Weekly Findings – September 9th, 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 9th, 2018

Weekly Findings – September 9th, 2018

Thought for the week: “Skeptical? – It Can Result In Outperformance”

  • Chart of the Week – Skeptical.
  • Who is Paying 48 cents per gallon for US Ethane?
  • Westlake – Dip = Opportunity
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Skeptical!

We have not published out Industrials Monthly in a while and it will likely become a quarterly report going forward, beginning at the end of September. That said, we keep the models up to date and the chart of the week stood out at the end of August: we are currently at peak (since 2010) levels of skepticism for multiple sectors. Underperformance has made the stocks more attractive on a relative basis and we have generally seen improvements in returns as earnings have grown. Note that the Skepticism Index (SI) is a measure of how misaligned earnings and valuation are at a given time. A high SI suggests that a stock/sector has (relative) upside or earnings are going to fall. See Prior Work

If we look at Conglomerates (excluding GE) – first chart below – we have seen higher SI values, but we are approaching the peak pre-the financial crisis. Within Conglomerates, MMM (second chart) is the high outlier as returns have improved both because of lower capital deployed and improved earnings. This is a stock we have had on our “avoid” list and it has underperformed this year (by around 16%) – driving part of the upward move in the SI. The rapid decline in the SI from the peak in 2007 saw the stock outperform the market, even as its returns fell – i.e. the correction was a combination of earnings declining and improving relative value – the stock fell, just not as much as the market.Today MMM looks like a place of relative safety if you are concerned about the broader market, as does the Conglomerates sector in general, notwithstanding our concerns on GE.

A stock we prefer is SWK and we show the SI index in the third chart – also at a peak since 2010 but less pronounced than MMM. In the case of SWK the capital base is growing – mostly through acquisitions and the high SI is mostly a function of cheap valuation – return on capital has recently returned to trend, following several acquisitions which were initially dilutive to returns. Given the stable base business at SWK this is a story that should work on a relative and absolute basis. The stock is trading at 10.4x 2019 estimated EBITDA and we believe that this EBITDA estimate may not adequately reflect the Craftsman addition, which should begin to impact earnings in 2H 2018. Our normalized framework suggests 25% relative upside today, and this is one of many stocks that should see a positive move in valuation when trade discussions draw to a conclusion.

  • Who is Paying 48 cents per gallon for US Ethane?

Last week ethane prices in the US Gulf closed at 48.5 cents per gallon, the highest price since April of 2012 and a jump of 8 cents per gallon in a week. Ethane pricing in the Gulf is rising quickly versus both natural gas and propane – first chart – as demand from ethylene units outstrips availability. The question is who is paying these prices as there are no economics in making ethylene – cash ethylene costs are around 25 cents per pound at these ethane prices and while the spot futures market for ethylene jumped to 19 cents per pound late last week from a last real deal at around 15.75 cents, the futures number remains well below costs. Current costs are higher than August contract prices – second exhibit – and we would expect contract prices to rise in September to reflect cash cost at a minimum. The buyers of ethane at these inflated prices likely fall into one of two camps:

  • New ethylene unit operators looking to test the capacity of new facilities and inadequately covered on ethane supply. This is possible but unlikely, as if they really are making no money, CPChem, Exxon and Dow would cut back other facilities to free up ethane for their new units.
  • Integrated ethylene/derivative producers looking at an incremental sale of something into the export markets. This is the more likely option as pricing for polyethylene, PVC and other derivatives in both Europe and Asia are still high enough to justify paying the higher ethane price.

But this is a downward spiral as the US is forcing incremental pounds of ethylene into other markets using marginal local economics. While we are seeing costs rise in the US, we are also seeing a slow erosion in US polyethylene pricing – 1-2 cents per pound per month – netbacks from exports are falling, so all producers would rather sell a few more pounds locally. At the same time PVC pricing is weakening is Asia – a market that had been stable and strong for some time. The US has surplus capacity of PVC and its precursors, EDC and VCM. Like ethylene glycol (MEG), EDC is a liquid and is fungible (i.e. “one grade fits all”) – consequently it is straightforward to trade in bulk. PVC itself is more fungible than polyethylene, in that pipe grade – much of the export demand – is both broad in terms of application and broad in terms of quality. The declines in international PVC prices are part of the problem/opportunity at WLK – see below.

The irrational behavior in US ethylene today has never been seen in the past – third exhibit – and frankly we did not expect it to last beyond June. It is a clear consequence of the current and growing surplus of ethylene and derivatives in the US, and the discomfort required to find new buyers outside the US – especially if it is an attempt to replace an existing supplier. The trade issues do not help – Chinese tariffs on polyethylene mean that US polyethylene must find markets elsewhere or accept lower prices. We had expected demand growth in 2018 to be sufficient to soak up the new US capacity, and while this may still be the case (only Eastman has talked about cutting ethylene production in the US, everyone else is pushing volume), it looks like pricing could remain under pressure for the balance of the year.

If ethane stays high we are going to see some significant earnings disappointments from LYB, WLK, DWDP and EMN. WLK was protected because of its exposure to the ethylene spot market, but that is little help when ethane pricing is pushing up spot ethylene prices. Integrated polyethylene margins in the US have now fallen their historic average last chart. See recent work on LYB

  • Westlake – Dip = Opportunity

While the current ethylene/polyethylene environment may be causing some hand wringing at LYB and DWDP today (maybe more at DWDP as they contemplate the first spin), we are fairly certain that no such thing is happening in the WLK office. No one likes to see share prices decline and you would expect that to be even more so at WLK because of the family ownership, but we have learned over the years that this is not how WLK thinks.

THIS IS AN OPPORTUNITY!!!

For WLK management it may be another opportunity to do a good deal – which is what they will be focused on, and why you should always own the stock. For an investor it is an opportunity to buy WLK on a dip.

  1. The stock price is not high – it may look so on an historic basis – first chart – but it looks extremely attractive on our normal value metric – second exhibit.
  2. It looks cheap because of M&A – adding the Axiall assets between the prior stock peak and this last one, improving return on capital – third chart – on a much higher capital base – fourth chart. All of this done without diluting shareholders as the Axiall deal was all cash.
  3. The stock is not as cheap as it has been at prior lows – second and second to last exhibit – but it is when valuations decline that WLK starts dealing and those deals have always been at valuations that have made sense and are generally very well timed with respect to cycles.

We would be much more aggressive buyers of WLK today because the stock is cheap, and the upside could be significant – our normal value for stock is $140 per share. Reflecting back on our chart of the week discussion, in the last chart we show WLK’s Skepticism Index. If you bought the stock at the last high you had a double in 9 months. The risk with all of these cyclical names is that fundamentals may get worse before they get better – much of that is reflected in current valuation, but incremental downside is still possible.

  • 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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