Weekly Findings – July 15th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley

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gcopley@/ssrllc.com

July 15th, 2018

Weekly Findings – July 15th, 2018

Thought for the week: “Stock coverage is deteriorating – an inevitable unintended consequence of MiFID II or more of a macro issue?”

  • Chart of the Week
  • Ethylene – Worse Than We Expected, But We Have Certainly Found a Bottom!
  • A SMID Pairs Trade – Long IPHS, Short BCPC
  • YTD – Trade Driving Underperformance – Corporate Action Winning
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Not Much Opinion Despite Lots of Uncertainty

Are we seeing one of the almost inevitable consequences of MiFID II – no research – or is this month just an anomaly?

I have been spending the last two days updating the now rather large data set that drives our monthly chemical industry analysis – this is something that I have not done for years and my involvement is prompted by the departure of my long-time associate. It has been an interesting exercise (if not time consuming given that I no longer have the computer skill of someone in their 20s). Part of the process involves refreshing consensus estimates – one month from the prior refresh – and I have been distracted by the lack of activity in what are effectively the 30 days leading up to a reporting period. In the chart of the week we show the average (current year) estimate revision across our chemical universe in the 30 days prior. July shows little movement, but July 2015 showed less and both are outliers. I would argue that today we are being bombarded with change – wavering economic confidence – M&A – volatile energy prices – collapsing ethylene profitability and rising fertilizer profitability. So, why are we not seeing revisions; is it uncertainty – July 2018 should be the high point for revisions – apathy or the absence of an economic incentive?

The chart of the Michigan Consumer Sentiment Index (below) which showed a disappointing July number last week is one of many things going on at the macro level:

  • Oil is high but volatile
  • Trade discussions are a rollercoaster and partly to blame for the sentiment index decline – they present both broad economic uncertainty and company specific uncertainty – especially in those industries in the US that rely on exports – so, Chemicals
  • Ethylene economics in the US have collapsed – hitting an all time low in July – see below
  • Fertilizer prices are rising – driving some of the only estimate revisions that we have seen over the last 30 days.

So, why the sell-side inactivity. Perhaps the volatility of the macro data is overwhelming and few want to risk a change of estimates that might trigger a change in recommendation based on a factor that could swing in the opposite direction quickly. The US Administration appears to be wielding a big and unpredictable stick on trade, while at the same time saying that it wants good trade flows with everyone it is currently doing battle with, creating a hard to model possible outcome.

However, some of the other factors are relatively easy to fit into an earnings model – especially changing costs and prices. It is quite likely that MiFID II has had the reverse impact on research that was intended – i.e. much less actual research being done! As investment managers cut budgets they are also for the most part increasing internal controls and accountability with respect to what research is paid for – as they should. This is manifesting itself for most companies in the shape of “interaction” databases; meetings, planned calls and of course corporate access. Today, if you want to get paid on the sell side you must get interactions – “research access” payments barely cover the rent for most sell side firms and consequently interactions are the focus.

The onus is falling more and more on the research analyst, with little he or she can outsource – the paying client relationship is with the analyst (not the salesperson) and the “all important” corporate connection is also with the analyst. As management pressure (and survival instincts) drive behavior, who has a quiet few days to think about earnings models and estimates, except for the four periods of the year where they are in focus?

The problem is more acute for smaller cap corporates who are at risk of losing research coverage altogether and already talk about the quality of the research following the have deteriorating. Four of the companies we cover in our SMID analysis have no formal analyst coverage and we are seeing the emergence of machine driven research where reports and recommendations are more automated.

As an investment manager, while you are being forced to manage your research budget and receive research from fewer providers, you are part of a process that is likely to result in less reliable (useful) estimates and a consensus that increasingly reflects company guidance and only moves when companies provide updates. Today it may not pay to do the work to support a non-consensus view.

  • Ethylene – Worse Than We Expected, But We Have Certainly Found a Bottom!

In our Chemicals Monthly, which we will either publish later today or early tomorrow, we have a changed format and added a monthly focus, which this month has to be ethylene. If mid-July raw material costs and prices hold for the month, July 2018 will see the lowest ethane based ethylene spot margin in the 38 years for which we have comprehensive data – chart below. At a cash margin of negative 7 cents, even the most efficient ethane based ethylene producer is selling at or below raw material costs, before and cost of conversion. Ethane prices have spiked quickly over the last couple of months and are off their peak, and it is likely that sellers of spot ethylene at 13.5-14.0 cents per pound are doing so from inventory that was made when ethane prices were lower. The margin in the chart is unsustainable as no-one would operate based on those economics – so either ethane will fall, ethylene prices will rise or production will be curtailed

This was all part of range of possible outcomes for 2018 – ethylene starting up before derivative capacity creating a short term ethylene surplus (Exxon the most recent start-up) – ethylene starting up before enough capacity to move ethane or NGLs from the Permian was completed, creating a short term limit on supply. These events have coincided and ethylene is squeezed in the middle with likely no-one really caring on the business side because it is all seen as temporary.

  • Polyethylene capacity and other derivatives will start up to consume the ethylene
  • Ethane availability will rise and prices will fall – in theory.
    • Longer-term the US ethane surplus is expected to be substantial – large enough that this month we have seen INEOS announce its intent to build a new ethane based ethylene unit in Europe to be supplied with ethane from the US.
    • As shown in the chart below current ethylene prices sit well below the MARGIN (green line) that you would need to justify investment – INEOS must be banking on a significant reversal to justify shipping to a new build in Europe, although INEOS is likely more focused on an ethane surplus in the US Northeast rather than the US Gulf.

We have always expected 2018 to be volatile and had expected Q2 to be a low point, but not this low and clearly Q3 is starting worse than Q2. There should be enough demand growth globally to absorb the new US capacity in 2018 and we still expect the year to end on a strengthening trend.

The near-term risk is that Q2 earnings reports and Q3 guidance reflects the current pricing environment. Polyethylene is giving up some ground with ethylene and it is unlikely that producers will be confident that they can make as much money in Q3 as they do in Q2 (LYB is currently expected to see a 7% drop in Q3 EBITDA versus Q2 – this may not be enough of a decline). DWDP is expected to see a significant drop Q2 to Q3, but most of this is Ag seasonality.

WLK is likely to be the winner as the company is currently the largest buyer of ethylene in the US – mostly on a spot basis. The spot versus contract difference in Q2 was worth around $50 million to WLK and given the relative strength in the PVC market, WLK could have a strong Q3. We would buy WLK and DWDP today and on any weakness. We might get a better entry point for LYB.

  • A SMID Pairs Trade – Long IPHS, Short BCPC

We highlighted BCPC as a possible short in our initial SMID report in January, purely based on valuation which discounted growth rates that looked highly unlikely. So far ewe have been completely wrong – the stock has continued to outperform despite growth and growth expectations that seriously underwhelm. In the first chart below, we show EV/2018 EBITDA for the SMID group with BCPC the obvious outlier. In the second chart we show the discrepancy with growth.

By contrast, IPHS, with has some significant end-market overlap with BCPC, while performing very well this year, has a major valuation discount to BCPC.

BCPC is at this point a “cult stock”, but can only maintain that status by buying something to drive stronger earnings growth and the company has enough of a stock premium to pretty much anything. IPHS could be a possible target for BCPC – it is large enough to move the needle. We like IPHS anyway as we think that the company has made the right divestments to create a growth platform, and we would be own the stock without the pairs trade.

  • YTD – Trade Driving Underperformance – Corporate Action Winning

Reflecting back on the macro issues discussed in the first section, we thought that as we head into earnings we would look at performance to date and we include the ten winners and losers in our large and mid-cap industrials group in the chart below. Interesting to note:

  • The S&P is up YTD almost exactly what the gain was last week – see very last chart.
  • The average stock in our group is down 3.4% YTD – despite positive revisions and strong revenue momentum across the board.
    • Economic doubt is the issue, primarily driven by the trade antics of the last 3 months.
    • However, if we had done the analysis at the end of March we would have similar average relative performance for the group.
  • In the leading group below, we have a number of special situations
    • RPM and PAH – Activism
    • SHLM – Acquisition; WAB expected M&A (which we still believe will disappoint and we would be short WAB).
    • Transport is a domestic sector for many – less impacted by trade and currency.
  • In the lagging group we have a bunch of different drivers:
    • Expectations bubbles bursting – SMG, ARNC and ALB
    • Selling shareholder overhang – VNTR
    • Trade – the machinery names
    • GE!
  • The different fortunes of CLF and KMT showing the benefits of producing metal in the US versus the possible negatives of selling into the consumers of metal markets which could slow as a consequence of higher prices.

  • 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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