Weekly Findings – SSR Industrials and Materials

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 6th, 2018

Weekly Findings – May 6th, 2018

Thought for the week: “Is There Any Reason To Buy DWDP Now?”

  • Chart of the Week – Cheaper?
  • DWDP – Any Reason To Buy Today
  • WLK – Why Bet Against These Guys?
  • KRA (Kraton) – An Interesting Longer-Term Play
  • Weekly Winners & Losers

Chart of the Week – Cheaper?

  • Chart of the Week – Cheaper?

The chart of the week shows the valuation pullback in the Industrial and Materials sector over the last few months, but at the same time it illustrates how expensive the group has become in absolute terms. Clearly the rise in valuations since the financial crisis (give or take some initial volatility), reflects the lower yielding fixed income market and the broad appreciation that equities have seen as a result.

The pullback in the “chart of the day” is a function of both the market pullback – chart below – and the rise in EBITDA estimates that have accompanied better earnings in the first quarter and further positive revision – see last week’s email for the proportion of companies beating expectations in Q1 2018. Regardless of how well companies perform in terms of earnings for the balance of the year, the levels of absolute value remain high and are vulnerable to further macro nervousness and higher yield alternatives in the fixed income markets. We remain confident that both the Industrials and Materials sectors can continue with better earnings this year and better free cash flow yields that are hard to match anywhere else, but clearly, we cannot influence broader market sentiment. Group EBITDA would have to increase meaningfully for the sectors to look cheap in absolute terms – probably more than is possible even in a best case in 2018/19.

We look instead for companies that are trading at major discounts to the groups and therefore offer very high current or potential free cash flow yields and absolute or relative upside as a result: DWDP (despite comments below), 1COV, HUN, AA, FCX, UTX, EMN, FUL, CCK. We also like growth stories that are underestimated; SWK, PX (and Linde).

See out monthly SMID Chemicals work for our preferences in this group – a list which increases today with the comments on Kraton (KRA) below.

  • DWDP – Any Reason To Buy Today?

Having read the release and then listened to the quarterly call, one could come away with the idea that DWDP management is not that interested in helping investors get a better understanding of what is going on today and what the potential might be. We have another set of quarterly numbers and accompanying guidance that can be interpreted either negatively or positively – depending on your bias – no real new information about what to expect next, and an attitude towards share buy-back that suggests the company does not necessarily think the stock is as big a bargain as it might appear (and certainly appears to us).

  • What will become the new “Dow” had a very good quarter, as did what will become the new “DuPont”, with both combined raising EBITDA enough to offset a major calendar shift in Ag revenues and EBITDA – with business apparently moving from March to April.
    • This unpredictability will be gone post-split, partly because Ag will be separate and partly because the Ag business will report on a seasonally appropriate calendar – with Q1 ending in February rather than March – as MON has done for years.
  • The “Dow” and “DuPont” Q1 results should be taken as a very positive sign except that the company guided to Q2 EBITDA that did not account for the whole Ag shift – either this is an attempt to be conservative or not all of the lost Ag business was simply timing (or something else is going on).
  • Consequently – the guidance can be interpreted both negatively and positively – an upward revision, but not enough of one.

DWDP should generate more than $20bn of EBITDA in 2018, based on Q1, Q2 guidance and synergy expectations for the second half – yet consensus sits at $18.6bn, despite the slight Q1 beat and the raised Q2 guidance. We have noted in the past that DWDP is not seeing the revisions that other companies have seen – we would have expected some movement after Thursday, but nothing so far and probably not enough when all changes have been made. Revisions might help the stock, but the rest of the commentary on the call probably will not; it is almost as if management is happy with the stock where it is.

Analysts are waiting for details around the splits in terms of capital structure and none of this has been forthcoming. While DWDP cannot give precise details, the company could have given guidance but chose not to – suggesting that we will have to wait until September. There was also no clarity around leadership for the Specialty and Ag business. So, again we must wait!

More concerning, at least to us, was the lack of enthusiasm for a larger/more aggressive buy-back program, especially in the light of where the share price is languishing – EV is only 8.5x 2018 EBITDA today. DWDP has $10 billion of cash on the balance sheet and is effectively forecasting 1H EBITDA that is $0.5bn higher than expected at the beginning of the year – the company also has a significant portion of its initial buyback allocation available – not stepping up purchases at current prices makes little strategic sense. The argument that the company is in discussions with ratings agencies about the spincos capital structures and does not want to rock the boat is weak, in part because the balance sheet is so clean, but also because of the higher EBITDA and the outstanding authorization. This all begs the question; “what is really going on?”

  • Does one of the spincos have a large cash based acquisition planned? We hope not.
  • Is there an internal turf war around who gets saddled with debt and who doesn’t?
  • Are there deals in the works today – such as a large RMT – whereby the residual business would. benefit from a low share price today because of the ability to reduce the share count by a maximum amount?

The last possibility could be a positive, but the first two; definitely not. We think there is a risk that, without news, the stock languishes through September as the overall sector generally does not do well in the summer. For the patient, we still believe that this is likely a very good investment, at an attractive entry point. We see a recent surge of chemical investment announcements causing problems for commodities post 2021, in additions to our broader longer-term refining concerns, but we expect new Dow and new DuPont to have a pretty good run for the next 3 plus years.

  • WLK – Why Bet Against These Guys?

Westlake delivered another very strong quarter, showing the overall strength in the vinyls business, driven by strong demand for both PVC and caustic soda, as well as some of the specific ethylene cost advantages that the company has in the US, in part offsetting some of the polyethylene price weakness discussed by others. In 2015, few would have anticipated the earnings growth that WLK saw in 2017 and is expecting in 2018. The opportunistic purchase of Axiall has been much of the driver but clearly improving markets have helped. Estimates for 2018 have doubled since Q1 2017.

However, analysts don’t think it can get much better than this, as indicated in the chart, with estimates essentially flat for 2019 and 2020 at the 2018 levels. Despite the strength in the PVC market, driven by a better global economy in general, and more specifically a step up in demand in India as the country aggressively pursues clean water programs, it is a stretch to see how prices and margins could improve further, but in a short commodity market anything is possible (look at aluminum) – a step up in US infrastructure spending would likely be a tipping point for PVC today and WLK is adding capacity to react to the stronger market. PVC is not a simple market to either enter or expand in as you have to have both the chlorine and the ethylene (ideally at favorable economics) – this is what is making it hard for India itself to respond to the rapid increase in demand.

If we thought that WLK was going to stand still at this point we would likely be less enthusiastic about the story given the outperformance and the valuation. But standing still is not what WLK does. As shown in the second chart, the company has improved its return on capital post the Axiall deal – largely because markets have improved but also because investments in reliability have given the company more product. Debt levels are falling – last two charts – and this is a company that has used leverage well to acquire attractive businesses at the right point in the cycle to create significant value.

The company already has one possible acquisition on the books – the balance of its 50% stake in the Westlake/Lotte ethylene plant that looks like it will be mechanically complete later this year. The price tag for Westlake will be around $1bn and the decision will rest on whether WLK wants to buy the ethylene capacity or buy the ethylene molecules (an some market related price) – at today’s spot price they would want to buy the ethylene and not the capacity, but WLK has a three to four-year window to exercise this option.

Otherwise the balance sheet pump is already primed to make another acquisition. In general asset prices are high, plus there is lots of PE competition for higher quality businesses. WLK has made its money by buying lower quality businesses at the right time and then running them better – these opportunities come up from time to time and WLK has market leading “opportunistic” skills.

We would not bet against these guys.

  • KRA (Kraton) – An Interesting Longer-Term Play

If we are truly worried about the world’s increasing focus on plastics waste and at the same time trying to model whether refiners become more interested in chemicals and fuel demand peaks and starts to decline, (see links to research at the end of this section) we would look for companies that might be on the beneficial end of both risks. Kraton is likely one of those companies, as long it can weather potential feedstock volatility over the next few years.

Kraton is focused in end markets that are not “one-time” plastic uses (except perhaps blood bags), but markets that are more durable in nature and with a bias towards infrastructure – which will need continuous investment, whether we drive gasoline or electric vehicles. We can see a scenario where a trend towards autonomous driving brings further pressure fix US roads from a safety perspective – an autonomous vehicle cannot change its own tire when it hits a pot-hole and down-time to repair run-flat tires will be an issue for operators.

Kraton buys raw materials that could become more surplus because of the two risks listed above. Any move towards better recycling of polymers and less single use is likely to hurt polystyrene more than other polymers in our view – lower styrene demand – cheaper styrene for KRA. More refinery butylenes hitting the chemical markets probably means cheaper butadiene and isoprene for KRA.

Today, the stock is not that expensive given forward estimates – but in the near-term it is vulnerable to possible spikes in both butadiene prices and styrene prices – given that both markets are tight enough for one or two production outages to cause pricing spikes – we saw one for butadiene early last year.

For a patient buyer, who is willing to accept the risk of volatility, this could be an interesting stock. Furthermore, as we think about possible downstream consolidation moves we would add KRA to the bucket of names that could be interesting to a strategic buyer or private equity looking at a roll-up strategy. We are adding KRA to our SMID Chemicals focus list.

Relevant research:

April 16, 2018: Petrochemicals: Time To Stop Investing – For Ever?

February 9, 2018: Friday Findings – February 9th, 2018

  • Weekly Winners & 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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