Chemicals April – M&A the Mood of the Day, Commodity Rally Loses Steam

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 18th, 2017

Chemicals April – M&A the Mood of the Day, Commodity Rally Loses Steam

  • Continued M&A activity in the Chemicals space as LYB hints towards to large capital deployment and Nova acquires ethylene capacity in the US
    • Growth prospects in Industrial Gas rest on the PX/Linde merger – PX appears to have upside vs. APD on relative multiple convergence and Linde in turn appears to have upside vs. PX on EBTIDA multiple convergence
    • PPG/Akzo would potentially surpass the SHW/VAL tie up as the largest player in a quickly consolidating Coatings space
  • The rally in commodity stocks tapered off over the past month
    • OLN and the ethylene players down 6% or more
    • HUN, OLN, WLK still 10% relative outperformers versus the S&P year to date
  • Since our last monthly report we have also published on:
    • Eastman – with much larger companies coming under fire for many of the same issues that EMN faces, this looks like a ripe target for an activist or an acquirer – we could see a reasonable sized specialty slice of the company yielding a quick gain from multiple re-rating and it is unlikely the remaining businesses would trade lower than the whole company does currently
    • The ethylene cycle – the IHS conference served to confirm our more bullish view on ethylene relative to consensus
    • Dow/DuPont – with regulatory approval likely forthcoming, we see plenty of upside here – 50% plus without assuming any benefit from factors (tax rates, repatriation) outside the companies’ control
  • Our preferences in the Chemical sector are summarized in Exhibit 1
    • We are positive on most of the large cap names in the space (DOW, DD, LYB) but have concerns in most subsectors, and at the subsector level would only be overweight Commodities and Ag Chemicals – in part because of valuations, in part because of improving fundamentals – for commodities we are assuming that oil stays around $50
    • We are underweight Industrial Gas and Coatings – continue to prefer Akzo in Coatings on portfolio optimization (forced or otherwise) and Air Lqiuide in Industrial Gas on Airgas synergies and US expansion, with relative preference for Linde as outlined above

Exhibit 1

 

Exhibit 2

Source: SSR Analysis – See Appendix 1 for background and see Appendix 2 for a larger version of this table.

Overview

The M&A market in the Chemicals sector remains robust, with a new deal adding a line to the summary of pending moves in Exhibit 3. The recently announced purchase of Williams Olefins by Nova is relatively small in size but could portend further consolidation in the ethylene space which to date has been largely left out of the M&A wave. Ethylene has become moderately more consolidated in developed markets over the past 25 years but the rise of smaller entrants in developing markets has resulted in a less consolidated global market – Exhibit 4. This as well as the low absolute level of the HHI for ethylene (an industry with an HHI reading under 1000 is considered to be unconcentrated) indicates there is scope for further combinations that should have considerably less trouble making it through the various regulatory bodies than some of the deals currently being contemplated in the Industrial Gas and Coatings industries. Commentary from Dow/DuPont that the Materials business will likely be the first of the three projected spins could be an indication of a bigger move in the pipeline.

Also updated since we last published Exhibit 3 is the planned close of the SHW/VAL deal – extended to mid-June from the earlier target of mid-April. This is notable if for no other reason than its highlighting of the potential complexities facing a PPG/Akzo deal. We still believe that Akzo will be hard-pressed to create more value on its own with a spin of the laggard Specialty business, and see room for PPG to maneuver at a price as high as €100.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Valuation

Exhibit 5 summarizes our valuation work and the subsector classifications are summarized in Exhibit 6.

Exhibit 5

Exhibit 6

In Exhibit 7 we show subsector discount from normal value as measured by our valuation framework, and in Exhibit 8 we show discount by company. No change in the sector valuation rankings since last month, but at the extremes, the outliers of Coatings and Ag Chem trended more expensive. Monsanto moved toward the Bayer offer price as other large Ag mergers are looking more likely to meet regulatory approval. SHW is the driver of the premium in the Coatings space, but this month it was PPG pushing the group higher on Akzo optimism.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – fertilizer names remain near extreme discounts. Eastman is no longer a 10% outlier but continues to stand out in Exhibit 8 – at an extreme valuation low while US economic growth is improving. We still believe that there is significant value to unlock at Eastman but are unconvinced that the current management team is focused on the right things – in other words we struggle to see a catalyst. The other stand-out in Exhibit 8 is WLK, where despite the improved stock price the market is not giving the company the benefit of the doubt regarding its ability to integrate and extract value from the Axiall acquisition. Betting against WLK in these situations in the past has generally been the wrong move. Note also that neither Dow nor DuPont looks expensive in the analysis below if you give the companies the benefit of the expected merger synergies.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 shows absolute and relative performance by subsector since our last monthly report. The rally in commodity stocks has faltered a bit over the past month, but HUN, OLN, and WLK were among the top performing Chemical stocks in Q1.

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. Both PPG and SHW are now at 10 year return peaks, suggesting why mergers are currently in focus in the Coatings space. CBT is also near an earnings peak – this is a stock that we highlighted on the negative side in our Chemicals SMID work. On the under-earning side, considerably sub-trend returns help explain the valuation discounts seen in the fertilizer stocks.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibits 11 and 12 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. Net income margin for the group in aggregate remains historically elevated despite a downward trend in recent months. Margins remain elevated in Coatings, appear to have crested in Industrial Gas, and are attempting a turn in Ag Chem.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 13 summarizes the 5 most attractive and unattractive stocks on our normalized earnings valuation and skepticism index frameworks as of the start of the month. We note that these are based solely on our valuation models and we do not make any judgment calls to adjust these selections (see Exhibit 1 for our preferences by Chemicals subsector).

The commodity and agriculture stocks had boosted these portfolios in 2016 and the early part of this year, but the rally has begun to stall. Weakness in the short side selections has helped the hedged results.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions – the addition of the revisions metric provides a momentum style factor. The revisions picture limits the list this month to just MOS, MON, and LYB – Exhibit 15. Exhibit 16 shows the recently updated performance results for companies meeting these conditions at various ranges.

Exhibit 13

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Marginally lower sequential consumer spend numbers in recent months could be the result of widely reported delays in tax filings relative to prior years
  • Durable goods spending fell below the 8% year over year growth seen in recent months but remained robust in the mid 7% range

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • Construction spending ticked back higher after two months of sequential declines, though the year over year growth figure fell below 3%
  • Exhibit 19 shows the long term trend in US construction spending and Exhibit 20 shows the trend over the past several years
  • After falling precipitously in the mid-2016, growth in construction spending has rebounded but appears to again be slowing – Exhibit 21

Exhibit 19 Exhibit 20


Source: US Census Bureau

Exhibit 21

Source: US Census Bureau

Agriculture

  • Ag pricing has trended higher since the middle of 2016 but is still down versus prior year levels and remains well below the mid 2012 peaks – roughly 45% below for soybean pricing, and nearly 55% for corn pricing
  • Yield efficiency continues to outpace demand growth for agricultural commodities

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • Another strong reading for US manufacturing, holding a very robust level in the high 50s
  • Production remains elevated and the absence of a corresponding pronounced inventory build up suggests strong demand
  • New orders notably remained above 60 for the fourth straight month – Exhibit 25

Exhibit 23 Exhibit 24

Source: ISM

Exhibit 25

Source: ISM

Trade

  • Our trade balance exhibit excludes medicinal and pharmaceutical products to more accurately reflect the composition of our chemical index
  • We see trade risk from a Trump presidency as a potentially significant headwind for the US Chemicals space
  • The trade balance is at its highest level since 2015 in the latest data through February. As all of the new capacity scheduled for this year in the US comes on line in basic chemicals and plastics we would expect a significant upward trend in the data from here.

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Plants coming back online and continued ramp from new facilities more than offset a spate of unplanned ethylene outages in March. Demand was down 3% in Q1 and is expected to remain weak until new polyethylene capacity generates a pull in 2H.

Production and operating rates are summarized in Exhibits 29 and 30.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Crude pricing is back in the mid-$50 per barrel range despite US commercial crude stocks that continue to trend higher – Exhibits 31 and 32. Natural gas in storage is above the five year average but no longer tracking the upper bound of the five year range – pricing is up in April to date but trails the gains seen in crude. Ethane pricing continues a choppy upward trend – Exhibit 35.

Exhibit 31 Exhibit 32

Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Exhibit 33

Source: EIA, SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Midstream Business and SSR Analysis

Exhibit 36

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 37

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is expected to temper as new facilities come online in the back end of the year, countering solid domestic demand that has drawn down inventory levels in the near term.

Exhibit 38

Source: Wood Mackenzie, Midstream Business, Industry Sources, SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical subsectors. The first exhibit (39) summarizes the results and is a repeat of Exhibit 5.

Exhibit 39

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41



Source: Capital IQ and SSR Analysis

Exhibit 42



Source: Capital IQ and SSR Analysis

Skepticism Analysis

Here we apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see past research for more detail.

Exhibit 43 summarizes Skepticism Index values by subsector, Exhibit 44 shows the extent to which valuation is historically explained by returns, and Exhibit 45 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 43 would suggest additional downside for the industrial gas companies. For Coatings, we think it more likely that returns normalize to equate current valuations, rather than valuations improving to match above-trend returns.

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46 shows SI by company. ALB and ASH are the most notable companies currently at skepticism extremes, influenced somewhat by recent M&A moves. Returns for these two stocks are sub-trend even with the inclusion of 2016 capital data adjusting for portfolio adjustments – valuations indicate the companies are expected to see returns move back to trend.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

April 17, 2017 – Industrial Gases: “Multiple” Risks – Driving the Attempted M&A

April 7, 2017 – Lyondell M&A: Triangulating to the Best Idea – WLK?

March 29, 2017 – “What’s Wrong with Eastman?” – A Common Question

March 27, 2017 – More Constructively Bullish on Ethylene: Takeaways from the IHS Conference

March 23, 2017 – Akzo: An Opportunity for Active Managers to Manage Actively

March 21, 2017 – Dow/DuPont: The Last Stretch of the First Step

March 9, 2017 – PPG/Akzo: A Smart Deal Rather Than a “Me Too” Acquisition/Merger

February 20, 2017 – Looking to Westlake for Clues

February 9, 2017 – Betting Against the Sell Side: Follow Up

February 7, 2017 – SMID Cap Chemicals: Plenty of Interesting Ideas

February 3, 2017 – Lyondell: Momentum Turning into 2017 So Far

January 31, 2017 – Chemical Commodity Rally: Just Getting Started

January 23, 2017 – Air Products: “Me Too” Folly or an Inspired Fix for a Tricky Problem

January 6, 2017 – Chemours, DuPont and Teflon: Understanding the Dimensions of the Iceberg

January 6, 2017 – Chemicals: Value and Momentum Unaligned – Limited Choices for ’17

January 5, 2017 – Dow/DuPont: Again in 2017!

Appendix 1 – Exhibit 1 Analysis

In Exhibit 1 the following apply:

  • Green is good – Red is bad. The more intense the shade of green or red the more interesting or negative the factor looks for the sector.
  • Length of bar – wider signifies more important
  • Arrow direction – “Up” means the situation is becoming more positive from a stock selection perspective. So a green valuation bar with an upward arrow means that the stocks look cheap from a valuation perspective and they are getting cheaper. A red ISM bar with a downward arrow means that the ISM numbers suggest downside and they are getting worse.
  • Arrow size – how significant the move is.

Input Analysis

In the input analysis bar we attempt to show how important the natural gas/oil advantage is for each sector (length of bar); how positive it is (color of bar); and which direction it is moving (direction of arrow).

Demand Analysis

For each of our industry sub-sectors we have taken company by company data and generated an average segment exposure. For some companies this information is provided explicitly and for others we have taken estimates from presentations, annual reports and other sources. The segment break-downs are summarized in the charts below: Exhibits 47 to 51.

Exhibit 47



Source: Company Reports and SSR Analysis

Exhibit 48

Source: Company Reports and SSR Analysis

Exhibit 49

Source: Company Reports and SSR Analysis

Exhibit 50

Source: Company Reports and SSR Analysis

Exhibit 51

Source: Company Reports and SSR Analysis

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 52 below.

The first table summarizes the data in the pie charts above and then shows which market driver we use to model each end market. The second table then breaks each sub sector into these market driver buckets and then adjusts for how much business is in the US and how much is external. We add a factor which we call “trade” which brings into play the US trade balance and the strength/weakness of the dollar.

This analysis then drives the “Demand” section of the schematic in Exhibit 2.

Exhibit 52A

Source: Company Reports and SSR Analysis

  • Note that for the “trade” component, we have arbitrarily assumed that 25% of offshore sales are influenced by the US balance of trade and by exchange rates, while 75% of offshore sales are influenced by the same factors as listed above. It is more than likely that this is a different split for different sub-sectors and this will be a subject for further analysis.
  • Note also that we have done some initial correlation work to look at the impact of the factors below on revenue growth and it does show that sub-sectors with a greater exposure (in our analysis) to the ISM data (for example) have a greater correlation between the ISM numbers and demand growth. This will also be the subject of future research.

Exhibit 52B

Source: Company Reports and SSR Analysis

Valuation Analysis

The valuation analysis draws from our mid-cycle “normal value” work detailed above and our revisions work also detailed above. We have – for the moment – assumed that valuation is 60% of the story and revisions is 40% for each sector.

Appendix 2

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