Weekly Findings – September 23rd, 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

September 23rd, 2018

Weekly Findings – September 23rd, 2018

Thought for the week: “How Much Higher Can Earnings Go For Industrials – Is The Peak a Couple of Quarters Away, or Just Behind Us?”

  • Chart of the Week – Return On Capital Signals
  • Sasol – More Debt = Terrible Project Economics.
  • Ethylene – What Should The Acquirers Do?
  • OLN – Disinterest = Time For Something New
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Return On Capital Signals

In research published on Friday, we looked at a sector level at return on capital cycles and valuation peaks, concluding, as illustrated in Exhibit 1, that a return on capital peak for the Capital Goods sector is a sell signal, regardless of relative value. Other segments are similarly but less well correlated with the exception Metals and Mining which appears to be mostly counter-correlated – i.e. you want to buy at peak returns. Capital Goods looks to be close to peak returns, even if many of the stocks look relatively inexpensive – largely because of the inflated market multiple today. The easy mistake to make as an analyst, or a sell side investor is to hold on to an idea too long, creating arguments to support you case – which in this instance would be that returns on capital could go higher. For Capital Goods the return on capital chart continues to show upward momentum – first chart below – but in every prior cycle it has done so until it has turned, with the turn generally caused by something visible but underestimated – which in this case could be:

  • A slowing of economic growth
  • Wage and other inflation in the US – especially raw materials for the Capital Goods space – in a rising demand or rising tariff environment
  • Increased international competition because of capacity overbuilding.

In the research on Friday we looked at a handful of possible short ideas in Capital Goods and also highlighted MMM, which is beginning to see some raw material issues. In the chart below we look at the return on capital for CAT – the most discussed component of capital goods. Returns today are at their highest level versus normal since 1980, with forward estimates implying they will go higher. The stock has seen considerable appreciation in September and is just a little over “normal value” today, with the significant premium in return on capital causing a very positive skepticism index – second chart. History would say underweight the stock today – if the economy continues to grow CAT could see improved demand even from current levels, but the risk is that the additional growth comes with raw material and labor inflation. A slowdown in growth would cause returns to peak.

In the third chart we repeat the scatter chart that we included in the research on Friday. We did not highlight CAT as a short because it is in the wrong quadrant. It is not in the sweet spot to buy – up and to the right, but it is not an obvious sell and there are better ideas.

Lastly in this segment we include the SI elements for DWDP in part to show that the company is inexpensive and is not close to a return on capital peak, but also to show anyone under 50 the golden age of Chemicals – when the sector had its own valuation bubble in the mid-70s. This was the age of plastics and synthetic fibers and new useful “large-use” polymers were a regular thing – oil was also cheap.

DWDP does not look expensive and our normalized analysis still suggests a target price well ahead of where the stock is today, but the company is not yet delivering enough earnings growth and now has the backdrop of the commodity margin risks that we have discussed.

  • Sasol – More Debt = Terrible Project Economics.

Since 2014 Sasol has seen its net debt and other liabilities rise by $7.8 billion – first two exhibits. Debt stepped up this week following a US debt raise of $2.25 billion at approximately 6%. The debt increase, and other liability increase are a function of cash from operations falling well short of capital expenditures and dividend needs, and most of this is a function of the major cost over-run in the US ethylene plant – which was approved in 2013/14 when oil was high. This was originally part of a much more ambitious plan to build a large gas-to-liquids facility as well as the ethylene complex. Consequently, the company purchased more land than now needed and cleared the land, adding to cost.

However, the cost over-run on the ethylene facility is extreme and the recent debt raise only adds further evidence as to how much the company is spending (the company is now saying $11 billion – versus comparable projects from others that have cost half of that number, or less). This project would need a dramatic reversal of fortune for the US ethylene industry from what has happened recently to have any hope of a respectable return on capital and it is hard to see any scenario in which the NPV of the project is not negative to the extent of billions of dollars. Whether or not Sasol has any ability to claw back some of the costs from its E&C partners – who clearly have much to answer for here – is questionable. Given the size of the over-run, any successful action on Sasol’s part could prove extremely problematic for the contractors, which at the time the contract was let included Fluor, Technip and Worley Parsons.

Sasol is on our list of underperformers for the week, although we do not normally include Sasol in this analysis. This is in part due to the debt raise, which has a direct impact on the enterprise value and multiple, but it is likely that the ethylene margin situation is also having an impact. Chemicals have been more than half of operating income for Sasol for several years (since oil peaked) but fell very short – particularly in base chemicals in the year through June 2018 – and energy (very linked to oil prices) took the lions share. The stock has had a good year but has come off its peak since the US ethylene market has weaken – and stepped down this week with the debt raise. It looks expensive on an EV/EBITDA basis compared with other chemical companies and also expensive compared to oil companies.

If the company were to start up the US ethylene plant today – it was supposedly 80% mechanically complete in early 2017 – which begs the question as to what the company and its contractors have been doing in Lake Charles for the last 14-15 months – the plant would be losing money on a cash basis on every pound of ethylene produced – assuming there is demand for all of the ethylene. Additionally, any capitalized interest associated with the project would become cash interest and it is possible that Sasol’s base chemicals business globally could slip to losses.

Any further strength in oil will help the energy segment and may support the stock, but it looks expensive to us and there are better chemical names and better emerging market ethylene names today – with Lotte Chemicals looking like the biggest emerging markets bargain today – Chart below.

  • Ethylene – What Should The Acquirers Do?

Sticking with ethylene – there are a couple of companies in the middle of negotiations for acquisitions today – with market fundamentals deteriorating and a great deal more uncertainty today that when discussions started. We believe that LYB is still doing due diligence on Braskem, and Aramco has publicly stated that it will buy SABIC. In our recent piece on ethylene we showed how the ethylene cost curve has moved dramatically in only a few months – charts below.

  • The primary cause of the change is the escalation in ethane prices in the US
  • But propylene and butadiene prices are higher – particularly outside the US which has lowered ethylene costs for most producers using feedstocks other than ethane.

We have not redone these charts in the last 10 days but since that time US ethane prices have risen so the US ethane-based production is now driving the marginal global cost. The change in the shape of the first chart below is marginal but incrementally worse for US producers.

Neither of the potential acquisitions is impacted by the moves in US costs – though it is unclear whether the Braskem facility in Mexico has seen any increase in ethane costs (unlikely as the problem appears to be isolated to the US Gulf). More concerning for both LyondellBasell and Aramco should be the slow erosion of ethylene pricing and polyethylene pricing globally, and whether this is a temporary 2018 issue or more systemic. The fact that the US is increasing exports of everything ethylene related is not up for debate as is the fact that the US surplus is going to increase as Lotte, Sasol (see above) and Shintec add capacity for ethylene, and delayed polyethylene plants come on line. The US is no longer a low-cost producer – maybe this persists and maybe not – but can keep pushing product out as long as European and Asian prices remain high (first exhibit). But there is a negative trend to these international prices – albeit a slow trend year to date.

If you are Lyondell or Aramco you run the risk of making acquisitions at the peak of a pricing cycle that could be undermined by US investors, especially if US ethane prices normalize as supply rises. Patient and opportunistic “bottom of the cycle” buyers have historically been the only people to make good returns in this industry – Westlake being the best publicly traded example today. One could make a case for Trinseo, but Bain Capital was the opportunistic buyer and both Bain and Trinseo shareholder have benefitted. OLN overpaid for the Dow business and it has been a problem for the company ever since – see below.

Nova Chemical paid more than replacement cost for the Williams unit in Louisiana last year and this must be a decision the company regrets today as current ethylene margins are likely zero or lower and integrated polyethylene margins do not support investment to consume the ethylene. Nova, Borealis and Total must be re-evaluating their plans to build in the US, particularly Nova.

If LYB acts now for Braskem, it could buy a business on a downcycle and the deal will look poor. But if LYB waits and the global market deteriorates, not only could LYB’s ability to pay for Braskem weaken, but price renegotiation could linger until we find a market bottom, at which point there could be more buyers.

The same is true for the Aramco – buy now and you might be buying at a peak. In Aramco’s case, the risk of waiting may not be as great as it is for LYB.

We would buy WLK and TSE – WLK because the company is likely to buy assets cheaply if the US ethylene fundamentals remain weak and pull-down derivative valuations. TSE, because the company remains in businesses where fundamentals are still good, and while the company will pay more for ethylene in its US JV, this is a manageable increment.

  • OLN – Disinterest = Time For Something New

Is it time for a radical change in thinking at OLN? The stock would suggest that investors are not interested in the status quo: – either in the current plan, the slightly better numbers this year or the leadership. In the first 2 charts we show a couple of measures of valuation, one relative – and on the same basis as our “chart of the week” analysis above, and the second absolute, looking at straight EV/EBITDA. The first chart is more concerning than the second as it shows that there has been a continued lack of interest in the name even as returns on capital have risen.

The primary issue with Olin, in our view, is that the company has never really admitted to, and therefore never tried to truly deal with, the fact that it overpaid significantly for the Dow Chlorine Products business. While the price paid may have been necessary to win in a competitive bidding situation (however, we suspect Olin overpaid meaningfully next to Dow’s next best offer). The company clearly did not do the required due diligence to pull apart the assumptions on the business that Dow presented at the time of sale – Dow did an extremely good job of maximizing value for its shareholders, at the expense of OLN.

  • OLN has underperformed in an improving chlor-alkali market, to which it doubled its exposure through the Dow deal.
  • OLN has failed to deliver any of the targets set for the Epoxy business, losing money in 2017 and making almost nothing in 1H 2018, while one of its main competitors, Huntsman has shown steady profits and healthy margins in its Epoxy segment in both years
  • With the Dow deal, OLN was able to secure ethylene supply at “cost” from Dow to meet its needs for EDC production – OLN paid up front for this. Since the new Dow ethylene plant came on line and the contract started, ethylene costs have been at or above ethylene pricing in the US, so OLN has not had luck on its side either
    • This is not OLN’s mistake, as anyone negotiating for the Dow assets would have taken an ethylene deal from Dow at the time the deal was done.

So, what should OLN do next – our best idea would be to sell – at less than 6x EBITDA the company looks inexpensive, but it is unlikely that too many offers are going to come in with the current uncertainty around US feedstock costs and trade. However unlikely a third-party bid might be today, it appears that nothing OLN has done over the last couple of years has found buy-in with the investment community. OLN is trading at less than 10x what 2019 were forecast to be in January – they have since fallen.

OLN needs some fresh ideas and a fresh strategy (and possibly fresh blood) – and perhaps the best way to get there is to start looking for business combinations – ones that would bring synergies, diversity and scale, but also perhaps some more creative management talent. When we suggest diversity, we do not recommend straying from the commodity roots of the company – just adding some adjacent and complimentary product lines. For example, in a recent piece we suggested a merger between OLN and Chemours (CC). This would do a couple of things:

  • Provide synergies through corporate overhead rationalization and through the business combination of the chlorinated organics segments.
  • Provide some back integration to chlorine for CC
  • Hopefully put a fresh set of eyes on the epoxy business and come up with a plan that makes sense around where those assets sit in the competitive landscape and how best to create value.
  • It would make sense to offload Winchester before any deal, and OLN needs to accept that what may look like a dilutive sale (most likely into private hands) will still likely give valuation a boost.

The most exploratory discussions that OLN has with other companies and/or experienced industry consultants/investment banks, the more likely the company is to come up with something that works and adds value. No one seems to be interested in the current story, largely because it is not believable based on recent history – over the last 5 years OLN has over-estimated earnings substantially – first chart below, and is the worst in the chemical sector – second chart. 2018 is looking no different directionally so far. If you haircut 2019 estimates aby the average miss over the 5 years through 2017 you would get $1.42 for earnings in 2019, which more than justifies the current valuation and could make an argument for downside.

It’s time for a new plan at OLN, the question is whether the management team realizes this and has the skill set to change tack. Had we not included Sasol in this week’s winners and losers’ analysis OLN would have made the bottom 5, again.

  • 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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