Weekly Findings – June 10th, 2018

gcopley
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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 10th, 2018

Weekly Findings – June 10th, 2018

Thought for the week: “A Technical Issue with DWDP – Maybe”

  • Chart of the Week – Is There Still Upside in Materials?
  • A DWDP Technicality – Bayer is Complicating Things
  • Brazil – Here We Go Again
  • Weekly Winners & Losers

Chart of the Week – Is There Still Upside in Materials?

  • Chart of the Week – Is There Still Upside in Materials?

The chart of the week shows the struggles with investing in Materials right now – absolute multiples are high, though off their recent peaks, but relative multiples (even with slight different data set definitions) look very low. EV/EBITDA multiples rise in anticipation of strong growth in EBITDA – something that the Materials sector has seen more recently than when the multiples began to expand. It is interesting to note that when we started the business at SSR in 2012, all of our valuation models suggested that you should buy the materials group and that we should have simply left the analysis there and not tried to be too clever. That said, staying away from metals for the first 3 years was the right call and throughout the period metals has remained the cheapest space on a discount from normal basis – just much less of a discount today than in 2012.

Continued EBITDA momentum will likely drive the sector higher, even without any further multiple expansion and this would be the reason to remain overweight. It is likely that several factors will continue to pressure further multiple expansion:

    • Concerns around the length of the current economic expansion – “it has to end at some point” – Materials is generally the most volatile at points of macro inflection
    • Trade – escalation could upset lots of industries within the Materials space
    • The lack of progress on US infrastructure – this is as much a sentiment driver as a business driver
    • Wage inflation – a subject being raised by a number of companies across Industrials and Materials today

Strong EBITDA momentum will keep investors interested in the space and revisions and earnings will likely be the deciders.

Few materials companies look very expensive today on a forward EBITDA basis (relative to their own history) – only PX because it is pricing in some of the Linde benefits and EMN, in part because its historical multiples have never been high. We like both of these names, but because of earnings momentum and not because we anticipate higher multiples. PX has a bump in the road from Brazil ahead (again) – see below.

  • A DWDP Technicality – Bayer is Complicating Things

The cost rhetoric from both sides of the DWDP camp have resonated, and barring any upsets the stock is likely to have a good second quarter. However, there are a couple of hurdles (Brazil – see below), and a technical problem that may have some impact arising from the closure of the Monsanto deal by Bayer.

With MON gone, DWDP is now more than 25% of the US chemical indices that many managers use as benchmarks. Some managers will not allow a fund to contain that large a proportion of one stock. It is unclear to us how many funds are impacted, but DWDP might, unless exemptions are granted, see a bit of selling pressure this week.

Exemptions might well be granted where possible, because, if not, funds would be underweight DWDP at the time of the first split, which may well see a step change in valuation.

It would be a shame for technicalities to get in the way of a good story as DWDP is articulating its cost opportunity very well right now and Ed Breen in particular appears singularly focused on doing what it takes to add shareholder value. We have now written about DWDP three weeks in a row, so it should be clear that we like the story – we have no idea whether there will be much, if any, selling pressure this week for technical reasons but we would buy on any weakness. Conversely – the rest of the group could benefit near term, as MON holders now have cash to redeploy – maybe in Chemicals – if you are not overweight DWDP already, it is an obvious place to go to get some Ag exposure back.

  • Brazil – Here We Go Again

The Real is falling – again – as Brazil’s policies towards subsidizing fuel have caused the CEO of Petrobras to resign and jarred confidence in the ability of the Brazilian government to maintain free and competitive markets. Many of the US chemical companies have significant exposure to Brazil and while we tend to start with Praxair, Air Products, DWDP and now FMC have significant exposure also. Bayer has just acquired significant exposure to Brazil with Monsanto. For the Ag companies the Brazilian seed and chemical market is going into its slow period and the Real impact today is not that high – it could get worse or better before it really matters from a seasonal sales perspective.

For the gas companies it is an immediate impact. As shown in the chart, the last collapse of the Real coincided with significant underperformance for PX. That said, not much was going right for Industrial Gases in general in that period, with US and European growth also very slow – Brazil certainly did not help. PX saw South American sales fall from just over $2bn in 2013 to $1.4bn in 2016. Margins remained high, but operating income fell by around $200 million over the same period (70 cents per share – pre-tax). PX managed to grow sales and EBIT in Latin America 2017 but the recent currency move, if sustained, will put a dent in 2018 earnings and may impact the stock even if investors are more focused on the merger. PX outperformed the market once the Real improved from 2016.

But PX is not alone with this exposure. PX has around 10% of its sales in Brazil. APD no longer breaks out Brazil or Latin America, but we estimate that around 5% of sales are in Brazil. FMC may now have one of the largest proportional exposures to Brazil after its acquisition of DuPont’s crop chemical assets – Latin America is 31% of FMC’s sales based on 2017 disclosures. Currently DWDP is giving minimal data – likely waiting for the splits, but Dow Ag historically had a significant Brazil exposure – much diluted in the larger DWDP today.

We would buy PX on Brazil related weakness as we believe that deal related regulatory issues will be solved fairly quickly – possibly this month – and the positives from the merger outweigh the risks in Brazil.

  • Weekly Winners and Losers

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