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 13th, 2018

Weekly Findings – May 13th, 2018

Thought for the week: “Who Needs Research Anyway?”

  • Chart of the Week – Research Coverage – Is Less More?
  • PPG – Is It Just Smoke?
  • Coatings – Where Next?
  • Arconic – More Downside is Possible
  • Weekly Winners & Losers

Chart of the Week – Research Coverage – Is Less More?

US Chemicals – All Market Caps

  • Chart (table) of the Week

The table of the week is the result of some analysis suggested by a conversation I had earlier this week with Tradegar Corporation – a very small cap chemical stock that has not had active sell side coverage since 2013 – nor does it particularly want coverage. At the other end of the scale I met with another mid-cap chemical company this week that has 20 analysts covering the stock. The table includes 48 US SMID chemicals stocks broken into thirds – the average company in the top group has 13 analysts covering the stock and in the lower third the average is only 2.5, with several at zero. We have to use trailing multiples in the EV/EBITDA calculations as we have no forward EBITDA for many in the lower third. The middle group includes NGVT, KWR and FUL – all trading at more than 16x trailing EBITDA because of acquisitions that impact forward EBITDA – take them out and the valuations for each group look similar.

However, the performance for each group is very different, and while it might be a preference for smaller cap stocks (which tend to have fewer analysts covering them), it may be specific to SMID chemicals (where we have a large sample set), as when we do the analysis across larger cap Industrials and Materials we get no performance correlation at all – table and chart below. The trailing performance of the most covered group in SMID chemicals is quite significant.

The constituents of each of the chemical thirds are shown in the last table – we have a strong preference for the following in the middle group – FUL, KWR, ENTG, KRA, TSE, CCMP.

All Industrials and Materials:

  • PPG – Is It Just Smoke?

The individual who has been held responsible for the accounting issues at PPG has apparently been dismissed from the company and two of his or her subordinates have been reassigned to other jobs. While the company is clearly acting with respect to accounting irregularities, we are not done, as the investigation continues and we are told that 2017 financial statements cannot be relied on. There would be no way in which anyone in a senior financial role at a company as sophisticated as PPG could personally benefit from “playing with the numbers”. Consequently, the individual concerned was either guilty of incompetence or was too eager to please – i.e. deliver numbers that might have seemed important to his or her superiors. Note that in the chart below, the accounting change for Q2 2017 was the difference between PPG meeting and missing estimates.

PPG subsequently missed Q3 estimates but would have met them had the accounting error not been made – assuming that there are no more issues to report following the review, which remains on-going.

In the first half of 2017, PPG was in the midst of its attempt to buy Akzo and a cynic might conclude that there was pressure on the company to outperform Akzo, by beating or meeting numbers, while Akzo was on a journey of earnings misses and negative revisions. However, by the time PPG reported Q2 2017 earnings the deal was off and PPG was officially in a six-month “cooling off” period based on Dutch M&A rules.

We are concerned that the accounting errors were either a function of pressure from the top, or a lack of oversight. If that is the case, and the audit committee does not do its job properly we end up with a company with weak leadership, likely to continue with poor or overly optimistic judgement. If, on the other hand, there is more to come and we see a change in leadership at PPG it could be a good thing, depending on who fills the role. It is no secret that the PPG/Akzo deal broke down because of a dramatic clash of character between the Chairman of Akzo and the CEO of PPG – both sides blame the other. With the right change at PPG and with the Chairman of Akzo now gone, the deal (which makes a lot of strategic sense for both) may come back on the table. The issue would be finding a credible successor for Mr. McGarry. When Dow Chemical replaced Michael Parker with then Chairman Bill Stavropolous in December of 2002, there was no real stock reaction and Bill was a well know and well liked prior CEO. Reengagement with Akzo, coincident with a popular change in leadership might be very positive for PPG, but for now we remain negative.

  • Coatings – Where Next?

As a natural follow-up to the PPG commentary above, we thought it might make sense to think about what the options might be for the coatings players in an industry that has generally seen quite high multiples because of good stable growth, but where end markets are now only growing slowly and most of the recent growth companies have seen has been generated through M&A.

In the US, PPG, Sherwin Williams and Axalta have all been acquisitive over the last few years. For PPG this has been normal course of business, but for SHW and AXTA it is a new strategy and AXTA seems to be doing a better job of integration and driving synergies than SHW – something we expect to continue for both companies as SHW has gone very off-piste in a number of directions with the VAL acquisition, while AXTA does appear to know what it is doing, even if earnings have been consistently over-estimated in recent years. Combining valuation and strategy today AXTA is probably the better place to be in the US, though things could change at PPG (see above) and both AXTA and RPM could be acquisition targets

In Europe we have seen BASF move tangentially with Chemetall and Akzo focus on coatings with the Chemicals sale. While Akzo has indicated that it will return its cash from the chemicals sale to shareholders, we are very skeptical and see the company more likely to chase an acquisition or do some sort or sweetened merger with AXTA, with an implied premium for AXTA in the merger ratio. This assumes that PPG does not jump back in.

As we think about future M&A – industrial coatings appear to be the most fragmented but also the most likely area to drag companies to the periphery of what we might consider coatings. We like FUL because we think it has a growth story based on its recent acquisition, but we could also see it as a possible take-out target for one of several companies, including the coatings players. In our recent Chemicals SMID piece we highlighted Quaker (KWR) – a metal working chemical supplier in the midst of a consolidating acquisition. KWR’s customers are the customers of the auto and other machinery coatings customers as well as the large steel producers – it would not be a stretch for a coatings company to group KWR within “industrial coatings”. Assuming that KWR is successful in closing the Houghton deal the company is currently trading at around 12x forward pro-forma EBITDA. PPG is at 11x and AXTA is at 11.5x. Akzo has cash and is trading a premium to the rest. KWR could be even more interesting to BASF following the Chemetall acquisition.

We would probably own AXTA at the margin because the roll up strategy seems to be working and there is the possibility of an attractive M&A/merger deal. We would definitely own FUL and KWR, with the caveat that KWR is pricing in the closing of the Houghton deal and should that not happen (last minute competitive bid, for example) the stock has downside.

  • Arconic – More Downside is Possible

Yet again the “better looking” parent is outperformed by the “ugly stepchild” (AA). But is the future for Arconic possibly bleaker than what is happening today? We are concerned that raw materials could remain high and stronger for longer for Arconic while customers are in no mood to accept any pricing given problems of their own. Aircraft engine makers will probably not want to see ARNC bankrupt, but they will not care much if margins shrink further.

Yes, the aluminum market is all about Rusal today, but the fact that a 5% supplier – see first table – some of which is consumed within Russia where there are no sanction/trade issues – can cause this much volatility and, frankly, sporadic supply panic, shows just how little slack there is in the world market. China could restart capacity, but this would go against some very clear environmental edicts that have come out of Beijing over the last couple of years – plus China is not short of aluminum – not their problem. It would take a couple of years to add material new capacity elsewhere in the world and given the very poor last 5 years producers might want to see more evidence of a stronger market before committing hundreds of millions in capital.

What has driven the market over the last few years will continue to drive the market – autos! For perspective, a market that is growing at 5% per annum is jittery about the partial loss of a 5% supplier. It is time to accept that the world is short of aluminum and those holding speculative inventory are likely going to get a payday! But this is a smaller group than it was previously, with lower inventories part of the driver of volatility in the market today – chart.

Arconic is on the receiving end; and it is worse than just aluminum as other metal prices are rising. The aircraft engine makers are generally under pressure to meet new designs with greater efficiency and lower costs (while raising profits) and should have little sympathy for a parts supplier with raw material issues. The businesses that the old Alcoa acquired to create Arconic were cheap because they had just been skewered by a cycle of higher raw material prices (first chart), lowering margins. Arconic has a lot of debt and high interest payments. Further spikes in metal pricing (we are well off prior highs) could impact interest coverage; the revisions that we have seen for 2018 – second chart – may not be enough. Aircraft engine makers margins are shown in the last chart – they are not growing.Note that while the GE margins is after tax, we suspect that it is before any financing charges sitting on the GE Capital books – part of GE’s larger problem in our view.

  • 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.

©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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