Weekly Findings – June 17th, 2018

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 17th, 2018

Weekly Findings – June 17th, 2018

Thought for the week: “The M&A Landscape Is Little Changed – Desire Is Limited By Opportunity”

  • Chart of the Week – M&A Outlook Has Not Changed
  • Braskem – A Smart Play for LYB if….
  • BPCP – Nothing Is This Special!
  • Weekly Winners & Losers

Chart of the Week – SMID Chemicals May 10-June 10

  • Chart of the Week

In the chart of the week we show the relative performance of small and mid-cap chemical companies versus their larger cap peers. To be fair, the small and mid-Cap group has done quite well in terms of earnings growth and revenue growth this year, but the outperformance, in our view, partly reflects investor ownership in anticipation of more M&A. We have been advocates for some time of owning a basket of intermediate mid-cap chemical companies for because of the likelihood of acquisition. This is likely no different in other subsectors of Industrials and Materials. While the overall economic outlook remains good giving companies organic earnings growth for the most part, few are under any illusion that we are a long way into this economic cycle and some of the organic growth drivers may not have much further to go. Earlier this week I read an article on one of the news outlets suggesting that larger M&A deals were behind us for the most part in the chemicals and that we were likely to see smaller deals going forward. There is no basis for this view. The desire to deals of any size is out there – see the Braskem/Lyondell section below.

The Small and Mid-Cap group in US chemicals shows a wide range of valuations today – largely based on expected growth – chart below – but the group also shows several names that are undervalued – and this before we think about potential synergies from the right acquisition or merger. Consequently, we see no slowdown in M&A desire and likely no slowdown in activity – in Chemicals or elsewhere. The issue is deal structure and premiums paid, given the very real risk that we are late cycle and that for the most part valuations are high. We should also not underestimate the billions of dollars of private equity looking for a home in this space.

Both the chart of the week and the chart below were taken from our Small and Mid-Cap Chemicals monthly, published earlier this week where we focused on some of the Mid-Cap names that we like in part because of fundamentals but also because of possible M&A – HUN, TSE, and FUL. Outside the US we would add Covestro (1COV) to this list. On the smaller cap side we would add KRA, IPHS and ASIX

  • Braskem – A Smart Play for LYB if….

When the rumors of a Lyondell/Braskem deal first emerged last year we wrote that this was probably the best deal for Lyondell and the one for which the stock would be least punished and probably generate upside. This came on the heels of LYB indicating to the market that it was looking for a large acquisition and the very negative reaction that investors had to that news. Our interest and conclusions were based largely on the chart below – which shows the very wide valuation discrepancy on an ethylene equivalent basis. DWDP is higher because the portfolio is only partly ethylene and WLK is higher because of its large vinyls business – Braskem and LYB are more comparable. LYB could pay a reasonable premium over the current Braskem share price – in addition to the rise already on Friday – see our adjusted weekly winners and losers chart – but with regards to whether this could be a good there are a lot of “ifs”:

  • If LYB can agree a price with Odebrecht, will Petrobras play ball:
    • Petrobras has indicated already that it is interested in selling its stake.
  • While Braskem management and independent shareholders can clearly be outvoted by the two big holders, will they try to insist on a high premium to buy the public stock and give up management control.
    • This then becomes a two step deal or LYB leaves the publicly traded stub, which makes it much harder to integrate the business – not ideal and synergy limiting
  • Will the competition authorities let the deal go through – the issue will be polypropylene and both the European and US regulators will want to take a look.
  • Even if LYB can acquire Braskem at an attractive relative value will potential synergies outweigh the risk of poor integration management and the currency risk in the eyes of US investors
    • The current LYB team does not have much M&A experience – also currently working on the SHLM deal which is yet to close.
    • During expected due diligence will LYB get enough information to get comfortable that the corruption issues are behind Braskem and that there are no residual liabilities – the last thing LYB needs is someone seeing its deep pockets as an opportunity find further fault with Braskem.

The valuation gap is wide enough to compensate for many of these risks, and the industrial logic is clear.

Whether LYB will have a clear run at Braskem is also an interesting question. Post-split, this would be a good deal for Dow Materials, but Dow’s hands are tied at the moment which may explain LYB’s timing – pushing this deal before the SHLM deal is closed. This is a cheap enough asset for WLK to look at but likely too big a deal. Unlikely that Private Equity would be interested as it is not clear what an exit strategy would like and the possible late cycle timing.

On the right terms and with great execution this could be a very good deal for LYB – better than SHLM in our view. However, the risks of it not happening or both poor terms and poor execution, are not zero and we would wait to see more progress before getting too excited. We still prefer both DWDP and WLK in this sector. We would be buyers of Braskem – this is a good stand-alone story (Real risk aside) without an acquisition – second chart.

  • BPCP – Nothing Is This Special!

BCPC hit $100 per share on Friday and our short recommendation is clearly not working. But, some interesting underlying valuation data suggests that we should not change tack:

  • Almost 20% above consensus target price (very limited coverage)
  • More than 30x 2019 estimates
  • EV/Forward EBITDA (2019) of 20x
  • Price to book – 5x
  • Price to tangible book – almost 40x
  • Expected annual EPS growth 2017 to 2019 – 12%
  • Story has been driven by acquisitions in recent years – nothing for 12 months and deals need to be bigger to move the needle
  • Stock currency is very high and could allow the company to make stock based acquisitions – possible targets might include IPHS given business adjacencies. Unconvinced that shareholders would react positively to a very expensive deal

Very unclear who the incremental buyer is here and this may be a function of inflows into index funds given that the passive investors seem to be the group growing ownership. Active managers should be getting very nervous at these valuation levels.

We have had this stock labeled as a short since the beginning of the year – we still believe in the short story (20+% downside) and while there have been some positive revisions and an earnings surprise so far this year, the magnitude does not support the valuation. Far too expensive to be an acquisition target.

  • Weekly Winners and Losers

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