Chemicals February – Headwinds Retreating, Momentum on the Rise, but Trade Risk Remains

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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

February 16th, 2017

Chemicals February – Headwinds Retreating, Momentum on the Rise, but Trade Risk Remains

  • Tone of Q4 earnings calls has generally improved versus a year ago and there appears to be some upside momentum on the top line
    • Nearly 75% of the Chemical companies having reported have beaten revenue estimates – last year it was below 30% – this for the most part is better pricing rather than conservative guidance
    • Comparing earnings call transcripts of the companies that have reported shows forward expectations of further momentum while many headwinds have receded relative to Q4 ’16
  • Our value based portfolios continue to produce gains as the commodity rally rolls on
    • OLN the standout in another strong month for the attractively screening stocks
    • Performance was weak in Industrial Gas, the only Chemicals subsector to trail the market over the past month (-4% vs. the S&P) – proposed deals are a sign of weak underlying business
  • Chemicals research since our last monthly report has included work on:
    • Commodity Chemicals – we see potential for the recent rally to sustain through at least 2H ’17 with valuations still reasonable relative to prior peaks and reduced output from China (pollution curbs) alleviating overcapacity and benefitting pricing (a notion confirmed by HUN on its earnings call)
    • SMID Caps – scanning the Chemical universe of stocks with market cap below $10 billion, we find a number of ideas based on currently relevant factors (US sales, tax rates, offshore cash) and fundamentals
    • Air Products – getting in on the M&A spree in Industrial Gas with a bid for Yingde would make most sense in our view if it would add critical manufacturing, design, and construction capabilities where APD is currently an industry laggard
  • Our preferences in the 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 or higher
    • We have moved Industrial Gas and Coatings to underweight – if we had to invest in these sectors we see relative upside for Air Liquide in Gas and AXTA/Akzo Nobel in Coatings

Exhibit 1

Exhibit 2

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

Overview

Chemical earnings for Q4 have to date supported some of our stock and subsector preferences – Exhibit 3. The Industrial Gas companies (APD and PX) stand out as two of the revenue laggards in a quarter when top line surprises have been otherwise predominantly positive – a currency issue to some extent for the gas companies but also indicative of the prevailing industry weakness that is a driving factor behind consolidation efforts. A surprisingly strong quarter from SHW was offset by less encouraging quarters from PPG and RPM – we continue to see risks in the Coatings space as TiO2 price increases go through and believe we have likely seen the crest of a multi-year growth cycle for this group. Commodity stocks generally have performed well, with OLN a notable positive outlier in Exhibit 3, MOS showing some signs of life in the fertilizer market, and DOW continuing to execute leading up to the DD merger. HUN also had a strong Q4 but the lack of clarity around the restart of its conflagrated Finland facility and the uncertainty related to its lawsuit against ALB/ROC for fraud and breach of contract with respect to a separate facility drove the stock down. Otherwise we think HUN is one of the more interesting names in the space. Outside the stocks for which we have complex valuation models (because of a lack of history), we remain positive on VSM, TROX, ASIX and TSE.

The commodity rally, while fueled by marginally better demand has really been pushed by the more limited surpluses coming out of China as the country cuts back production in an attempt to control pollution. This may be more acute in TiO2 than in others, but it is impacting Caustic and PVC (OLN and WLK), Urea (CF) and additionally both aluminum and steel.

We remain positive on the ethylene cycle, with a very high long-term conviction for LYB. There is less positive momentum in the ethylene chain today than in some of the other commodities, but ethylene is less fragile in our view because we are not depending on Chinese production discipline – we simply think that demand is growing at least as fast as supply is coming on and the fact that all the 2017 supply is in the US is a “red herring” that is unnerving investors. Polyethylene demand growth remains very strong and the market has taken new facilities from Braskem and Nova over the last 9 months in its stride – consuming all available capacity and pricing globally remains strong.

Exhibit 3

Source: Capital IQ and SSR Analysis

In Exhibit 4 we show a new bit of qualitative analysis – descriptive word clouds that measure the frequency with which certain buzzwords were mentioned on earnings calls – the bigger the word the more mentions. The insights of this analysis are limited but as a quick visual these word clouds essentially measure the corporate mood. At a high level we see “favorable” and “momentum” more prominent than in Q4 ’15, which had a much higher rate of “headwind” and “pressure”.

The tone is clearly changing, but the risks remain as well. We are still very unclear on Trump policies – especially on trade and this is a concern because there could be some very large swings for chemicals – positive and negative based on what his real intent is and then the tactics he employs to move forward.

We are very much for initiatives that increase US manufacturing – but we do not believe that a broad trade restriction is the right way to achieve the manufacturing goal – at least not for several years.

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 sector discount from normal value as measured by our valuation framework, and in Exhibit 8 we show discount by company. The discount in Ag is little changed from a month ago and remains the highest in the Chemicals group, but Commodity is now not far behind – DOW’s updated fiscal 2016 capital data has the stock looking less expensive than it previously did. Coatings’ premium ticked higher though we remain wary.

Exhibit 7

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 8 – none of our stocks are currently at valuation extremes, partly the result of the Trump rally which has lifted many of the cheap commodity names off their lows.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 shows absolute and relative performance by subsector since our last monthly report. Merger moves have not excited Industrial Gas investors as the stocks lagged materially for a second consecutive month despite talk of further industry consolidation. SHW drove the Coatings move but the commodity gains were broad based.

Exhibit 9

Source: Capital IQ and SSR Analysis

Profitability

 

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level. In the agricultural chemicals space, returns remain subdued – CF and MOS within 10% of multi-year earnings lows. Expectations here call for continued difficulties in 2017 but there are indications that the upswing could come sooner than currently anticipated. On the over-earning side, SHW forward estimates continue to show strong growth and CBT is approaching its 10 year earnings extreme – we highlighted this stock as a negative in our Chemicals SMID cap work.

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 small downward tick in recent months. We have seen further deterioration in Ag margins, and Commodity margins continue to roll over near historical peak levels – this could continue through Q4, with potential for a rebound in 2017. Coatings margins remain a concern – plateauing as input costs rise while heavy discounting at the retail level suggests elevated inventories.

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).

Value stocks rebounded in 2016 after a tough year in 2015 and so far the momentum has continued into 2017– Exhibit 14.

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. LYB is the lone holdover from last month, joined by three commodity stocks – 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

  • Another strong durable goods figure (8% year over year growth) boosted US consumer spending in the latest data through December
  • For the year, total consumption expenditures averaged 2.7% growth over the prior year, a healthy figure coming off a 3.2% comparable in 2015
  • 2016 spending on goods (+3.5%, 35% of total consumption) continued to outpace spending on services (+2.3%, 65% of total consumption)

Exhibit 17 Exhibit 18
Source: BEA

Construction

  • Construction spend in the US declined sequentially in the latest data (December) but was still up 4% versus the prior year
  • Exhibit 19 shows the long term trend in US construction spending and Exhibit 20 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period – though recent data suggests the possibility of a breakout
  • After falling precipitously in the middle of the year, growth in construction spending is again on the upswing – Exhibit 23

Exhibit 19 Exhibit 20

Source: US Census Bureau

Exhibit 21

Source: US Census Bureau

Agriculture

  • Ag pricing has been strong thus far in 2017, potentially positive for fertilizers: soybeans +5%, corn +8%
  • Pricing has trended higher since the summer but remains 40-50% below the mid 2012 peaks

Exhibit 22

Source: Capital IQ, SSR Analysis

ISM

  • The US PMI hit 56 for the first time since November 2014, rising for the fifth consecutive month
  • Production has risen sharply without a build up in inventories, suggesting strong demand
  • New orders held above 60 for the second straight month

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 rebounded in the latest data through December, after a sharp dip in the prior month

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Despite recent capacity expansions, maintenance at several facilities is likely to trim US ethylene production by 3% in Q1 versus 2016. Domestic demand looks to be down in Q1, offset by growth north and south of the border and continued derivative export demand.

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 up modestly in February despite a sharp rise in stocks of US commercial crude – Exhibits 31-32. Natural gas has fallen below $2.00 per mmBTU – gas in storage has normalized to the middle of the 5 year range – Exhibit 33.

Ethane has seen large price gains recently, to the highest levels in several years, tracking natural gas but also aided by the increased demand coming from exports and expected quick demand growth as US ethylene capacity restarts. Propane has seen an even more significant move higher. Given the more significant move in ethane relative to crude oil, the US is losing some of its competitive edge in ethylene.

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

Capacity continues to start up, with Nova starting its LLDPE facility early in January and Ineos expected to have its Texas HDPE facility running by end Q1. North American export growth of polyethylene is expected to be 10% in 2017 as prices are cut to offload the domestic surpluses. It will only be possible to maintain US integrated polyethylene profitability under these circumstances if global demand growth is robust enough to absorb all of these increases, which we believe is possible – see recent research.

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. No stocks currently show a skepticism extreme.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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!

December 21, 2016 – Praxair: Linde: Keeping Everyone Happy, Except Perhaps the Shareholders

December 19, 2016 – Mosaic: A Necessary Move, But Value Unclear

December 12, 2016 – LYB: Several Reasons to Pay Attention

December 9, 2016 – Paints Wars: A Reminder and Some Fresh Perspective

December 2, 2016 – Praxair: Compensating for Lack of Growth!

November 28, 2016 – Whyondell?

November 21, 2016 – Could or Should Aramco Buy Lyondell?

November 18, 2016 – Dow or DuPont? We Suggest DuPont

November 14, 2016 – Ethylene: Discounting Too Much Downside, Despite the Trump Trade Risk

November 8, 2016 – Fertilizers: Fundamentals at or Close to Trough – Attractive Risk/Reward

October 31, 2016 – How Concerned Should We Be About the US Paint Market

October 24, 2016 – When is a Sell a Buy? (When the Sell-Side Says So)

October 17, 2016 – Paint Wars! Sending Negative Signals

October 14, 2016 – Versum and AdvanSix: Smaller Portions at Attractive Prices

October 10, 2016 – RPM: Not All Chemical Stocks Only Look Attractive When They Are Cheap

October 5, 2016 – China Coal: Not Out of the Petrified Forest Yet

October 3, 2016 – Chemical Deal Mania: When to Hold Them and When to Show Them

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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