Weekly Findings – October 21st, 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

October 21st, 2018

Weekly Findings – October 21st, 2018

Thought for the week: “Are we in for a natural gas surprise”

  • Chart of the Week – Out Of Gas?
  • Materials Discount – Quick Performance Update
  • Materials, Industrials and Housing – Making Our Best Ideas Better!
  • PPG – Recap and Questions
  • DWDP – What Can We Derive From The Poor Messaging
  • 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

Natural gas inventories in the US are falling well below seasonal five-year averages and the most recent 5 year low. This is despite record natural gas production in the US and it is likely the production rates that are keeping price increases in check today. The last time inventories of natural gas were this low at this time of the year, as a proportion of demand, was 15 years ago and prices were a lot higher.

In the chart below we show Mid-October inventory levels by year in absolute terms. This October we have the lowest absolute levels since 2003. In the second chart we annual average daily demand (using EIA data) and in the third chart we combine the two data sets to show the number of days on inventory in the ground. We do not have enough history to find a level expressed as days of demand as low as we are seeing right now.

While the market may be more confident that the higher production levels in the US can meet winter demand and that inventories are less of a signal than they were – see the last chart on pricing where the 2014 inventory low did not get the same pricing reaction as lows in 2008, 2005 and 2003 – we would make the following observations:

  • US demand for natural gas is growing more quickly than in recent years
    • Power investments and being made at the margin to exploit what is expected to be abundant cheap natural gas
    • Manufacturing activity in the US continues to improve.
  • LNG exports will step up over the next 6-8 months as new capacity in the US Gulf comes on line.

It is possible that another couple of low inventory numbers will push natural gas prices above $4 per MMBTU quite quickly – maybe as high as $5.per MMBTU. This would be another hurdle for the Chemicals industry in the US as it would provide some support for higher NGL prices and additionally many companies are significant buyers of natural gas as a feedstock or for fuel.

  • Materials Discount – Quick Performance Update

After another volatile week in the market we have seen more earnings concerns than victories for both the Materials and Industrials sectors – first chart. This continues a trend that has dominated the last 6 weeks – second chart, with materials the clear loser. Without some “feel good” news on the global economy or on the geopolitical front Materials will likely be the marginal sale of choice for investors – and there is no reason for the direction of either charts to really change. Earnings misses (PPG) and write downs (DWDP) won’t help, if (as expected) they continue.

  • Materials, Industrials and Housing – Making Our Best Ideas Better

In research published earlier today, we look for ideas to buy now in the housing space and where we might be better off waiting for at least this quarter to play out. YTD performance from the housing names has been poor – chart below, but only a handful of names look cheap enough to take the risk today. Any company with a sub 6x EV/EBITDA (see chart in PPG section below) should be interesting in a sector that MUST consolidate in our view. On a relative basis we would focus on WLK and EMN in the US, and BASF in Europe. While we see huge potential upside in SWK, we may not have seen all the downside yet.

  • PPG – Recap and Questions

Please see our more comprehensive piece on PPG, published last week for more details.

PPG announced earnings this week in line with the revised guidance of the week before but nudged down the Q4 range by a penny. The news was taken well by what was already an interestingly valued stock, and we imagine PPG management has been in full investors engagement mode ever since. It is our understanding that the company is visiting as many owners as possible over the next few days and likely spoke with many on Thursday and Friday.

We would hope that Trian is among this group and it would be very ill advised for PPG not to, at a very minimum, hear Train out. This was the course that DuPont took, but immediately then concluded that Trian was not a shareholder they could work with and the rest is well documented history.

If we were meeting PPG this coming week we would ask the following:

  1. Has there been a dialogue with Trian and if so what is Trian looking to change?
    1. If there has not been one, is one planned
  2. The quarterly miss – how long had the company known that it would not be able to meet estimates and why wait until the last minute rather that issue some qualitative guidance during the quarter that spoke to the directional problem that feedstocks were presenting.
  3. Were the refinish issue in Europe and China (in general) surprises.
  4. Why buy a refinish business?
    1. Are we not seeing the eventual death of refinish as auto technology advances quickly?
    2. AXTA has not met expectations with its refinish acquisition strategy
  5. Why did PPG not buy Ostendorf?
  6. Is Akzo back on the table?
  7. Is senior management concerned about lines of communication
    1. An accounting issue and an earnings miss that in part seems about internal communication – i.e. senior management not knowing about issues until the last minute.
  8. Interest rates, housing and autos: how hard will it be to grow earnings in 2019 if the current trends continue
    1. Note that consensus still calls for growth of 12% versus 2018.

PPG is not expensive on a normalized basis – relative to a strong broader market – see piece linked above – but it is not that cheap versus its own absolute history and versus a basket of housing related stocks – chart below. While the state of the US housing market and global autos is key for PPG, it is likely that the interaction with Trian is more important medium-term for the stock. A collaborative engagement with Trian could be good for PPG and for Mr. McGarry, as it was for Dow and Mr. Liveris (with Third Point). A combative posture from PPG is going to distract a management team that already seems a bit too distant from the day to day. With hindsight, once the battle lines were drawn between Trian and DuPont it was a time to sell – with a much better entry point after a couple of further significant earnings misses.

  • DWDP – What Can We Derive From The Poor Messaging

DWDP’s stock price is essentially unchanged from the morning of day the deal was announced and despite the promise of synergies, better aligned companies and better management the stock has underperformed the S&P500 by 35% over the period as well as most of its chemical peers (only AXTA has performed worse than DWDP over the same period). This comes despite earnings growth, albeit at a lower rate than we, and (clearly) investors, were expecting.

Given the ebb and flow of feedstocks and commodity chemical markets, there are, and will always be, things outside of DWDP and its eventual break-up companies’ control and certainly some of these uncontrollable factors have had an impact on stock performance, including weakness in the Ag markets and the wild gyrations of ethylene feedstocks costs this year.

But despite the obvious excuses, we are becoming increasingly concerned with the messaging choices that DWDP is making. DuPont was never that slick when it came to investor messaging and spinning its story, but the Dow machine had worked well for years, despite the chronic optimism pre-2014. It is possible that, because the companies are essentially operating as largely separate entities already – especially new Dow versus the rest – that the ball is being dropped somewhat at the current holding company level. There are still essentially two IR teams etc. All of the quarterly reports since the merger have been messy – with charges and conservative guidance undermining what were fairly good results. The Ag write down this week is another example of poor communication and while some, including the company, says that this should not be a surprise and should not impact income, it clearly was a surprise, enough to provoke financial news articles on all the major channels and move the stock price.

Also, slightly odd, is the company filing the form 10 for the Ag business before the Form 10 for Materials, which is supposed to spin out first. This also suggests that old DuPont is doing its own thing and old Dow is doing its own thing and may help to explain why the coordinated messaging is weak. Note that the Goodwill write down on the Ag business is only around 6% of the Goodwill created by the merger. The bulk of the rest of the Goodwill sits on the Ag and DuPont books

The earnings trajectory has the combined company on track to improve on trend return on capital – including the Goodwill step up – chart below – but it is an unacceptably low return on capital and one that the company should not be satisfied with either on a combined basis or once separated. Note that given the long history for both companies and the nature of our valuation models, creating an historic proxy for the combined company is fairly straightforward and very helpful. The negative trend was pronounced for the predecessor companies – as summarized in the second chart – note the very similar earnings volatility for both companies – often surprising for those that see Dow as the more commodity focused.

In our work on “what makes a good company” we concluded that it was not the level of Goodwill on a balance sheet that distinguished good companies from bad, it was how much of the Goodwill was written down over time that mattered. Companies that improve their return on capital by writing down their capital base generally do not make for god investments. For a full explanation of the charts below please either see the piece linked above or contact me directly.

So, what to do with the stock here?

Clearly it is a lot cheaper than it was, but it is not a bargain on an absolute level – chart below – and much of the outperformance since the deal was announced has been aspirational, supported by some better earnings – but in our view underwhelming earnings versus the potential that we had identified. Note that in the chart the stock is back to trend on both a normal and forward earnings basis. As we head into Q3 earnings we do not fear Q3 numbers that much as the company would have said something in its “write down” commentary. However, we do expect another guide down for Q4 and probably little commentary for 2019 given the expectation that we will have 2 companies by the end of Q1, 3 by the end for Q2 and maybe more by the end of the year.

The current price is clearly interesting, as are the multiples. However, if “non-DWDP” factors continue to disappoint – Ag and Commodities especially – the guidance could be quite cautions and the break-up quite volatile as there will be a contingent of investors who don’t want another Lyondell and another contingent who don’t want an Ag business – both spins could see selling pressure and maybe this is what is being reflected in the combined stock price today. We like the idea of the split, and the price is interesting, but we would still apply our broader Materials thesis here, which is that you might still get a better entry point. Regardless, we hope that the separate companies do a better job of messaging/communication than the combined company has shown, or investor skepticism will continue – it is approaching a 20-year high – chart below

  • Weekly Winners and Losers

For the next two to three week the performance chart is likely to be dominated by earnings surprises – both positive and negative. The volatility in Alcoa continues and we do not expect much of a change – Aluminum demand remains robust but the pricing volatility, more driven by speculators than the physical market, is likely to continue, driven by incremental economic news, trade news and earnings reports and guidance from consumers. We still believe that the Aluminum market is tighter than reflected in pricing today, but this too volatile a story to warrant a high conviction recommendation.