Weekly Findings – November 18th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

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gcopley@ / asalzillo@ssrllc.com

November 18th, 2018

Weekly Findings – November 18th, 2018

Thought for the week: “Will 2019 be a year of raw material and energy volatility? If so, expect valuations to reflect the uncertainty in lower multiples”

  • Chart of The Week – A little Cold Snap…a little More Volatility
  • Bad News Over-Reaction Versus Good News Under Appreciation – Late Cycle Nervousness
  • Lyondell/Braskem
  • Is Styrene Done – Again?
  • Weekly Winners & Losers

Chart of the Week – Price Volatility

  • Chart of the Week – Price Volatility

It is unclear whether the fundamentals for many of the materials and industrials sectors will be as favorable in 2019 as they were for the first three quarters of 2018. With more talk about economic slowdown and the ebb and flow of trade negotiations – not to mention that the possible debacle that is Brexit and what a “no deal” future would have for the UK and its trading partners, you can get as many forecasts for 2019 as people you ask. Corporations with exposure to all of the factors mentioned are becoming more careful in their choice of words in discussions around the near to medium-term.

Where you are getting agreement is on the idea that volatility could remain a problem in 2019. In the chart of the week we highlight the volatility in crude, natural gas, US ethane and Asian ethylene over the last few months – there has been a major deviation from the relative stability of the first 7 to 8 months of 2018 and most of 2017. Aluminum was volatile in the early part of the year but has been on a steady decline since a peak in Q2 and steel has been more stable.

Volatility is a problem for corporations – hedging can work but only if you get the direction right and can be destructive if you have pass through calculations in your pricing contracts and get the wrong side of a hedge. Volatility is a more significant problem for investors and in a couple of charts below we show some loose correlations between valuation and crude oil volatility. We will do more work on this as we have only looked at crude oil, we have a limited data series and an outlier point that seems to influence the trend more than it should in some cases, and we are only looking at absolute value. The charts show Capital Goods and Chemicals – but we have done the work for all the Industrial and Material sub-sectors (E&C shows an inverse correlation – albeit weak). The data is from 2006 – we have all the data to go back further but we would need to shrink our company sample groups.

This analysis suggests that crude volatility has a negative impact on multiples – this is intuitive as the volatility drives uncertainty and investors pay less for more risk. As we think about 2019 we consider the following factors:

  • Very low natural gas inventories and what might happen if supply logistic constraints coincide with a cold winter – we have had a taste this week.
  • Crude volatility driven by the possibility of both supply and demand surprises.
  • Specifically, for US ethylene – further volatility in ethane pricing – in our view highly likely through 2019.
  • On a more macro level – economic growth and US growth – if we continue to see stimulus and strong numbers, metals could rally (especially with a move to boost US infrastructure spending).
  • Trade and Brexit – pre-buying (inventory builds) create false strong demand now – only to be replaced with weaker demand later.

The correlations in the charts are poor, but they demonstrate something we already know – uncertainty is not valuation’s friend. The drop in EV/EBITDA multiples over the last 3 months across the sectors has more to do with uncertainty than it has to do with EBITDA, which is generally good. We have this analysis by sub-sector and by company and will be following up with something more comprehensive and hopefully more actionable after the holiday next week.

  • Bad News Over-Reaction Versus Good News Under Appreciation – Late Cycle Nervousness

One a similar topic; we have spoken with several chemical companies over the last week and there is a broad and understandable frustration with the recent stock performance after what was promising to be a good year until September. In one case a company suggested that its stock was priced for perfection and they did not deliver perfection, but we do not believe that expectations were that high. What has been the driver, in our view, is late cycle nervousness, leading to an over-reaction to bad news and a discount on any good news. A small earnings miss results in an exaggerated stock drop. Energy gyrations create knee-jerk reactions in stock prices.

Part of this is algorithms – triggered by earnings misses or guidance or energy or other commodity pricing moves. Part is complexity – the easiest piece of a company to model is often the more volatile piece.

An anecdote from the New DOW meeting is illustrative. Dow spent an afternoon talking about a number of moves aimed at creating value, but one of which was limiting commodity sales exposure by increasing downstream integration in many of their major monomer platforms – this was discussed with respect to polyethylene and acrylates but emphasized more strongly in polyurethanes – Dow exiting the commodity end of the chain as more and more materials are upgraded internally. These were believable presentations; but..

  • The first question to the polyurethane business leader was about the price of MDI (a commodity input that has been volatile this year). Very little was asked about the upgrading strategy.
  • Most of the questions were to the feedstock business head – around future ethane pricing
  • In the breakout session at the end, many of the business leaders (of some very interesting businesses with some very interesting strategies) were largely ignored, while the feedstock guy was mobbed.

We are in one of the longest periods of continuous economic growth in history – and history tells us that it is unlikely to continue for many, if any, additional years. Investors are looking for signs of a slowdown and when they see one – however small – they sell. This is particularly bad for materials – despite the better relative week – as it is always possible to find something negative if that is all you are looking for. This is what was happening at the Dow meeting – sell and buy-side analysts alike were looking for what could go wrong rather than what could go right, which is why the stock is down 17%YTD despite 19% positive revisions for 2018 earnings since January 1st.

DWDP is not unique in this and MDI is not the only focus – last week the subject-du-jour was natural gas prices, and investor attention is fixed on this rather than anything else any company might want to discuss. Analysts are looking for things they can measure (TODAY) rather than looking at the potential for a business as strategies evolve. This is always the case but more front of mind towards the end of an economic cycle as the downside in the Materials space in an economic slowdown is generally very pronounced. That said in a broad economic contraction, this is a sector that should, once it reaches a bottom, outperform significantly on a relative basis as it did through 2009 and 2010, after a painful 2008.

We do not believe that the signs are there for a broad economic slowdown yet, but no-one has done a good job of predicting them in the past. However, given the length of the upcycle, investors are looking more acutely for reasons to sell rather than reasons to buy, and it is unclear what will change that sentiment. There is no compelling BUY signal today.

  • Lyondell/Braskem

We refer you back to the short piece we wrote on this subject in the Fall of last year, which is attached as a PDF. In the piece we discussed a number of possible strategic moves for LYB, which were circulating at the time, including the idea of a combination with Braskem. Braskem has a current enterprise value of around $19bn US, of which 55% is debt. EBITDA for the last 12 months was around $3.2bn (all data taken from CapIQ). The debt has a long maturity schedule but is expensive relative to what LYB could likely borrow for. Interest expense is close to $1bn and LYB could probably get another $200-300 million by refinancing. Obviously, this is not additive to EBITDA, but it is additional cash. The other variable that could add to the pie is whatever deal LYB can strike with Petrobras for naphtha supply for the ethylene capacity in Brazil.

In the chart below we have recreated the chart in the piece attached to reflect changing valuations and to correct DWDP’s ethylene capacity based on the disclosures earlier this month (we were a little light previously because we did not account for the JV’s appropriately). Braskem remains the cheapest route to ethylene capacity and LYB could pay a 40% premium for Braskem and only pay the same value per ton of ethylene that LYB has today. Even at this price, the deal would be hugely accretive to LYB. The valuation risk would come from adding more variables and uncertainty to the LYB story.

LYB is focused on maintaining its current credit rating, while also maintaining its dividend and the ability to repurchase shares. As we did a year ago, we like this idea, geopolitical risks notwithstanding, but given the macro uncertainty discussed above and investor skepticism, to offset risk and maintain some dry powder for a downturn, LYB probably needs to pay for some of this with equity. As anyone covering the company for 20 years will know, old Lyondell had a very bad experience paying for something with cash and stretching the balance sheet just as the macro environment turned against the company. LYB is not expensive, and while our model (second chart) has to make use of proxies because of the limited history, we generate a current fair value of around $145 per share.

We currently have LYB on our “avoid” list – because of sentiment and US feedstock issues. This will likely be wrong if a good deal is structured with Braskem – but LYB could still dip on the news – because of the increased complexity/risk.

  • Is Styrene Done – Again?

Apple destroyed the styrene market in the last decade and it is possible that social media (in part enabled by Apple devices) will stick the knife in once again over the next 5 to 10 years. Clearly investors believe this, and it is reflected in Trinseo’s valuation collapse over the last few months – first chart.

The I-Pod was a huge red flag for styrene when first introduced, but at the time very few saw what sweeping changes it would drive. Traditional music and video media had been a large and growing segment of the styrene (and polycarbonate) market. With CDs and DVDs made from polycarbonate and sold in polystyrene cases and VCR tapes largely made from polystyrene (the container, not the tape itself). As digital media took off, styrene suffered. Demand fell, plants were closed – many producers contemplated closing, even if they did not – and profitability plunged. Styrene’s recent resurgence has been because of limited to zero investment for more than a decade and slow steady growth from the non-media segments.

While good growth rates continue in most styrene derivative markets today, the industry is likely to take another hit, again aimed squarely at polystyrene. This possibility comes at a time when we are seeing the first significant new capacity in a while (in China) and it only makes sentiment worse – note that TSE has some, but only minimal, expected decline in EBITDA for 2019.

The risk for polystyrene is the waste plastic issue. We believe that the pressure to respond to the problems of waste plastic will only increase from here and that polystyrene will be a disproportionate victim. Dunkin Donuts decisions to phase out its expandable polystyrene (EPS) cups is a specific example, but the problem could be much more widespread – especially as consumers and users of packaging plastics look to improve the levels of recycling. Polystyrene competes with polypropylene and in some cases polyethylene and PET in packaging applications – these days mostly on price – there are alternatives for polystyrene in all packaging applications. One of the moves that we expect the packaging industry to make (in response to customer pressure) is more standardization – aimed at making separation and recycling more straightforward. If this happens, polystyrene will likely lose to polypropylene mainly, but also to polyethylene and PET. In some applications polystyrene is hard to distinguish from other polymers and will likely be look at as a major contaminant in any strategies aimed at increasing recycled use into the food and beverage markets.

Declining demand for polystyrene would undermine the styrene market again and we might see another round of closures. Lyondell is the 800-pound gorilla in styrene (together with Shell), with their styrene/propylene oxide processes defining the low end of the cost curve. Even so, they would see, lower operating income and returns in a weak polystyrene market. Westlake has a small styrene unit – too small to make much of a difference to EBITDA and would be a possible closure candidate in a major downturn. TSE is more of a loser than a winner. While the company has a substantial SB Latex business, which is still growing and would benefit from cheaper styrene, TSE has substantial styrene and polystyrene capacity – with much of the styrene and most of the polystyrene exposure in the US JV with CPChem.

The winner in the table below would be Kraton (KRA) as a buyer of styrene for use in styrene/butadiene co-polymers mostly used in the latex market, and hard to substitute, and in durable end-markets such as infrastructure.

This risk to polystyrene may not play out for a couple of years and will be driven by the customers. We cannot think of a good strategy for the styrene producers except buy more demand (in non-packaging end markets) – another reason to look at a very cheap Kraton. TSE looks very attractively valued, but it is unclear who the marginal buyer is – maybe TSE itself (the company can buyback a lot of shares at current 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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