that looks attractively valued to us.
  • On the optimist side, we remain concerned about GE and OLN, but have OLN in our “take out” bucket as the business needs a fix and is probably more fixable than GE.
  • Nothing to add on the shorter time frame analysis.
  • On Chemicals it is noteworthy that the two additions to the optimist group on the 5-year analysis, when you add 2018 data, both have activists in their stocks – PPG and RPM – and in both cases the activists appeared in 2018.
  • On the 10-year analysis we like all of the conservative chemicals names – for different reasons and on the 5-year analysis we would only be cautious on LYB because of the strategy shift and uncertainty with respect to what the company might do next.
  • ECL is an eternal optimist but keeps going up because the company misses an ambitious growth number and therefore still grows. In our original work (in 2012) we identified Cytec as having the same problem – the stock rose, but the multiple never really reflected the growth in part because of the optimism – Cytec was an attractive acquisition for Solvay in part because of the discount versus growth.
  • We remain cautious on APD. No strong opinion on FMC. ALB looks like a buying opportunity.
  • Is VSM the Chemours of the Semi-industry

Housing sneezes, paints catch a cold and TiO2 gets pneumonia!

Is the same true in Semis with commodity gases, like NF3, the equivalent of TiO2?

This is what VSM’s stock chart would suggest – below. VSM is levered to the commodity gas side of the business but it is not all that VSM does and while the company has seen some recent negative revisions for 2019 – so has ENTG (CCMP has seen positive revisions – mostly related to the KMG acquisition). Hello Chemours! Same problem – second chart – revisions not that negative – other very attractive products, growing quickly – but trading on the expectation that the TiO2 business is in trouble because, in this case, housing, has peaked.

All the good stuff in VSM’ s portfolio is being valued based on the bad stuff and the same has been true for Chemours. Chemours appears to be in the process of a strategic pivot and has had a better start to 2019, in part because of the expectations around dividend and buy back consistency. Chemours has raised its dividend and repurchased around $1bn of stock. VSM has purchased no stock and has a nominal dividend. VSM has enough cash flow to increase its dividend and start a buyback – either or both strategies might be more appealing to investors who seem disinterested in getting to know why VSM should be seen as more than a supplier of price volatile chemicals into the Semiconductor industry.

As we have written previously, we had expected VSM to be a creative bidder for DuPont’s electronics business, post the DuPont split in the summer. The better opportunity now looks like DuPont buying VSM – based on valuation – assuming DuPont has the skill-set to integrate the businesses and drive stronger growth. DuPont could then spin out a larger and better business in 2022 or 2023, potentially creating a lot of shareholder value.

  • Q4 Revisions – Some Correlation With Performance

In the first chart below we show the largest estimate moves for Q4 2018 since September 31st, 2018 – the ten most positive and the ten most negative – as the average for the quarter for our coverage group was -7.3% it was easier to find the negatives than the positives.

In the charts that follow we look at the groups against both performance and valuation – as we did with the yearly winners and losers last week. Some observations:

  • While the correlation is not very tight – the best fit line in the performance chart at least has the right direction.
  • No-one on the list has positive performance in the quarter regardless of revisions – indicating that fear or concern over 2019 more generally was the overwhelming influence. We mentioned OSK above and this analysis should also garner investor attention.
  • We still like fertilizers – the only segment of Ag that we do like.
  • OLN seems to have been treated well versus revisions – perhaps because the stock was already very cheap – OLN is on out “take out” list for 2019.
  • TSE’s excessive underperformance is in part due to the announced departure of a very well-liked CEO and broader concerns about longer-term demand for styrene – concerns that we share.

The valuation chart, below, is a bit less organized.

  • The premium in GE is exposed again – as it was in last week’s analysis
  • Covestro, Alcoa and UFS all look very cheap. UFS is the clear winner for the last week

Notwithstanding our well documented concerns on GE, we can make a case for buying most of the names highlighted in this analysis. ( CNBC: Is GE’s market bounce here to stay?)

  • Weekly Winners and Losers