Weekly Findings –November 11th, 2018

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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

November 11th, 2018

Weekly Findings –November 11th, 2018

Thought for the week: “Economic Point of Inflection, Plus Peak Oil = Drift in Results”

  • Chart of the Week – The Q3 Drift
  • DowDuPont – Some Mostly Subjective Views and Investment
  • GE – What If They Know?
  • Weekly Winners & Losers

Chart of the Week – The Q3 Drift

  • Chart of the Week

In the chart of the week – which is a little messy – we show sector by sector how Q3 2018 has compared to Q2 2018 from an earnings and revenue surprise perspective. There is an overall drift down and to the left and almost every sector follows the overall patterns. Having said that, the average Industrials and Materials company beat expectations for both revenue and earnings – just by less than the average in Q2. The big mover was conglomerates – and while we immediately think of GE, note that others in the group also had some problems – MMM missing both top and bottom line estimates and HON flat versus revenue expectations. The only improvement we saw was for Paper and Packaging and Transports on the EPS side.

With several additional companies reporting last week, the chart below is almost complete for the 3rd quarter, and we have not added any real outliers in the last 7 days. SMG (a stock we like) missed badly on EPS but saved the day by announcing a significant dividend. The stock finished up for the week but remains extremely inexpensive – second chart below.

Despite the negative drift in Q3 2018, we still have growth with almost 90% of companies reporting showing year-on-year revenue and EPS growth, even if a higher proportion are missing estimates. As seen in the second chart below we are off the peak for the number of companies reporting revenue growth and EPS growth.

It is interesting to note that the prior peak coincided with the peak in oil – higher oil drives pricing power – drives revenue growth. Lower oil drives a negative inventory swing initially – lower base demand – weaker prices. Oil’s moves in Q4 2018 to date do not bode well for Q4 revenue and EPS growth but we would expect to see more damage to the revenue trend than the EPS trend if oil is the driver as we did in 2014.

  • DowDuPont – Some Mostly Subjective Views and Investment Options

We offer some subjective opinions on the investor event that DowDuPont hosted in New York spotlighting the three stand-alone companies. Overall, we have liked the merger/split idea from the first day of the announcement, three years ago, and we have not changed that view, even if we have been disappointed with the stock performance. The investors days have helped to clear up some of the company specific issues and New Dow presented a lot of new data and a much more granular approach to its message.

But at the end of the day:

  1. New Dow looked like Old Dow, still polished, but with more realistic targets and a much more joined up sense of purpose – more shareholder friendly in terms of cash management.
  2. New DuPont looked like Old DuPont, but a lot happier and bit more polished than the Old DuPont
  3. Corteva looked like a hybrid of the two, but we find it hard to get excited about the Ag chemical and seed business, however fast the population may be growing.

Through Q3 2018 the trends have been good (chart below) – the incline is steeper for New Dow than for the rest, but this should not be surprising given that capital spend at Dow leading up to the merger and in 2017 in the US Gulf Coast and in Saudi Arabia. We have been a little critical of the overall performance as we expected better results than this given the combination of synergies and new capital, as well as the tailwind from the stronger global economy – many companies have had very good results and good growth this year. In the second chart below we show EBITDA for APD, BASF, HUN and EMN on the same basis – we have not adjusted for divestments or acquisitions etc.; these are just the reported recurring numbers. In the table below the chart we summarize the annualized rolling 4 quarter growth rates for Q1, Q2 and Q3 2018. DWDP does not look that special in this analysis – especially given synergies and Dow capital spend. Corteva looks anemic – hence our disinterest in the sub-sector.

New Dow

Despite our more cautious view on ethylene, we do see global underinvestment in 2019 and 2020, and a short-term opportunity to make money if demand holds together. Dow’s demand forecasts are reliant on a stable economy in our view, but if we get it, the businesses could be stable from a fundamental perspective, while Dow drives more synergies, removes stranded costs and gets some incremental innovation led growth. What we liked about the Dow presentation was that the strategy was more incremental than big picture – more fact than assumption or assertion. Expect a sizeable dividend and a strong buy-back program. We hope that Sadara will be the last major “overpromise and under-deliver” from Dow.

Dow will always be vulnerable to moves in the commodity markets and given how much emphasis was placed on how good the company was at reading energy markets and hedging, we should expect at least one major hedging blow-up over the next couple of years because no-one gets it right every time!

New DuPont

Less sleepy than Old DuPont, but not as buttoned up as Dow. The stories all sound good, but the DuPont stories always sounded good and more grounded than Dow, yet still managed to miss the mark. For a portfolio of differentiated products in a strong global economy, DuPont is doing better than old DuPont would have, but much of that is cost control and synergies and in our view the company is still falling short of potential. If Dow can meet its expectations, the stock will do well. If DuPont can meet its targets, it will not look much different to peers in our view – though better than in the past. We came away from the presentations wondering whether the better move would have been to spin out Ag and then stop (at least for a while) – some of Dow’s better businesses feel like they are more special, and more value-add than some of DuPont’s (maybe the cultural differences are just too great). DuPont has the branded franchises, but they are old franchises.

We believe that the opportunity with the New DuPont is for a further break-up – selling both the electronics and health and nutrition platforms; both of which should fetch much higher multiples than the rest of the DuPont portfolio. It will also leave residual DuPont easier to manage from a cost and incremental innovation perspective.


We are not a buyer of the Ag chemicals or seed space in general as we think productivity gains will continue to undermine the business for many years to come – the product pipeline screams “greater productivity per acre”. We would not own DWDP today only because we want the Ag business. We suspect that you will get a better entry point into Ag after the spin. To be clear – we do like the fertilizer sub-sector, where supply and demand appear much more aligned.

So, what to do with the stock today? It’s not expensive, and you might want to own Dow depending on the valuation and the state of the base chemicals industry in 1H 2019. Dow will likely dip on the spin – almost every company in this sector has done that recently – VSM, CC, ASIX, even Livent. But, if DWDP rallies 20% from here, which is possible, especially if we get a trade agreement, a 20% drop in Dow post spin, would leave you better off buying DWDP today rather than waiting. The stock is way off its peak, but well above its recent dip. We would still own the stock here.

In a continued broader materials rally there are more levered ideas, such as HUN, EMN, WLK and even LYB (assuming no Braskem deal).

  • GE – What If They Know?

Last week we wrote a cautious few paragraphs on GE, with a focus on the disappointment we had in the company for still not knowing the extent of the liabilities and a more precise cash need at GE capital – we made the point that after 18 months of doing nothing but looking for ways to fix the company, you would expect that they would know. Well; what if they do know?

This would be, in our view, significantly more concerning than them not knowing, because Larry Culp needs to air all the dirty laundry if he is going to find a floor or a base line from which to move forward – he knows this, his board knows this, and all the investors know it. If GE does know the full extent of the problems at GE Capital – liabilities, potential litigation costs, taxes, legal settlements, but is unwilling to put a framework around it for investors it means that the answer is too bad to disclose. We understand that in some comprehensive research this week, a key analyst covering the stock has concluded that GE Capital could be a drag on valuation by $3-4 per share. This conclusion has been drawn with the data available – which anyone who has read a GE 10K or 10Q, or visited their Investor relations website, will know, is woefully incomplete, requiring far too many educated guesses around accounting issues and liabilities that most analysts are not qualified or experienced enough to have much hope getting close to.

What if the real answer is that GE Capital has a negative value of $6 per share of higher – how would we know. But, GE might, and recognizing the negative impact such a disclosure would have on the stock would rather hedge their comments while they search for remedies that might make things look better.

Last week we talked about the likely need for a capital raise. With the stock fall since the earnings release that is looking harder to imagine – a $20 billion equity raise would be 25% dilutive to existing shareholders at current prices.

We concluded last week by making the point that GE was only giving investors reasons to sell. Maybe this latest research opinion will be enough to shake the company into more aggressive action with regard to disclosing the size of the net liability at GE Capital or at least putting a range around it and then discussing alternatives for fixing it. GE’s quick rebuttal of Friday’s research might suggest that a capital raise is on the cards, and the share price move on Friday will not have helped.

In terms of “are we there yet”, the chart below is probably meaningless, but to repeat the relative low of 2008, when bankruptcy was being discussed for a number of companies (including Dow Chemical), GE’s current share price would need to fall to $5.70 per share. The stock would need to fall to $7.00 to get to the level of 1995.

  • 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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