Weekly Findings – January 27th, 2019

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

January 27th, 2019

Weekly Findings – January 27th, 2019

Thought for the week: “Economic/Market Uncertainty and Volatility – Focus On What You Can Control or Predict – Key Measure Is Dividend Policy”

  • Chart of The Week – Dividend Growth Matters
  • TSE – The Perils of Formula Pricing – Who is Next?
  • SWK – Doing All The Right Things – Just In The Wrong Sector
  • Weekly Winners & Losers

Chart of the Week – Industrials and Materials

  • Chart of the Week – Dividend Growth Matters

The chart of the week is taken directly from our “what makes a good company” work and shows a plot of 20-year dividend growth (average) against years of market outperformance. Of all the analysis we included in the “good company” work, this one had the strongest positive correlation. Not surprisingly “optimism” had the strongest negative correlation. The ability to raise a dividend consistently is a function of being a good company rather than a driver – it is a consequence. Only those companies with appropriate capital allocation strategies are able to grow cash flows consistently and raise dividends without sacrificing other growth strategies. Note: In the chart, the dividend growth is calculated from the two end points – the dividend per share in 1997 and again in 2017. In some cases, dividends have been both cut and increased in the period – this in not factored into the analysis.

Air Products announced a slight earnings miss on Friday and made a slight cut to guidance. While this is a company that we think is overvalued relative to its strategy and its likely trend in return on capital – the company included a dividend growth chart in its earnings release and it is compelling. While the company may have an investment strategy that is in our analysis dilutive to return on capital and adds more risk to the story, consistent dividend growth, if it continues, likely limits downside.

The top ten dividend increasers for 2018 are shown in the chart below, plotted against their annual average increase. LSTR made a big statement in 2018, but it was the first increase in years, hence the low average – FDX looks more interesting until you look at absolute yield (second chart). FDX is raising its dividend, but the yield is not overly compelling and ITW and POL look much more interesting as the yields are high and the increases are at an above market return rate. If we look at the same analysis for 2017, only FDX, POL and ITW appear on both lists.

Both LSTR and AME appear to have got the message – that dividends and raising dividends are important; and while current yields are low, if both companies continue to increase the share of free cash flow used to pay dividends and/or simply grow free cash flow, they could be interesting stories. ITW, POL and HUN look most interesting from a yield perspective, but you would lean towards ITW and POL because of the consistent focus on dividend increases, despite the obvious valuation attraction of HUN.

Current high yields for our group are shown the next chart and we have discussed how a number of these names could be take out targets simply because the dividend payment would cover most of the cost of the debt required to make the acquisition. IPHS is not as interesting as it was a few weeks ago because the stock has rallied, but the take-out logic still holds. None of the high yielding stocks are in the charts above, which makes sense if rising dividends causes stocks to outperform (chart of the week) – the group below are there because they have underperformed over the last year for the most part.

Dividends, dividend policy and dividend growth are factors that become more important in times of fundamental uncertainty. When it is harder to model earnings growth or revenue growth you should focus on what you can control as a company and what you can measure and rely on as an investor. The group in the table below pays no dividend at all – this would seem like an obvious easy positive opportunity.

  • TSE – The Perils of Formula Pricing – Who is Next?

Despite a fairly dreadful earnings miss this week, TSE does not make our worst performers list (it was the 6th worst performer) and in fact the stock recovered somewhat from its initial losses after the announcement. In part this was because the stock has already been beaten up quite badly – chart below – and in part a number of the reasons given for the miss were seen to be reversable: we are less confident.

A meaningful portion of TSE’s earnings miss for Q4 is a function of formula pricing, whereby TSE sells styrene derivatives – polystyrene, EPS and Latexes – based in part on either the price of styrene or the price of styrene raw materials. Price formulae generally reflect price references for the month of the product sale. In a period of rapidly falling prices – the charts below offer several examples – the current price of the raw materials is driving the current selling price for products, but companies are making the products out of raw materials they bought many weeks prior, to maintain at working level of inventory to ensure plant reliability. As TSE rightly points out, a reversal of pricing works to the company’s benefit but as we have written previously and often, we are in a macro environment where good news is being largely ignored in the Industrials and Materials space and bad news is being amplified. Separately, while we often see quick price collapses – price increases are less likely to run at the same rate – partly because many customers have limits to how much a price can move in any given month or price implementation delays. While TSE claims that the price issue will reverse, it is unlikely that it will manifest itself in the same way and it is not a reason to buy the stock in our view.

The charts above show a few base chemical price profiles in the US for the last several months and indicate exactly the problem that TSE has faced – with styrene following benzene (the first chart above). US ethylene prices collapsed earlier in the year but were then supported by a spike in ethane pricing and we have written about this many times over the last few months – as ethane has eased, ethylene prices have fallen again since October.

Two obvious questions:

  1. Who else is impacted
  2. How should we think about TSE

The major player in US styrene is LYB, and LYB is also a major polypropylene and polyurethane player – possibly impacted by collpasing propylene pricing. BUT.. LYB reports on a LIFO inventory basis and consequently their costs are based on the last ton of feedstock they bought. Earnings should be largely unaffected by the recent pricing moves but the balance sheet will be impacted as LYB has higher priced inventory or raw materials still sitting on its books.

Otherwise, Westlake has a small styrene business and CPChem (Phillips 66 most exposed) through its American Styrenics JV with TSE. On the polypropylene side, Braskem is a major US player, as is CPChem.

The more obvious winner should be KRA – which is a major buyer of both styrene and butadiene, and while the company may have an inventory based Q4 issue, its products are less commoditized annd price sensitive and the company should see ultimately margin expansion.

What to do with TSE is a more complex question, but longer-term we think that the company has a very problematic future; as does anyone in the styrene business. Styrene polymers, polystyrene and expandable polystyrene (EPS), are likely to be the big losers in any attempt to improve recycling and minimize plastic waste. They are, for the most part, easy to substitute with other polymers and they are hard to separate and recycle. Weaker styrene polymer demand will creates styrene supluses and break-even margins for producers. Good for the handful of styrene buyers not making products for the packaging markets. Estimates for TSE for 2019 may be fine, but after that we expect to see a sharp fall off.

The polystyrene industry has started a collaborative initiative to help wth recycling, but with New York City banning polystyrene clamshells for fast food packaging from January 1st of this year and Dunkin Donuts also phasing out its EPS coffee cups over the next couple of years, the writing is on the wall in our view. TSE has a good styrene latex business, which should be largely unaffected from a demand perspective, but it is likely to be overwhelmed by the styrene and polystyrene oversupply.

  • SWK – Doing All The Right Things – Just In The Wrong Sector

When we first recommended SWK, several years ago we pointed to the discount in the stock because of belief that, after a handful of deals, the company could improve its return on capital back to trend. We believed that the acquisition integration track record of the company was good and that the assumptions in the stock were overly pessimistic. As the chart below shows, we got the return on capital trend correct and initially it was a good stock call – second chart – but despite the better earnings, rising interest rates and concerns over consumer spending and housing (and China) have hurt SWK over the last year. Interestingly the trend return on capital in our model generates a 2019 “normal” EPS of $8.80 per share, which was where consensus stood before the guidance last week.

It would be bold to recommend SWK in the face of disappointing housing numbers, especially given affordability, but here are a few reasons to pay attention to the stock:

  1. Despite the rally in 2016 and 2017, the stock only managed to get to “normal value” – chart below and has retreated to a significant discount again – consequently it looks like a very interesting relative play.
  2. The stock is close to a peak multiple discount to Home Depot – second chart – so possibly a hedge.
  3. While Sears itself is an issue, SWK was relying on selling the Craftsman brand through Lowes and Ace rather than through Sears and this is still to fully play out – suggesting upside to the return on capital profile – above normal (the cost of the deal is already in the capital base).
  4. Skepticism is close to peak – 3rd chart – (if we exclude the tech bubble), suggesting that valuation lags results meaningfully. Our valuation model suggests that SWK should be closer to $160 per share today.
  5. The stock would rally on a resolution to the China trade issues and on any bipartisan support for a US infrastructure bill.

  • Weekly Winners and Losers