Weekly Findings – November 4th, 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 4th, 2018

Weekly Findings – November 4th, 2018

Thought for the week: “GE – Now the risk/reward looks more interesting, but the Rumsfeld rule still applied both internally and externally – what are the unknown unknowns? GE keeps giving reasons to sell – no reasons to buy!”

  • Chart of the Week – Chemicals: Small Cap Disinterest or Just Disinterest?
  • GE – Tempting, but the risks are unchanged
  • Q3 – results update
  • Ethylene – Weaker Europe and Asia are now the larger concern
  • Weekly Winners & Losers

Chart of the Week

Note; In all of our weekly summaries and most of our regular published research we include only a fraction of the data we have accumulated over the years and we also provide somewhat generic conclusions – targeting the “average investor”, if such a thing exists. We also assume that every reader is well versed in many of our thematics around “optimism”, “skepticism”, “complexity” and others. We are always happy to tailor research specifically for individual clients and have done more of this in recent years. Please let me know how we can be of help.

  • Chart of the Week

No-one is questioning what a bad year this has been for materials in general and Chemicals specifically, but in the chart of the week we are looking for a market cap bias and we appear to have found one. The smaller cap names have fared much worse than the pack over the last couple of months, and the smaller the cap the worse it gets. While last week was a better week for chemicals and materials – last chart of the report – the performance of the smaller cap group is explained by negative revisions, which have been more aggressive for this group than for others market cap ranges – first chart below. There have been some notable quite negative earnings surprises – including two of our favored names – ASIX and IPHS, and in addition, the TiO2 space continues to suffer, with negative sentiment hurt by earnings/guidance disappointment and the overhang of Huntsman’s explicit declaration that it is actively shopping its stake in VNTR.

The second chart below looks at valuation, and while EV/EBITDA based valuations have dropped for the entire space, the drop for the smaller group has been more severe and started from a lower base. Note that we are using training EBITDA in this analysis because many of the smaller cap names have either too limited coverage to rely on forward estimates or no coverage at all.

We still believe that this small group is likely to be the target of take-overs, especially as valuations fall relative to larger peers. The disinterest in the space is in part due to the overall market distrust of the global economy, which has impacted all of the material and industrial sectors, with small-cap generally the more levered on the way down and on the way up.

We continue to recommend ASIX and IPHS, despite the significant recent upsets and still see IPHS as a take-out target. We would be aggressive buyers of VNTR as one of two outcomes is likely – HUN finds a block buyer (or a couple) for its stake – the overhang goes away and the stock rebounds to reflect a better EBITDA multiple; or HUN buys it back and takes advantage of an opportunity to grab a very cheap cash stream.

Note that in the first chart above we have shown two lines for the mid-cap group – one with and one without CF as the performance and revisions overwhelm the average. We see less and less of an opportunity in CF as the stock gets above $50 per share, although we still like fertilizers as a sub-group. Also, Praxair, now Linde PLC, is removed from all of the analysis as we have no month-end data.

  • GE – Tempting but the risks are unchanged

We have said for a while that GE below $10 looks interesting, as it is not a stretch to believe that someone of Mr. Culp’s caliber could create something worth $15-20 per share through restructuring and break-up over the course of three years – so a good return. We would be more comfortable with the idea had the Q3 conference call gone differently, but of course had it gone differently, the stock would not be below $10!

We got what we expected and have been forecasting in Power for a while – a large write down and some more negative guidance. We also got the split which is likely the best way to manage the power business through the changes needed over the coming years – all of this was positive.

What was negative – and troubling – was the commentary on Capital, as well as the broader SEC investigation. Every question on Capital was met with an answer that a greater cash injection might be required – for more than one reason. At the same time there was a hope that the dividend cut plus the cash flows from other businesses could provide that cash injection.

Our read on this is troubling and despite the much more attractive stock price – still raises another red flag – and a reason to sell rather than buy – yet another one. Since the exit of Mr. Immelt – now 18 months ago – one would have thought that getting GE Capital into quantifiable buckets of “good”, “bad”, and “don’t know”, would have been the highest priority. Yet, 18 months on, the don’t know bucket is still so large that Larry Culp is unable to or unwilling to frame it for investors. The stock cannot move forward until all the news is out, all the closets cleaned, and all the charges are taken. No-one knows this more than Mr. Culp and the majority of the GE board, we suspect.

Reasons so far not to own the stock:

  • The first dividend cut – income fund forced selling
  • The debt downgrade – more forced selling from funds that have debt rating criteria
  • The SEC investigation and the insurance charge – forced selling from funds with ESG mandates
  • The second dividend cut – more selling from any dividend driven fund that still held it – that gets us to where we are today…..
  • A capital raise – while rejected as an idea on the conference call, we think it is likely and we suspect it is influencing the share price – “if they are going to issue a block of shares, why not wait until they do and buy at the discount.”

GE may not need a capital raise, but it will be some time before the company can convince investors that is the case – in the meantime the stock will likely remain under pressure in anticipation.

GE’s stock may actually do better if the company issues $10bn of equity (or a mix of equity and debt) – even at current prices – especially if they can convince investors that $10bn is the worst case for shoring up GE Capital and enabling the break-up of the rest of the business – it may the reason to buy that people are waiting for. If $10bn turns out to be too much and the businesses do better and the SEC investigation results in minimal action, GE can always return some of the cash to shareholders by raising the dividend or buying stock. Otherwise we see no obvious positive catalyst, and lots of potential negative headline risk.

  • Q3 – Results Update

Below we update the charts we showed last week – we now have results from roughly 75% of the group in the analysis. We have taken much of the labeling off the first chart because it was becoming too busy, but we have shown some of the outliers. In the second chart, Q3 looks better with another 20 or so companies joining the mix than it did last week – still down on Q2, but not by as much. Q4 guidance has been mixed but incrementally negative and we would expect a flat to downward move in Q4 versus Q3.

  • Ethylene – Weaker Europe and Asia are now the larger concern

Lyondellbasell provided surprisingly positive US Q3 results, confirming how little US ethylene and polyethylene is sold at published prices and how much is tied to costs – so as ethane increased, so did pricing for many. These formulae include references to ethylene and polyethylene published prices as well as raw material costs and consequently the pricing data is not completely insignificant.

By contrast LYB’s non-US olefins and polyolefins results were much weaker – in part driven by higher crude oil prices and higher naphtha costs, but also from price weakness, which has accelerated in October – chart. This is consistent with BASF’s earnings report and some quite negative guidance. These non-US ethylene prices are very important for everyone as it is the pricing umbrella, above costs, that has been keeping the global industry afloat for the last couple of years and has created a gap wide enough for US exporters even as US costs have risen.

Crude oil prices are off their September highs, and this is likely part of an explanation for the global ethylene price weakness, but we think it is likely more supply/demand driven, with US exports of ethylene and ethylene derivatives creating competitive pressures in a demand environment that is now not quite strong enough. DWPD did not revise their guidance for the year and neither did LYB meaningfully, but these global pricing trends do not tell an encouraging story.

  • Weekly Winners and Losers

If, at year end, we tally the number of weeks each company we cover has been in the loser group, only GE and VNTR can hold the record at this point

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