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 27th, 2018

Weekly Findings – May 27th, 2018

Thought for the week: “GE – Are The Stand-Alone Businesses Worth More Than The Whole – How Would Anyone Know?”

  • Chart of the Week – Can Dow Catch Lyondell?
  • A Good Deal From GE? – Or The Only One Possible?
  • And Does Anything Matter Except Power and Capital? And How Do You Model It?
  • Weekly Winners & Losers

Chart of the Week – Can Dow Catch Lyondell?

  • Chart of the Week

While we heard this story from a third party, apparently DOW CFO-elect Howard Ungerleider threw down the gauntlet in a recent meeting with some investors, suggesting that DOW would target the LYB cost structure and aim to be the low-cost producer in polyethylene and other products. Clearly the definition of “lowest cost” is open to interpretation, and it is highly unlikely that DOW is targeting the LYB return on capital, as illustrated in the chart of the week, at least we hope that is not the case. LYB has the benefit of having been though a Chapter 11 process – not beneficial for the equity holders at the time, but very beneficial from a capital structure perspective today; LYB’s capital structure and liability position is streamlined and reduced because of the Chapter 11 process. DOW is riddled with legacy pension expenses, environmental liability tangibles and intangibles, and things that cannot be removed from the balance sheet without a Chapter 11 process.

New DOW could get a long way there by transferring all the bad stuff onto the Ag business or the Specialty business pre-spin, but it is unlikely that the company could get away with such a move from a regulatory perspective and more importantly, Ed Breen would likely not let it happen. So, what does DOW really mean by this statement. Is it in fact an admission (finally) that Dow is not in the lead from a cash cost perspective, despite its focus on building basic chemicals only where the company feels it has a feedstock edge? As any psychiatrist will tell you, the first step in fixing a problem is identifying it and admitting to it – so this could be good.

Below is a chart we published in early 2015 when we were laying in to both old Dow and old DuPont for bloated cost structures, and it shows the vast EBITDA per employee gap at LYB versus old Dow. While this was the year of peak oil prices – which significantly benefitted LYB – DOW was also a beneficiary. The point of this chart was that Dow was lagging both LYB and MON – proxies for both of Dow’s then main businesses. We are going to leave DuPont out of this discussion – the terrible position in the chart below helped precipitate the huge changes at DuPont subsequently.

If we look at DWDP today we have a company with roughly 100,000 employees and expected to make $18.7 billion of EBITDA – so roughly $190,000 of EBITDA per employee – already a dramatic improvement from pro-forma 2014, but still way short of LYB – expected to be $530,000 per employee in 2018.

If we assume a New DOW with a current pro-forma of $225,000-250,000 per employee (should be higher than the current DWDP average), there remains significant upside, even if you assume that $150,000 of the LYB benefit is capital structure related. If DOW could get to $350,000-360,000 per employee this would still be a significant step change in profitability. It is very hard to translate an analysis like this into a valuation statement today as there remain so many unknows in the impending spins with respect to capital structure etc., and we do not know the employee split precisely. But acknowledgment from New Dow that its costs are too high and that there is room for improvement is a significant milestone while at the same time giving notice to Dow employees that headcount is coming down further. Despite concerns about the longer-term ethylene market we still believe that DWDP is significantly undervalued today, but struggle to see a near-term catalyst and we likely need to wait until later in the year before the company gives us enough data to be able to model the new businesses properly.

  • A Good Deal From GE? – Or The Only One Possible?

GE has this week agreed to sell what appears to be its best business – Transports – who would have guessed! In the deal presentation to the investment community GE talks about growth in the Transport business over the next two years that dwarfs anything the business has done in the last 5 years – first chart – and also what the analyst community is expecting from GE as a whole second chart.

We wrote about the likely negative implications for WAB in a separate piece earlier in the week, but what is the right read on this for GE? Clearly the company is pitching the business in its best light – no different than having your car detailed before you try and sell it – but whether GE’s expectations for the business represent the top end of a range of possible outcomes rather than the median is hard to tell – though we suspect it is the top end. This would be a very difficult projection for WAB to verify, plus it would also be hard to estimate how much extra cost may be required to get even close to the revenue projections – see the WAB research for our thoughts on why WAB is a short from here.

But what if GE’s projections are accurate – why is GE selling a business that could create the greatest revenue growth for GE in 2018 and 2019 and the greatest cash flow growth? Two reasons:

  • It is too small to move the needle in terms of cash flow contribution – GE needs to keep its large pools of cash flow (engines and healthcare – and possibly energy at $75 crude) to shore up what is happening in Capital and Power.
  • It is a business that could be sold and sold well – this is a good deal for GE in terms of the valuation and the tax efficiency – part of the reason why we are negative on WAB.

But it does not really move the needle for the company – it perhaps sets a more positive tone in terms of what Mr. Flannery is thinking, but coming in the same week as an admission to further problems in the Power business we would argue that despite this sale, the company came out of the week on its back foot after starting on the front foot.

  • And Does Anything Matter Except Power and Capital? And How Do You Model It?

We had planned to fill this section with charts of profitability, volatility and returns in the two business segments that are ultimately either going to drive GE out of this trough or closer to Chapter 11. Sadly, our attempts proved unsuccessful and raise a whole variety of corporate governance and regulatory red flags – pushing us further in the direction that this is a mess that might not be fixable. We make extensive use of the S&P Capital IQ platform for company and market data and include the Compustat financial data in our subscription. Historically this system has been both reliable and for the most part accurate – Until You Get To GE – at which point it falls apart and it looks like the data feed from GE is at fault rather than the efforts of Capital IQ. Since 2002 GE has reported revenue segments in close to 30 different ways. Making it almost impossible to draw trends for many of the businesses that remain in the portfolio today. In some cases, data is simply missing – Compustat has a data series for Power revenue but no corresponding income line. Both Compustat and the Capital IQ financials have a year in which GE supplied no comparable income number for the Capital segment – different years in both cases? Trying to read through the 10Ks drives even more frustration as again the data is not laid out in a manner that makes it easy to understand the underlying performance in many of the businesses, especially Power and Capital. We take our hat off to the analyst at JPM who has clearly devoted hundreds of hours to the subject and consequently has been the most accurate in terms of predictions. A comparison between Compustat and Capital IQ GE Capital net income margins is shown in the chart below – useless, but with a very worrying recent trend

In our view the fate of GE rests in the Power business and in GE Capital – both of these businesses have the potential to sink the company and their thirst for cash likely prevents GE from divesting other high cash flow businesses. The company is being investigated for reporting in its insurance segment, but it is not a stretch to see the investigation spread more generally. We were drilled into proper financial accounting at Bernstein and in how to find the elements of any companies accounting practices that contributed to or created investment controversies, but this is a real mess – created by the company and quite possibly deliberately to make third party analysis almost impossible.

While GE Capital remains a black box, GE Power is a bit easier to understand – it is an over-invested in business facing a market that no longer requires the capacity that GE and others have to support the possible market demand – even in a best case. Notwithstanding our utilities colleagues more positive view of power investment over the next 5 years – see their recent body of research – we are concerned that massive oversupply among power equipment manufacturers will lead to much more intense competition for new business and that margins will suffer. This is not inconsistent with GE’s recent guidance that results in the power business will not improve through 2020. We still anticipate a major write down in this business this fiscal year.

Despite the good Transport deal – which barely moves the needle for GE – we remain concerned that the closets remain well stocked with skeletons – impossible for the street to model – and likely to drive more problems. The downside risk remains, and while change of leadership (outsider) might give investors some hope, the problems remain unchanged. We think the risk is high that the stock sees $10 before its sees $20.

  • 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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