Weekly Findings – January 20th, 2019

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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

January 20th, 2019

Weekly Findings – January 20th, 2019

Thought for the week: “Expect Widespread Cautious Guidance – No Prizes for Being Bullish Today”

  • Chart of The Week – The Slowdown Begins
  • PPG, FUL, SHW – All Showing Caution as a Consequence of Uncertainty
  • PPG – Playing The Next Move Correctly
  • The Small Cap Rebound – Looking For Deals Not Earnings
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – The Slowdown Has Started

In the chart of the week we show the proportion of companies in our broad Industrials and Materials group beating revenue expectations over time, and the sharp Q3 drop off is evident. In the chart below we show the proportion of our group growing revenue and earnings in each quarter. We had long expected Q2 2018 to be the peak, in part because of initial concerns about the slowing Chinese economy and in part because of the “confidence killers” of trade and Brexit. It looks like our Q2 peak prediction is likely to be correct as while Q3 was only a slight downturn, earnings warnings and initial results for Q4 2018 suggest a larger step down for Q4, both in the chart of the week and the chart below.

Q4 stock performance was a clear reaction to this expectation – with Industrials and particularly Materials very levered to the pace of economic growth and always the more volatile sectors as economic expectations change. Where we go from here is less clear from a stock perspective, as while we could see the trend in the chart of the week get worse, companies could still grow revenues and earnings in 2019: IF we get the trade settlement, IF we get an end to the shutdown, IF we get some resolution in Europe, and especially IF we get some infrastructure focus in the US. The sectors have rebounded in 2019, though not by much (we comment on the smaller cap rebound later in this report), and multiples remain low – reflective of more worries than excitement. While we have some select larger cap favorites, we still believe that the better 2019 opportunity is to buy into the expectation of consolidation M&A within the smaller-cap arena where there is a significant valuation disconnect – see prior work. The work focuses on Chemicals, but the same disconnect/opportunity applies across Industrials and Materials

  • PPG, FUL, SHW – All Showing Caution as a Consequence of Uncertainty

Following PPG’s initial warning for Q4, early in he quarter, what we have since heard from SHW, FUL and RPM should not be much of a surprise. Markets around the world and in the US have slowed just enough to lower volumes for Q4 versus expectations, with high incremental margins having a magnifying impact on earnings. Some currency issues have hurt, as well as the more significant slowdown in China.

What is more interesting is the guidance for 2019 – where it has been given. Not unexpectedly, companies are looking at the slowdown in China, on-going trade deliberations, falling commodity prices and the government shutdown in the US and are rightly concluding that there are going to be no prizes for being overly bullish for this year – at least not today. The stocks are trading as if there is a real risk of a 2019 recession, so why set a stretch earnnigs goal for 2019 – better to take the opportunity to reset and suggest something that you can beat.Why be an Optimist – It Does Not Pay! (See research published on Friday)

As we go through the Q4 reporting season, we will be looking for the optimists – those with more “hope” in their guidance for 2019 than makes sense, either relative to economic projections or relative to peers. These will be the companies most likely to disappiont, or with limited upside surprise potential if the macro environment improves.

See separate comments on PPG below; but in general the negative surprises have not punished stocks as badly as they might have 6-8 weeks ago. SHW has already fully rebounded, FUL is up, PPG is up and RPM is also recovering. While RPM and PPG have other things going on, we believe that there is some reflief because of the reset for 2019 in each case. We like the RPM story.

  • PPG – Playing The Next Move Correctly

In a one-line bullet point as part of its 2019 guidance, PPG indicated that it was looking at the Trian proposal of splitting the company in two. In a subsequent Reuters article, it was suggested that Trian would not push for director changes in a proxy fight at the next annual meeting as a consequence of this commitment by PPG. The stock is up since the news, despite some conservative guidance from PPG for 2019. The longer-term pricing chart below does not really show the improvement, as it is small, and still leaves the company stuck in the range the stock has been in since 2014.

The stock has not kept up with the market in 2019, so far, and remains inexpensive on our normal framework – second chart. Because of the willingness to consider Trian’s suggestion we have taken PPG off our “concerned” list for the moment.

PPG is taking the correct path (of least resistance) with Trian and has the advantage of being able to look over many activist engagements over the last 5 years to judge the likely outcomes of different responses. Fighting activists has not worked for anyone, with Dow and Air Products approaches creating far less business and stock disruption than the DuPont, and GE approaches. The question will be whether PPG is simply paying lip-service to Trian and looking to “kick the can down the road” in the hope that the business environment improves and that either the company can pull of a large deal, or simply that earnings start to grow again.

We do not see too much value creation in splitting the company in two unless it can be done in conjunction with a consolidation move in the architectural business – either combining PPG’s piece with Benjamin Moore – or better yet selling to or merging with Akzo. There is probably something that PPG can do that creates more value than business as usual, but it is likely more complicated than a simple business split. Buying Akzo could still work, if the parties could come together.

  • The Small Cap Rebound – Looking For Deals Not Earnings

Subsequent to our M&A piece – published at the beginning of the year – we have seen a rebound in valuations for the smaller cap names in the chemical sector in January – first chart – in contrast to the 2H collapse in 2018 – second chart. While we are not claiming responsibility for this – all small caps have rebounded – we think that our logic is what is driving the rally – M&A.

With the earnings warnings that we have seen so far in 2019 there is some chance in select businesses and geographies that the smaller companies are going to avoid the slower growth and broader market concerns, but it unlikely to be widespread. In many cases they are more levered because of a lack of scale or diversity and revisions could be worse than for the larger cap names. It is likely that the rally in the space is much more driven by expectations of transactions rather than better than expected earnings. Despite the recent rally, the smaller cap group remains at a significant discount to the rest of the sector and the deal multiple arbitrage is little changed.

As a reminder of the conclusions from the M&A work

  • The more obvious take out targets are: KRA, OLN (for someone with vision), IPHS, HUN, FUL, RPM and RYAM, but also possibly WLK.
    • Mergers could include: ASIX/OMN, HUN/EMN, or HUN/CE.
    • LYB should buy 1COV rather than Braskem; HUN should buy rather than sell VNTR.
  • See our work on Optimism for comments on who is vulnerable to activist intervention
    • OLN is one of the more candidates – not straightforward, but with lots of upside from the right focus.
    • Otherwise, the optimist group is littered with paper and packaging names – unlikely to be targets of activism unless there is a path to further consolidation, but the companies do not need an activist to pursue M&A.

  • Weekly Winners and Losers

©2019, 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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