Weekly Findings – September 2nd, 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 2nd, 2018

Weekly Findings – September 2nd, 2018

Thought for the week: “Plenty of Unloved Stock and Sectors Within Industrials and Materials”

  • Chart of the Week – Goodwill Climbing.
  • GE – The Power Debate Continues – We Worry About Commoditization
  • HUN, 1COV: Free Polyurethane – Bargain Stocks, But Bad Read for LYB and DWDP
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Goodwill Climbing

The Chart of the Week shows the proportion of balance sheet capital that is comprised of goodwill for a selection of large industrial and material companies. We drew this chart as a consequence of looking at the growth in goodwill as a proportion of capital for GE, which has been dramatic over the last few years and which is covered later in this report. We were a little surprised to find that GE had so much company at such high portions of goodwill. Further analysis suggests that GE remains a unique story and that the rest of the group (except DWDP) are a function of growth through some well-timed and executed acquisitions – exceeding regular capital investment and causing Goodwill’s share of the capital base to rise.

In the case of DWDP, the “merger” was accounted for by a Dow acquisition of DuPont, and the very high Goodwill is a function of stepping up the value of DuPont relative to its depreciated capital base. Good Goodwill versus bad Goodwill is perhaps best looked at by comparing the return on (full) capital for the companies with large Goodwill bases – chart below.

HON, MMM and EMR have managed to sustain and even grow returns on capital despite higher levels of intangible assets, with MMM the standout. UTX has had a more volatile past, but GE is the clear loser of the group – no surprise. What we cannot judge from this broad analysis is whether GE’s Goodwill is a problem – we will cover that in the section below. The high proportion of GE’s capital that consists of Goodwill is as much a function of declining capital as it is rising Goodwill. The other companies in the analysis have increasing capital bases and their better return profiles suggest much better stewardship of capital than GE, with UTX struggling more than MMM and HON, but less than GE.

Even in a faster economic growth world all of these companies are struggling to find high value added large capex ideas as they have either ample capacity or low-cost expansion opportunities. Consequently, M&A has been a theme (in the case of GE it has been divestments), and we expect the theme to continue – we would not expect Goodwill to fall without write downs, and GE is the only company where that looks likely and where the write downs could be meaningful, see below.

The third chart shows the underperformance of the sectors so far this year – some of this is not surprise to us as we highlighted both Capital Goods and Conglomerates as sectors close to or above prior peak valuation at the beginning of the year – we have been more cautious on MMM than HON because of more extreme valuationThe surprise is Paper and Packaging – which now looks even more interesting than it did at the beginning of the year.

The pull back in Capital Goods and Conglomerates (the performance is similar with and without GE) is probably not enough for us to change our cautious stance on the groups yet, but HON has had some quite positive revisions YTD. HON is not cheap, but as shown in the skepticism chart below, its premium to normal value is justified by its above trend earnings. We still prefer UTX in this group, but HON is worth a look.

  • GE – The Power Debate Continues – We Worry About Commoditization

Earlier in the year we suggested that we might be interested in GE below $12 per share – something the company achieved (for a short while) last week. We note that the analyst that has been most bearish on GE – and most correct – has stepped down his target price as the stock has declined and in situations like this it is important to establish whether you are moving your target price to stick with a story that is working or because you have new information.

Last week we touched on one of the problems of chasing a stock up – which is the eventual overestimation of earnings leading to negative surprises. Sell recommendations are far less common, but the same logic can apply. Rather than take our target price down for GE we are going to lay out a logic for the stock to move below $10 per share. For this to happen we would need to see further earnings degradation and another step down in estimates – probably below $0.75 per share for 2019. This is not unlikely on a reported basis – in fact we believe that reported earnings could be close to zero over the next 18 months – but GE’s businesses would need to get much worse for this to happen on a recurring basis.

First the reported numbers. We expect GE to take some substantial write downs over the next 18 months as well as further restructuring charges. This based on the assumptions below:

    • Goodwill is too high – first chart.
    • Has risen dramatically as a portion of overall capital – second chart
    • In part because capital has fallen – third chart
    • And despite the falling capital – returns have not improved – 4th chart

We do not see, given results (in both the power and energy businesses) how the Goodwill associated with either can pass any normal impairment tests. It is unclear why we have not seen impairment charges already – which leads to a broader concern, and one related to recurring earnings, that GE still does not have its hands around its finances and its accounting practices.

Given the well documented problems in the power business as well as lower business activity in renewables, we expect further headcount cuts and restructuring charges in both businesses as well as charges associated with both the Transport divestment and the Healthcare separation.

On the recurring side of earnings, for things to get much worse we would likely have to see another step down in earnings in the Power and/or the Renewables segment. While Energy could disappoint, it would likely be largely ignored in valuation because the company has elected to separate the business. The Capital segment is also a wild card, but is generally looked at as non-recurring, and while it has the risk of driving significant cash charges – as does the pension plan, unless it called into question balance sheet solvency of the company it is unlikely that further manageable charges would take the stock much lower.

As the chart below shows, margins in both Power and Renewables appear to have stabilized – albeit at low levels and against much reduced revenues in both segments.

Our concern for recurring earnings in these segments is driven by the decline in revenues – second chart – and its possible impact on market dynamics:

    • The revenue issues are not just GE issues and every participant in the power and wind industries are experiencing reduced demand and underutilized capacity.
    • Companies behave in their own perceived best interest when in downturns and this is more than likely to lead to price pressure, not only on new plant and equipment but also om maintenance as every player looks at market share gain opportunities to offset slower overall demand
      • Almost every industry has seen dynamics like this – no reason why it should not happen here also.
    • In the wind space there is also pressure from the customer – with limited subsidies and more competitive global natural gas prices, wind farm operators need to lower capital costs to be competitive and it is not a stretch to see a scenario where suppliers cut prices to win volume.
      • In these situations, the companies with less regard for metrics like return on capital and a more aggressive market share mindset will likely make headway at the expense of GE – or could drag GE pricing lower as maintenance contracts come up for renewal.
    • The maintenance side of the power business is similarly at risk in our view, but more because of competition than because customers have a competitive need to lower costs in the way that wind (and solar) based generation does.

This is all very hard to quantify, but further cuts in revenues and/or margins in both the renewable and power businesses are what it would take to drive GE towards $10 per share in our view – barring something unforeseen and calamitous in GE Capital. The scenario we outline above has a much greater than zero chance of taking place – maybe as high as 40-50% and consequently we still cannot see a reason to own GE. Note that each time we have made this call in the last year or so we have done so with the concern that we were perhaps missing the bottom, and so far each time we have been correct. This is a business where no-one “batts a thousand” and we are clearly getting closer to a bottom – probably not there yet.

  • HUN, 1COV: Free Polyurethane – Bargain Stocks, But Bad Read for LYB and DWDP

The investment community has no love for the polyurethane markets, punishing both Huntsman and Covestro (those with the largest proportional exposure) year to date despite extremely low valuations and positive revisions – first and second charts below. HUN appears in our weekly losers’ chart, but Covestro had a worse week than HUN (down 6.6%), though not included in our US centric analysis.

Both HUN and 1COV are on our favored list (and have been for a while), because they operate in business segments that have not seen over-investment in recent years and have strong exposure to improving economic growth and some pricing power. Both BASF and DWDP are significant participants in the polyurethane markets, but the businesses are a little lost in much larger portfolios. LYB is a significant polyurethane ingredients producer. The market seems to be focused on expected oversupply in 2019 of isocyanates (MDI and to a lesser extent TDI) – both ingredients in polyurethane manufacture, but all participants are showing strong growth in 2018 and it is likely that the impact of new capacity is significantly overblow in stock valuations – especially for HUN and Covestro – third chart. These companies are throwing off mountains of free cash and we struggle with the idea that private equity is willing to look at ARNC at 8.3x EBITDA in preference to either HUN or 1COV (notwithstanding the issues of trying to take a company private in Germany without strong corporate support).

Other observations from the charts:

  • Given the discount in HUN and 1COV versus the others (1COV especially), why is LYB not looking to buy HUN or 1COV to create an integrated polyurethane business – much higher valued within DWDP
  • Contrary to the above – if polyurethanes are so unloved, why is LYB getting bigger in the intermediates segment.
  • Dow Materials, when spun out is going to look like LYB with a bit more HUN and 1COV in the portfolio than LYB – this does not bode well for Dow Materials valuation – DWDP is 2 multiple points higher than LYB and 4.5 multiple points higher than 1COV today.
    • If polyethylene continues to weaken, and polyurethane valuations do not improve, market conditions will not be that attractive for a spin out of Dow Materials in the next 6 months.
  • Is DWDP really worth 2.5x EBITDA more than BASF?

We like every stock on this list except LYB which we have written about recently. It is hard to ignore the attractive valuation of the European names – more beaten down by higher oil and trade concerns than the US names so far this year – despite strong revisions. We see another great entry point for HUN.

  • 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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