Chemicals August – Earnings Up, Stocks Down

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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

August 15th, 2017

Chemicals August – Earnings Up, Stocks Down

  • Earnings results were generally positive in Q2 but the tone and guidance generally underwhelmed as every Chemicals subsector has trailed the S&P since our last monthly report
    • Earnings results most notably lagged in the Coatings space – SHW, PPG, Akzo, RPM all disappointed – valuations remain stretched in our view even after a month of 8% relative underperformance
    • WLK and LYB also missed revenue expectations but we would be buyers on post-earnings weakness
  • Over the past month we have written:
    • Extensively on the changing dynamics in the industrial gas industry
      • Praxair/Linde – our detailed earnings model suggests significant upside to earnings and share price
      • Air Products – likely to be nudged out of capital spending opportunities by its larger competitors, and valuation looks stretched relative to estimates
      • Air Liquide – less hamstrung than APD given US (Airgas-related) growth potential; upside not as significant as for PX/LIN and will be determined by the level of cost focus
    • Short pieces on:
      • VSM – we saw upside to the company’s Q2 report and results did not disappoint
      • Akzo – the Q2 miss is likely to be repeated as the company struggles to meet the ambitious targets set out in its PPG takeover defense
      • Lyondell – remain positive on the stock but are unenthusiastic about the company’s decision to expand propylene oxide capacity rather than make a consolidating move in ethylene or buy back stock
    • And specifically on the ethylene market
      • Entering a period of likely volatility, WLK and LYB look cheap enough to offset this risk
  • 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, PX, PPG) but have concerns in most subsectors, and at the subsector level would only be overweight Commodities and Industrial Gas – in part because of valuations, in part because of improving fundamentals or mergers – for commodities we are assuming that oil stays around $50
    • We remain underweight on Coatings – our underweight on Akzo is tempered by Elliott’s continued (increased) presence; SHW continues to look stretched in our view

Exhibit 1


Exhibit 2

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

Overview

Revenues in the Chemicals sector grew for the fourth consecutive quarter and at a pace not seen since 2012 – a history of average revenue surprise and year over year growth for the US Chemicals group is shown in Exhibit 3. Looking at the individual results – Exhibit 4 – the Q2 laggards have clearly been in the Coatings space (where valuations, SHW’s in particular, look stretched in our view) and to some extent the ethylene plays, WLK and LYB.

Encouraging results on the whole were offset by generally underwhelming guidance, however, and the result was widespread underperformance for the group with only a handful of names outperforming the market. CF (not pictured in Exhibit 3 due to its negative EPS estimate) has been a performance standout after topping revenue estimates by 6% and posting an EPS gain versus the expected loss. Results for MOS were also encouraging and suggest some life in the depressed fertilizer space. VSM’s Q2 results were the most robust in the group and we continue to see the stock as an intriguing small cap play, with a potentially long growth runway and high operating leverage.

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 current subsector discount from normal value as measured by our valuation framework, along with the range in valuation for each since 2010. Exhibit 8 shows discount by company.

Weak results for the Coatings companies led to significant underperformance over the past month – Exhibit 9 – and the sector has moved off its expensive peak on our normal valuation framework. Ag stocks remain near an extreme discount despite better than expected Q2 results. The Diversified group screens expensive only without giving DD the benefit of DOW synergies, and Industrial Gases valuations are near the lowest of the decade, with much of this value in Praxair and in particular relative to Air Products.

At the stock level – on the cheap side, over the past month we have written specifically on the two cheapest screening stocks in our Chemicals index, CF and EMN.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

 

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. SHW’s returns are inflated as the capital base does not yet accurately reflect the acquired VAL assets.

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. Coatings margins continue to stretch higher, along with Diversified. Ag margins are off the recent lows but appear to have stalled, while commodity and gas margins are rolling over from recent peaks.

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).

Results are tracking well again in 2017, particularly in the overlap group which continues to produce the most robust returns – Exhibit 14.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions –Exhibit 15. CF and LYB rejoin the three holdovers from last month (WLK, EMN, and MON) as revisions have turned positive. Exhibit 16 frames the historical performance results that inform this portfolio selection methodology.

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

  • An all around flat month for consumer spending in the latest data through June
  • Year over year growth slowed in all categories; goods spending (+2.8% year over year) remains more positive than services spending (+2.2%)
  • Year over year growth in durable goods (5.3%) fell below 6% for the first time in 10 months

Exhibit 17                                                                       Exhibit 18


Source: BEA

Construction

  • Latest construction data through June showed a 1% sequential decline and barely positive year over year growth; figures for April and May were each revised down ~1%
  • Exhibit 19 shows the long-term trend in US construction spending and Exhibit 20 shows the trend over the past several years

Exhibit 19                                                                        Exhibit 20

Source: US Census Bureau

Exhibit 21

Source: US Census Bureau

Agriculture

  • The USDA was out with corn and soybean yield forecasts that were higher than expected, sending prices down – 6% for soybeans, 3% for corn

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • Slight decline in the July ISM reading but the overal PMI retains a strong expansionary tilt
  • Inventories are off the recent highs and production remains elevated
  • New orders continue to show strenght – fourth month in the last six with a reading over 60

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
  • 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, and the 12 month rolling average (dotted green line) is trending higher quickly.

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene operating rates in the mid-90% range (compare to a five year average of slightly under 90%) have contributed to several consecutive months of record production, with outages minimal and supply coming online. Demand, weak earlier in the year, was up 6% in June (latest data) versus the prior year.

Production and operating rates are summarized in Exhibits 29 and 30. Operating rates are not rising because capacity is increasing as fast as production.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Output reductions have not broken the downward trend in crude pricing – Exhibit 34 – and US crude stockpiles, while off recent all-time highs, are still elevated – Exhibits 31 and 32. Natural gas is back round $3.00 per MMBTU after dipping below at the end of July. Gas in storage is essentially in line with the 5 year average – Exhibit 33.

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 demand is picking up, with June’s 4.5% growth exceeding expectations for a 2% year over year increase. Inventories have been drawn down, from a peak of 37 days in May to 26 by the end of June.

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

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. Only SHW currently sits at a skepticism extreme – ROC does not accurately reflect the acquired VAL assets.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

August 10, 2017 – Air Liquide: Good or Great Will Depend on Approach to Costs

August 8, 2017 – Air Products: Needs to Find a Very Big Rabbit in a Very Small Hat

August 7, 2017 – Linde/Praxair: The Size of the Prize is Substantial

July 27, 2017 – VSM: A Beat and Raise Coming Up!

July 25, 2017 – Akzo: Everybody Loses When Management Does Not Have a Clue

July 24, 2017 – Lyondell: A Poor Capital Allocation Decision

July 17, 2017 – Ethylene: A Tough 12 Months to Model – Likely Very Volatile

July 5, 2017 – PX/Linde: Hard to Quantify but Possibly the Largest Opportunity – CAPEX

July 5, 2017 – Clariant: We Are Not Alone in Questioning This Complex Deal

June 30, 2017 – FUL and SHLM: Potential Divergent Optimism Paths

June 27, 2017 – Nitrogen Fertilizers: A Game of Thrones Winter!

June 20, 2017 – Eastman: Misplace Rally on the Blackstone-Celanese News

June 13, 2017 – Akzo: Time for a New Game! Problem or Opportunity for PPG?

June 7, 2017 – LYB, WLK: A Risk to the Upside – Albeit Remote – Qatar

June 5, 2017 – Akzo/PPG: Maybe the DEVIL is in the Details – Did PPG Dodge a Bullet?

June 2, 2017 – PX/LIN: Buy Both – Now We Have the Deal Terms Out of the Way

June 1, 2017 – PPG/Akzo: Probably the Right Move for PPG but Disappointing – Unanswered Questions for Akzo

May 24, 2017 – The Cheapest Pound of Ethylene: Why LYB Should Buy LYB – or WLK!

May 23, 2017 – HuntsmanClariant: Could Two Poorly Understood Businesses Combine to Make Matters Worse

May 22, 2017 – Huntsman: Another Cross Border Deal – Another Reaction to Slow Growth, but a Good Idea

May 9, 2017 – Akzo: Arrogance and Optimism: Likely to Hurt Every Stakeholder

May 5, 2017 – Lyondell: Dip = Opportunity? Harder to a Deal – Bring Back the Buy Back

May 2, 2017 – Air Products: Back Down the Rabbit Hole?

May 1, 2017 – Making Money in Ethylene: Much Harder Than it Looks

April 24, 2017 – PPG/Akzo: Is the Negotiation Over?

April 17, 2017 – Nova: Flexing Its Financial Muscles – Changing the Shape of US Ethylene

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

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 51 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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