Weekly Findings – February 3rd, 2019

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

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February 3rd, 2019

Weekly Findings – February 3rd, 2019

Thought for the week: “We had years of productivity to drive earnings – then we had a very strong global economy – what do we have in 2019?”

  • Chart of The Week – From Productivity To Growth – Now What?
  • DWDP – Are We Getting Squeezed on Polyethylene Just As New Dow Spins Out
  • GE – Time For US To Take A Back Seat – Almost
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – From Productivity to Growth – Now What

The chart of the week shows the average earnings and revenue surprise for our group of roughly 120 Industrials and Materials names. While we have not seen a quarter of average earnings misses for years – chart below – we are certainly trending in that direction, albeit with only half of our coverage group reporting thus far for Q4 2018. What is interesting from the chart of the week is that 2016 was clearly a year of productivity gains – earnings surprises without the revenue surprises, and from the chart below it looks like productivity was key through much of the 2012 to 2016 period. The decrease in oil prices in 2014 will have opened up margins for those with oil exposure, but otherwise it was earnings gains without the revenue gains. Revenue surprises moved positive in 2017 and have remained so through 2018 – but they were limited in the second half of 2018 and earnings surprises have declined in average magnitude also. What appears evident is that it takes very strong economic growth to get the revenue lines to surprise to the positive for these old industry segments and 2019 does not look like it is going to deliver that growth. So, what happens next?

It is probably wrong at this point to assume that the line moves down and to the left as we enter 2019; not because the world looks better, but because expectations are being managed and as the chart below shows, 2019 estimates have already taken a beating since September down an average of just over 6%. This has also happened when we are only part way into earnings season, and while (on average) companies have beaten numbers that for the most part have been revised down over the same period, we are getting a steady cautionary tale when it comes to guidance and some examples are copied at the end of this section.

The question is whether the guidance is cautious enough as there are some large unknowns:

  • China and Trade
  • Europe – Growth and Brexit
  • Energy – Venezuela
  • The US Economy
  • Weaker Commodities

Companies are getting better advice these days about expectations management and we think it would be unusual to have a quarter where the average company in our group missed earnings, even if they go back to having average revenue misses. IR teams are focused on earnings rather than revenues for the most part. The better measure in our view remains our measure of optimism which looks at how far off annual earnings are versus projections at the beginning of the year – ignoring guidance driven revisions by quarter. Those accused of optimism in 2018, copied below from our analysis earlier in January, will likely ask for a pass – “who could have predicted the trade situation a year ago”? The number of variables for 2019 that look like they are beyond reasonable prediction today are significant and this may be a second year where macro shocks/steps change the game as the year progresses – these will be used as excuses if guidance has to fall further and will be largely ignored if they prove to be a positive. In the meantime, we would expect the (6.2%) average in the chart below to be slightly worse by the end of reporting season – the number fell from (5.8%) to (6.2%) in the last three days of last week.

Many stocks do not look expensive – and we highlighted SWK last week as well as others. However, this is a space that does not do well as numbers come down. DWDP would be a good case in point over the last week – DWDP is one of the worst performers for the week and the second chart below shows how the stock has essentially round-tripped since before the deal was announced.

Examples of Earnings Guidance


The company also announced its outlook for 2019. Honeywell expects sales of $36.0 billion to $36.9 billion, representing organic sales growth of 2 to 5 percent; segment margin expansion of 110 to 140 basis points, or 30 to 60 basis points excluding the favorable impact of the 2018 spin-offs3; earnings per share of $7.80 to $8.10; operating cash flow of $5.9 billion to $6.5 billion and adjusted free cash flow4 of $5.4 billion to $6.0 billion, representing conversion of approximately 100 percent.

“We have an established software business and strategy in our connected enterprises which continues to grow at double-digit rates as our shift to a software-industrial company continues. We continue to make improvements in our supply chain and working capital to drive better sales, margin and free cash flow; and we have begun the digitization of Honeywell processes to improve organizational efficiency and enable enhanced analytics to drive better decision making. It’s an exciting time to be part of Honeywell, and we look forward to continuing our track record of matching our say with our do in 2019,” Adamczyk concluded”.


“We expect global economic expansion to continue in 2019 at a moderately slower pace than 2018,” said Howard Ungerleider, chief financial officer of DowDuPont. “We continue to closely monitor macroeconomic and geopolitical developments, including ongoing trade negotiations and the pace of economic activity in China. In this environment, we remain focused on the actions in our control, including capitalizing on our growth investments, capturing cost synergy savings, delivering productivity actions and advancing our spin milestones.”


Following a record year for profit per share, Caterpillar expects 2019 profit to increase to a range of $11.75 to $12.75 per share. “Our outlook assumes a modest sales increase based on the fundamentals of our diverse end markets as well as the macroeconomic and geopolitical environment. We will continue to focus on operational excellence, including cost discipline, while investing in expanded offerings and services to drive long-term profitable growth,” added Umpleby. Beginning in 2019, the company does not plan to exclude restructuring costs from adjusted profit per share as these costs are expected to return to normalized levels.


Donald Allan Jr., Executive Vice President and CFO, commented, “During 2018 we successfully navigated dynamic end markets and overcame multiple external headwinds while delivering a strong overall financial performance. We are preparing for a similar operating environment in 2019, and expect to generate above-market organic growth of approximately 4%, adjusted earnings per share expansion of 4% – 6% versus prior year and continued strong free cash flow generation, which will primarily be allocated toward achieving our deleveraging objectives in 2019.” Management expects its 2019 EPS to be $7.45 – $7.65 on a GAAP basis and $8.45 – $8.65 on an adjusted basis. Free cash flow conversion is expected to approximate 85% – 90%, as we make the payments associated with the 4Q’18 cost reduction program.

The following represents key 2019 adjusted EPS assumptions: • Organic volume (~+$0.30 to +$0.40) • Benefit from the cost reduction program, net of modest investments (~ +$1.05) • Incremental tariffs, commodity inflation and currency partially offset by pricing (~ -$0.90 to -$1.00) • Tax rate to approximate 17.5% (~ -$0.15) • The benefits from the MTD partnership and lower shares partially offset by higher interest expense (~+$0.10)

Sherwin Williams

“We enter 2019 well-positioned and focused on what we can control. While the current macroeconomic outlook is less than clear, we see significant opportunities for profitable growth throughout the business. In The Americas Group, we will continue to invest in our store model and best-in-class products while executing on share of wallet and new account activation initiatives. In the Consumer Brands Group, we are excited by the exclusive national partnership and shared commitment to growth we have with our largest retail partner, as well as by our strong relationships with other leading retailers. Finally, in the Performance Coatings Group, we are focused on leveraging the combined capabilities of our integrated organization across the various end markets and geographies we serve.

“In the first quarter of 2019, we anticipate our net sales will increase two to six percent compared to the first quarter of 2018. The first quarter 2019 will include the expenses related to the defined benefit plan annuity purchase of approximately $.43 per share. For the full year 2019, we expect core net sales to increase four to seven percent compared to full year 2018. With annual sales at that level, we anticipate diluted net income per share for 2019 will be in the range of $16.77 to $17.77 per share compared to $11.67 per share earned in 2018. Full year 2019 earnings per share includes acquisition-related costs and other non-operating expenses of approximately $3.20 and $.43 per share, respectively. We expect our 2019 effective tax rate to be in the low twenty percent range.”

  • DWDP – Are We Going To Get Squeezed on Polyethylene Just As New Dow Spins Out

Timing is everything – sometimes it is your friend and sometimes it is not. If we look at the analysis from the Chart of the Week, the Dow-DuPont merger happened at a time of economic and energy tailwinds – it has taken three years to pull the deal together and get ready to spin out the pieces, but they have been a good three years from a fundamental perspective; until now. All three segments have grown EBITDA – chart below – with only New Dow showing some recent weakness versus trend. While we have always been supporters of the deal and recognize how much hard work has gone into the combination and then the preparation for the spins, we remain somewhat underwhelmed by the numbers and by the EBITDA growth – for a couple of reasons:

  • The synergy numbers are significant and are driving too much of the EBITDA growth given the economic backdrop
  • New Dow has so much new capital in the ground in the US and in the Middle East that (despite the slope of the trend line, which is very positive) it is disappointing to see the recent slippage (although less disappointing relative to LYB).

Jim Fitterling and his team will have an opportunity to ride without the training wheels on soon, and we believe that the company has the management competence and strategy to do the best they can with the businesses and the assets they have. We expect to see greater capital discipline than in the past and a more generous share of free cash flow heading back to shareholders, but the issue is what they cannot control, and here we are concerned both short-term and longer term.

Short-term, Dow’s comments around weaker polyethylene margins in Q4, don’t appear to tell the whole story, which was really much weaker margins through November and December, which have carried over in to January – chart below. LYBs numbers tell the same story but came with a significant earnings miss, making the DWDP numbers look much better by comparison.

LYB talks about polyethylene volumes recovering in January, but the damage has been done on the margin front – a bit of volume does not offset a major drop in margin. As polyethylene pricing has come down, ethane pricing has started to edge back up again – second chart – note that ethane came off its Q3 2018 highs because of planned maintenance shutdowns in the US, which lowered ethylene production and ethane demand. Anecdotally, inventories of polyethylene appear to be high in the US and still high post any attempt to correct in December and January. In the first chart below there is minimal incentive to move US polyethylene to Southeast Asia – many of those shipping are using integrated ethylene economics and accepting lower margins than the polyethylene pricing chart would imply.

If the inventory overhang remains, the likelihood of improving margins looks low, unless we see another fall in energy pricing, although both DWDP and LYB blame lower energy pricing for part of the Q4 problems and TSE and others with FIFO accounting would likely see another headwind in Q1 if oil fell further.

Longer-term, New Dow is likely to be a winner in the quest to reduce plastic waste – it is focused in polyethylene and because of polyethylene’s relatively low carbon footprint the focus is going to be more intense on collecting and recycling than eliminating the product. This puts Dow in a stronger position, in our view, than those that also make, or only make, polypropylene and polystyrene, but this is an overall trend that is unlikely to see any winners – Dow will do better on a relative basis – but it is hard to see an outcome that increases virgin plastic demand growth above historic trend rates.

At the moment the plan is to spin out New Dow on April 1st. At this time, while Q1 results will not be available, there will quite a bit of anecdotal information on the state of the market – note that we have already seen plenty of downgrades in the commodity space in January based on lower margins and the sense that polyethylene inventories are plentiful. It is likely that New Dow will probably have to update already cautious Q1 guidance at the time of separation and the company has additionally promised more detailed disclosure going forward, which may or may not be a good thing at the time of the spin. While Q4 EBITDA for New Dow was light, at $2.1bn, we still believe that “normal” earnings for the business is closer to $10bn a year, even if Q1 2019 also suggests a lower number. Today, LYB is trading at less than 6x EBITDA, despite its high yield, although the EBITDA multiple should rise as estimates fall for 2019.

New Dow is going to need to pay a high dividend (company has talked about 45% of net income as a target – which should be enough) – or LYB will be seen as the safer investment – DWDP did not meet Q4 estimates because of fundamentals for New Dow. The same polyethylene pressures that LYB is facing impact Dow just as significantly.

We have yet to build a “normal model” for New Dow – it is not possible without a share count and interest payment – but we would estimate that a “normal EV” would likely be in the $70-80bn range.

  • This may be hard to achieve initially if polyethylene margins are cyclically low.
  • With around $14 billion of net debt, this would put the potential “normal” equity value in the $55-65bn range.
  • At a cyclical low, as we see with LYB, the EBITDA multiple can be much lower. At 5.5x the equity value of DOW could be as low as $40 billion.
  • If we refer to our long-term Old Dow Normal Value model, one standard deviation of share price cyclicality was 26% – taking $60bn as a normal equity value – a one standard deviation low would be $44 billion.
  • Given Dow’s stated dividend policy – at this $44bn equity level the stock would have a dividend yield in the 4.25-4.7% range – based on the EBIT for 2018 and a 45% net income payout. LYB has a 4.6% yield today. So, it all seems to align.

If the wheels fall off the polyethylene market in Q1 2019, which may well be the case, and consequently, post spin and post likely initial selling pressure, an equity valuation of New Dow falls below $40bn, this would look attractive. It is not clear to us what that means for DWDP today – the stock is sliding, based on the guidance and on further downgrades. Even though the company is buying back stock, it is unclear why you would buy the stock today, pre-spin(s).

  • GE – Time For US To Take A Back Seat – Almost

We did not enter the GE debate in earnest several years ago because we thought we had a better model or valuation “bread box”. The stock had sat in our coverage universe since we first started at SSR, but we felt we did not really have an edge. Then we started to see some behavioral patterns that reminded us of other stories we had followed over the past 25 years, and then Trian entered the game talking about many of the issues that had been raised with DuPont a couple of years prior. We do know a lot about business optimism and complexity and we have spent out entire careers understanding commodities and commoditization. At that point we concluded that we had something to say – and it has been an interesting journey. We still have some concerns, which we will discuss below, but see no point in being negative just for the sake of it, especially in the face of major change.

  • Optimism – something that had plagued the company for decades – resulting in misallocation of capital and chronic earnings and stock underperformance – no more! Larry Culp could probably not have handled the quarterly results any better than he did this time. He was appropriately conservative but committed to fixing things and showed confidence that he knew what he was doing. 2019 carries considerable uncertainty, but the stock is rallying because of belief that he can bring the right change to the company, not because investors are optimistic about 2019 earnings
  • Complexity – is being dealt with – sales and spins with significantly streamline the company over the next couple of years, although core GE will remain diverse and the Power business is a complex mess all on its own.
  • Commoditization could continue to be the thorn in the side – more below.

In our view, the “more clarity to come soon” comment from Mr. Culp is about wanting to have the answers before he unveils more issues. He wants to be able to say “this is the size of the cash hole at GE Capital and here is precisely how we are going to fill it” and he wants to get another restructuring charge the power business right so that it is the last one. These are the right ways to run the business and the right ways to communicate. But the key question is whether the road bumps in 2019 will be enough to break the fragile confidence that he has gained.

It is clear that 2019 is all about cash. Raising as much as possible because the company needs as much as possible. The restructured WAB deal is all about maximizing cash to GE, at the expense of the original tax-free structure and we think it adds considerable risk:

  • GE will get the cash up front – and maybe that trumps everything else right now – but WAB will likely suffer from a major stock “overhang” with GE as a stated seller of its stake. We have seen what that has done to companies in the past like TSE and 1COV – both of which languished at low values until their major holder sold down – in both cases the major holder (Bain and Bayer respectively) did not see any real value in hanging on to the stock – the stocks both appreciated meaningfully on their exit.
  • Huntsman has the same problem today with Venator – VNTR is being damaged by a lack of confidence in the industry, but HUN’s stated intent to find a buyer for its 53% stake has pushed VNTR to extreme lows relative to its peers.
  • GE has seen the same with GE Baker Hughes – its (cash need) driven decision to sell rather than spin its stake in BHGE had an immediate impact on valuation versus peers – see chart. In our view the overhang on BHGE will remain until GE sells out completely or decides to return to a spin.

Our other parting concern goes back to the power business and the risk of commoditization. We tend to think about commodity cycles in energy, paper and packaging, metals and chemicals, but manufacturing can have ugly commodity cycles and we have seen horrible examples in the auto and aircraft industries if we look back far enough.

  • No one is questioning whether there is overcapacity in power generation equipment manufacturing – the question is how much. Our colleagues, High Wynne and Eric Selmon have done significant work on the subject and are more bullish on global equipment demand than most. Especially a couple of years out. However, even their forecast leaves substantial over-capacity.
  • GE needs to decide where it can play competitively and still make money and focus its business from a construction cost and margin perspective – hence our view that another write down is coming and more lay-offs are likely.
  • Profitability in the business remains evasive and we remind readers of what we have presented in the past, which is that in the major petrochemical downturn of the early 1980’s – where global overcapacity ran at 30-35% – the worst year for industry profitability was the last one – the year before demand caught up with capacity and margins spiked. It was not the first year or the second – chart below.