Weekly Findings – SSR Industrials and Materials

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 29, 2018

Weekly Findings – April 29th, 2018

Thought for the week: “Sunday is the new Friday! We are experimenting with a different publication day for this piece so that we can include all information for the week and look forward to the week ahead – comments on the change welcome”

Chart of the Week – The Momentum Continues – The Market is Disinterested

  • Chart of the Week – The Momentum Continues – The Market Is Disinterested
  • 52 Week Lows – Bottom Fishing – DWDP, UTX, CCK, IP and OI
  • 52 Week Highs – Looking For The Short Ideas – WAB and APD
  • PX/APD – PX More Levered To What Is Working
  • What LYB, EMN and 1COV Tell Us for HUN, TSE, DWDP, BASF and OLN
  • Weekly Winners & Losers

  • Chart of the Week – The Momentum Continues – The Market is Disinterested

The chart of the week shows analysis we have repeated every quarter for a while, measuring the real momentum in the Industrials and Materials sectors. With roughly 50% of the group reported at this time we see a continuation of the improving growth trend in revenues and earnings that began in the middle of 2016. In Q1 2018, we get the benefit of tax reform and it is not surprising that the earnings trend is more pronounced than the revenue trend, which may be peaking simply because the measure is approaching 100%. These very positive trends are driven by two factors – strong, though perhaps no longer accelerating, global economic growth, and higher energy prices, which have an inflationary impact on pricing. Industrial and Materials companies are able to pass on pricing much more easily when demand is growing – as it is today.

But the market does not seem to care – companies beating earnings are not seeing share price increases – or not as much of an increase as the earnings change would suggest, and those few that are missing are not being punished that much – the market is indifferent to the group with a negative bias to that indifference. There is perhaps a sense that we are peaking in terms of momentum and valuation – we do not share this view.

As shown in the chart below, we still have more than 80% of companies beating revenue expectations, which suggests sell-side lack of confidence in pricing more than anything else as we can all equate better economic growth, industrial production and consumer spending with volume. These are industries that have seen deflationary pressure for years and we are not used to seeing pricing. Today there are two drivers – costs and product shortages; costs from oil pricing and other commodity pricing (aluminum, copper for example) and product shortages, which in our opinion will only get worse (or better, depending on whether you are selling or buying). For companies that are seeing demand growth and cost inflation, where they have the ability to price (based on their customer agreements), we see further revenue growth and margin expansion.

  • The aluminum story is just getting going in our view – Rusal is a catalyst, but the root cause is more demand than supply. AA remains a favorite – volatile, yes, but we expect an upward trend
    • Copper also – so maintain our positive view on FCX
    • Rising metal prices bad for those who cannot pass through the costs – ANRC most exposed in our view.
  • Intermediate chemicals are in short supply in general and prices should continue to rise – good for HUN, FUL, BASF, 1COV, DWDP, LYB, CE, many of the smaller cap chemical names and the Europeans in general.
    • Ethylene the only wild card because of supply, but the global market seems tight and is absorbing new US capacity, even if the US is seeing some short term price volatility.

We have seen a couple of companies give cautious second half guidance – EMN and CAT specifically – this follows cautious Q1 and 2018 guidance from DWDP in January which seemed out of step with the rest of the world. We believe that two forces are at play here – some high level of skepticism at the corporate level that the momentum can continue (its been too good for too long!) and an attempt to reign in runaway sell-side earnings estimates – which will be the subject of separate work. The sell side has generally had a positive bias, but MiFID II has the risk of making this worse in our view. A number of companies have had to deal with estimates that are too high in Q1 rather than businesses that are not performing well.

  • 52 Week Lows – Bottom Fishing

In the table below we show the stocks in each of our sectors that are currently closest to their 52 week lows. For perspective, the S&P 500 is 13.7% above its 52-week low.

For each stock we have also included 2018 EPS revisions year to date and both current EV/forward EBITDA ratios and 10-year historic averages. Sifting through the data and qualifying some of the stories, we would focus on the following ideas on the long side:

  • DWDP – cheap versus history and likely to see positive revisions and earnings surprises.
  • UTX – not expensive versus other conglomerates (ex GE) and earnings momentum improving.
  • CCK – inexpensive and strong earnings momentum because of the accretive nature of a recent large acquisition. Some confusion over how much gain from the acquisition and how much accounting change was reflected in recent guidance, but at a minimum this name warrants further analysis.
    • Inevitably some caution from rising Aluminum pricing – but CCK should be able to pass on increases over time.
  • IP and SLGN also look interesting – we see Paper and Packaging as one of the more interesting sectors this year. Rare earnings beat for IP this week – very positive earnings momentum.
  • PCAR – cheap – strong earnings guidance and momentum. Not a sub-sector which we expect much multiple growth opportunity going forward, but earnings should drive performance.

We cannot get excited about the following: LECO – too expensive; PPG – no earnings momentum; VVV – multiple likely capped because of longer-term auto view; GE – more write downs to come; UPS – the Amazon risk will not go away.

  • 52 Week Highs – Looking For The Short Ideas

We repeat the analysis above – looking for ideas that appear over-priced and where the momentum on earnings is not there. Only three stocks stand out:

  • WAB – with no earnings momentum – rating outlook moved to negative from stable by Moody’s – Q1 beat not enough to justify stock price – any possible GE deal that gives GE the cash it needs would not help WAB – WAB too big to do an RMT for GE’s business.
  • APD – see below.
  • BPCP – very expensive stock based on very strong acquisition driven EPS growth in the past that is unlikely to continue in 2018 and 2019 – too expensive to be a buy-out target.

  • PX/APD – PX More Levered To What Is Working

For many years PX’s large US and LATAM presence has been an issue; the US market has not grown and LATAM has had growth and currency issues. APD has done better in part because of its cost focus but also because it has been more heavily invested in the regions that have been working.

As US growth picks up, PX’s US leverage is helping to drive stronger earnings again for PX versus APD as illustrated in this quarter – PX beat comfortably and guided up – APD beat earnings, missed revenue, and guided down. PX’s return on capital growth is accelerating while APD’s is decelerating – chart. Air Liquide is seeing similar strength in its US packaged gas business (acquired with Airgas) based on Q1 revenue data published past week.

Air Products is as much a victim of devotion as it is business mix. The company remains extremely popular with the sell-side despite its very high valuation (12x 2018 EBITDA). To maintain “buy” ratings analysts have to keep target prices well above current prices and to justify the target prices they raise estimates.

PX is also at a high multiple (13.2x 2018 EBIDA), but is cheaper than APD if you give credit for synergies that will come with the Linde deal. PX remains our best idea for 2018/19 as we believe that the deal will be approved, the divestment proceeds will drive a major buyback, and synergies are underestimated as is future growth.

  • What LYB, EMN and 1COV Tell Us for HUN, TSE, DWDP, BASF and OLN

LYB, Covestro and EMN have all produced strong earnings beats in the last few days, confirming that volume and pricing trends are positive in the chemicals intermediates space as well as in basic chemicals for the first quarter. Higher raw material pricing is allowing companies to push through intermediate chemical pricing, with some companies – especially Eastman – more vocal about price initiatives than other.

In basic chemicals and plastics there is more price momentum in polypropylene than polyethylene given new and expected polyethylene capacity in the US and polyethylene producers will likely be very happy with flat margins in Q2 versus Q1 and are likely planning for declines. LYB’s Q1 US ethylene and derivatives business EBITDA was flat with Q4 2017 but its European business was up as was its intermediates business globally – these are what drove the earnings surprise. Covestro’s beat shows strength in the polycarbonate as well as the polyurethane markets

To put the current ethylene market into perspective we show a rudimentary current ethylene cost curve in the chart below. The US shale advantage has expanded as oil prices have risen, even as international naphtha pricing loses ground relative to crude oil because of oversupply. The major anomaly in the market today is the gap between US spot ethylene pricing and Asia and European prices. The US price reflects the growing US surplus of ethylene derivatives and the incremental price needed to move an additional ton of polyethylene, other ethylene derivatives or ethylene itself, offshore. The margin for those moving and selling their own polymers – DWDP, Exxon, LYB, WLK, for example, is huge. As a significant buyer of ethylene in the US, WLK is particularly advantaged by this dynamic – the ethylene producers (DWDP and LYB) are generating EBITDA on ethylene but not acceptable returns on capital or assets near term. We expect the US ethylene market to improve as the year progresses.

The read throughs are a positive for many stocks that are on our favored list – TSE, HUN, BASF and of course DWDP. Reporting dates are summarized below – all this coming week. In the chart we show discount from normal value for each company and include LYB. We do not have enough historic data for Covestro to do this analysis and consequently we show EV/forward EBITDA for all, including Covestro in the second chart.

We like all of these names in a strong global growth environment – many of their core products are in short supply and we have seen from the aluminum market recently what happens when the next ton of supply is not available.