Weekly Findings – June 24th, 2018

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 24th, 2018

Weekly Findings – June 24th, 2018

Thought for the week: “We are now likely trading away growth and jobs for a tariff policy that makes little sense at any level – some small wins for the US will likely be overwhelmed by broader economic damage in our view”

  • Chart of the Week – Trading It Away
  • Scotts – Would It Be A Miracle For It To Grow? – UPGRADE
  • Westlake/Lyondell -The Mid-West Edge
  • GE – Adding More Power To The Debate
  • Weekly Winners & Losers

Chart of the Week-Trading It Away

  • Chart of the Week – Trading It Away

Two weeks ago, we showed a chart that illustrated how EBITDA momentum in the Chemicals space had accelerated, but despite this, the chart of the week shows that the sector has underperformed for the year, with only a handful of stocks beating the market. Some of the worst performers have company specific issues, but given the earnings momentum this year we think that most of the underperformance is trade driven – either product specific (products like Low Density Polyethylene targeted by China – along with many other chemicals and plastics), or because of a general economic slowdown fear stemming from the trade issues. Chemical trade has been volatile but growing – chart below – and all of the US investment in basic chemical and derivative capacity requires more exports – with (Linear) Low Density Polyethylene (for packaging) one of the most significant US investments (DWDP, Exxon, CPChem, and Sasol, adding around 2 million tons of capacity between them).

If we believe that the trade issues will escalate from here, from an investment perspective we should be looking for companies with minimal non-US exposure and ideally inexpensive – SMG comes out at the top of the pile – chart below and section below. This trade concern and the analysis below leaves us somewhat comfortable with our WLK and CF positions, but it is clearly a risk for DWDP, EMN, and FUL (all of which have valuation support) and HUN which does not have valuation support unless you believe that history is a poor guide for HUN, as we do. The chart shows that the group is not expensive, albeit relative to a very expensive broader market.

  • Scotts – Would It Be A Miracle For It To Grow? – UPGRADE

SMG’s disastrous year – chart of the week – needs to be placed into context. Somewhat like ALB, its stock price was dragged up by sentiment in 2017 around new growth and new earnings momentum – in the case of SMG it was hydroponics and the legalization of marihuana sales in many US states and now all of Canada, and in ALB’s case, lithium. Here is where the comparison ends, as the decline in ALB is all sentiment, given that earnings expectations are unchanged and the decline is driven by supply/demand uncertainties several years out. For SMG earnings have come down significantly as the “weed” promise has not delivered – chart. Estimates have crumbled for 2018 – less so for 2019.

But is now the time – or at least is the time close? All the “this is the bottom” signs seem to be flashing – downgrades, insider selling, etc., but the stock is not expensive on our metrics – first chart – and return on capital has turned a corner – second chart. The decline in return on capital was partly a function of capital growth because of acquisitions, and past recoveries back to trend or above trend have been good times to buy. Note the rapid change in relative valuation during the financial crisis: SMG was seen as a relative safe haven and outperformed significantly – another reason to look at the stock today.

Analyst sentiment is low and declining – not quite at the screaming buy signal that we would look for – first chart – but close. More important, it is one of the least loved stocks in the group and consequently a relative sentiment indicator would suggest an interesting entry point. Note that CF is one of our favorites and LYB would be if we could get clarity on strategy – see last week’s piece on Lyondell/Braskem.

In a trade concerned world – SMG has the lowest exposures outside the US in the Chemicals space – second chart in first section. Consequently – all things considered – this is probably a good time to buy the stock:

  • Sentiment bearish
  • Minimal non-US exposure
  • Valuation attractive relative to history
  • Safe place in a market correction
  • Hydroponics upside essentially for free today

  • Westlake/Lyondell -The Mid-West Edge

Oil and gas production growth in the US is driving pricing anomalies that are logistic rather than product intrinsic value driven. This has been well documented in the discounts that exist for West Texas crude oil today, where the spread versus Gulf Coast has reached an all-time high. The other all time high appears to be in the discount for NGLs, and specifically ethane in the Mid-West. As shown in the chart below we have almost a 25 cent per pound spread between Conway and Mt Belview ethane in June – this is 10 cents per pound of ethylene cost advantage to the three ethylene plants in the region – one belonging to WLK and two to LYB. The second chart shows the quarterly difference in ethane pricing Q1 vs Q2 and the table shows what this delta would mean for WLK and LYB – not much in the grand scheme of things for either company – but another positive.

This delta between Conway and the Gulf Coast likely reflects at a minimum what might be achieved in terms of ethane value in the Marcellus today, and should be a significant encouragement for Shell to press ahead with the announced project there. We have a preference for WLK over LYB today, but a Braskem deal could be very good for LYB.

  • GE – Adding More Power To The Debate

This week our colleagues Hugh Wynne and Eric Selmon published a comprehensive analysis of the likely demand for new power equipment under a number of possible forward scenarios, including possible outsized growth of solar and wind power. The conclusions of the analysis are summarized in the chart below.

Base Case and Alternative Scenarios For New Global Gas Turbine Power Capacity (GW)

This is analysis that we have not seen elsewhere and consequently provides a significant set of input data for anyone trying to piece together the complex mosaic that is GE. However, it also helps to highlight the problems that investors face and that Mr. Flannery faces as he attempts to fix the business – the range of possible outcomes is high and all of the scenarios are believable.

Even the best case falls short of the capacity to produce power equipment and this brings an addition set of issues:

  • Will the (limited) number of participants compete hard for the business and will we see further margins compression even under some of the better scenarios?
  • Will the participants “right-size” capacity though closures and write downs – assuming a base case for demand somewhere in the range above? We are expecting write downs in this GE business.
    • If we do get capacity closures and a resizing from equipment producers, the better scenarios above might create a better market balance and some pricing stability or even recovery.
    • If we do not see enough cutbacks demand will still fall short of capacity and aggressive pricing to gain share remains likely.
  • Equally important for GE – there is minimal growth expected in any scenario for the next few years – years in which GE needs to evolve its strategy and portfolio into something that generates shareholder value and reverses the trend of the last several years.

GE is a “Donald Rumsfeld” stock! It is the “unknown unknowns” that are the real problem and there are too many of them. Hugh and Eric’s work helps put a framework around the largest and most controversial GE business today, and if the company is thinking about separating this business it will need to present a robust business case, using analysis such as the work done here.

The other major black box remains GE Capital, and as we cannot rule out more problems in this unit we still cannot get comfortable with the story – despite the more attractive price. The stock hit a new 52-week low last week, following news of its exit from the Dow Jones Index. Estimate revisions are still incrementally negative, but owning the stock around earnings reports has been the wrong move for some time now.

Please contact Hugh and Eric directly or your SSR salesperson for more details on the work referenced above.

  • Weekly Winners and Losers