Chemicals January – Will Trump Slow Down Investment and Deals?

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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

January 17th, 2017

Chemicals January – Will Trump Slow Down Investment and Deals?

  • Gases have been the worst performing stocks in the Chemical space over the past month – merger moves hint at desperation in the face of stagnant industry dynamics
    • PX not receiving any benefit to its share price as Linde deal develops
    • APD’s pass at Yingde caused little market reaction – prefer Air Liquide in the space
  • Coatings was one of only two Chemical subsectors (Ag being the other) to outperform the S&P, as VAL rallied back from its earlier dip when the SHW deal seemed in question
    • SHW up as well, offsetting weakness in RPM on the heels of a poor earnings report suggesting continued pressure in the paint markets
    • PPG enters the attractive overlap of valuation and skepticism metrics – Exhibit 15 – valuation for PPG is becoming compelling but Mexico is another headwind and we would wait
    • We continue to see price erosion in architectural paints so do not think the negative trend is over
  • Ag Chemicals saw a bounce at the end of 2016 and the momentum has thus far continued into the New Year
    • CF leading the way, +18% versus the market since mid-December – this is not supported by Urea price moves to date and suggests that the market believes in continued pricing gains
  • Chemicals research since our last monthly report has included work on:
    • Dow and DuPont – likely to trade with the macro and/or company specific stories (good or bad – see below) until the deal closes, upon which we think the stocks have real upside – continue to prefer DD as a standalone
    • Praxair and Linde – concessions needed to get the deal past the regulatory/shareholder obstacle course likely to limit synergies – no near-term fix for poor industry fundamentals in our view, with only Air Liquide showing potential for upside
    • 2017 outlook – with value and momentum unaligned, we would only be long LYB among large cap chemical stocks, with the DOW/DD deal exception noted above
  • 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, MON) 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

The chemical sector is extremely exposed to the uncertainty associated with the incoming Trump administration, with the new President just as likely to do or say something that helps the industry as he is something that hurts. Most of these large uncertainties are around trade policy. CF has been one of the best performing stocks of the year, despite what are still weak prices for Urea. However, a proposed 45% import tax probably justifies more upside in CF than we have seen already were it enacted. CF is in a small group – companies where the US is a net importer of the primary products they produce. The opposite list is far longer, with Chemicals and Plastics combined one of the country’s largest sources of export income. Reactionary trade policies by those countries targeted by Trump would likely single out the US Chemical Industry as the one most damaged – particularly the plastics subsector. Over time the US could build the manufacturing capacity necessary to consume much of its chemicals and plastics domestically, but this is neither a quick nor an easy fix.

Exhibit 3

Source: Capital IQ and SSR Analysis

The slightly negative trend in Exhibit 3 is reflective of the decline in prices caused by the oil reset since 2014. Volumes of exports from the US are on a rising trend, despite the volatility in the chart, and with the new capacity being added in base chemicals and plastics in 2017, this trend should continue. The relative weakness in LYB and (until recently) WLK is more a factors over concern about fundamentals and possible oversupply of polyethylene in 2017, in our view, and something we believe is too pessimistic, rather than fear (yet) of the secondary consequences of a trade war.

Proposals to boost jobs and economic growth in the US fall into two categories – infrastructure and reversing the trend in manufacturing (bringing manufacturing back to the US). These are likely both longer-term positives for the US Chemical producers, but neither path, assuming its policies get support from the House, will likely create near-term earnings growth, and in the meantime, most US chemical companies will see the impact of the strengthening dollar on non-US business more than offset any gains in the US.

At the beginning of the month we used all our screening tools to suggest the more interesting places to invest across all of industrials and materials. In Exhibit 4 we summarize the chemical names that appeared on the top and bottom of each screens – these are not inconsistent for the most part with our current preferences and concerns, with the exception of DOW/DD which screens much better on normal value if you add in the expected synergies to forward normal earnings – Exhibit 5. We also included the best and worst on our optimism screen – Exhibit 6.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Valuation

Exhibit 7 summarizes our valuation work and the subsector classifications are summarized in Exhibit 8.

Exhibit 7

Exhibit 8

In Exhibit 9 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 10 we show discount by company. Coatings and Ag remain expensive and cheap outliers respectively in what is otherwise a reasonably valued sector in aggregate. We continue to see signs of pricing pressure in the coatings space at a time when raw materials are likely to maintain an upward bias in part because of more limited China supply and in part because of rising oil prices. While PPG has dropped into an attractive intersect between valuation and skepticism (a measure which drove considerable subsequent outperformance in 2016) we now have the additional PPG worry of its exposure to Mexico through the Comex deal and the translational impact that the weaker Peso will have on earnings in Q1 – there is likely a better entry point for PPG.

On the Ag side the whole farm complex looks challenged by continued weak grain pricing, resulting in poor farm income and limited ability to buy discretionary items and accept higher seed or chemical pricing – hence the M&A. Urea could benefit from a high “Trump” import tariff.

Exhibit 9

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 10 – we have only MOS remaining within 10% of a 10 year valuation low following the Trump rally. DOW remains at an individual 10 year peak in valuation but looks considerably less expensive with the benefit of DD synergies.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11 shows absolute and relative performance by subsector since our last monthly report. Merger moves did not excited Industrial Gas investors as the stocks lagged despite talk of further industry consolidation.

Exhibit 11

Source: Capital IQ and SSR Analysis

Profitability

 

Exhibits 12 through 14 show profitability at the sector, subsector, and stock level. In the agricultural chemicals space, returns remain subdued – CF and MOS within 5% of multi-year earnings lows and MON only just outside this threshold. Expectations here call for continued difficulties in 2017 but there are indications that the upswing could come sooner than currently anticipated. Sub-trend returns for ALB and ASH are likely to be moderated with the inclusion of fiscal 2016 data reflecting the respective additions/deductions to their capital bases. On the over-earning side, SHW forward estimates continue to show strong growth.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibits 13 and 14 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 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 15 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 – OLN, for example, screens as cheap but we see good reason for this and have long been concerned about the stock (see Exhibit 1 for our preferences by Chemicals subsector).

Value stocks rebounded in 2016 after a tough year in 2015 – Exhibit 16. Many of the troubled names emerged from early year bankruptcy fears to post gains throughout the year, with the Trump rally providing a final push for good measure. So far the momentum has continued into 2017.

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. For the second consecutive month only two stocks appear on this screen – LYB and EMN – Exhibit 17. Exhibit 18 shows the newly updated performance results for companies meeting these conditions at various ranges.

Exhibit 15

Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17

Source: Capital IQ and SSR Analysis

Exhibit 18

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • The latest US spending data showed modest positive revisions to July through October figures and a sequential flattening for November’s data
  • Year over year growth rates declined modestly for Goods (4.1% from 4.6%) and increased modestly for Services (2.3% from 2.1%).
  • Durable goods, coming off a robust 8.3% year over year growth figure in October, held strong at 6.9% in November’s data

Exhibit 19 Exhibit 20
Source: BEA

Construction

  • Modest negative revisions to September and October figures were accompanied by a strong November construction spend number in the latest data – +1% sequentially and +4% year over year
  • Exhibit 21 shows the long term trend in US construction spending and Exhibit 22 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period – though the latest 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 21 Exhibit 22

Source: US Census Bureau

Exhibit 23

Source: US Census Bureau

Agriculture

  • Ag pricing has seen modest gains since mid-December, mostly in soybeans and wheat, each up ~4% so far in January
  • Pricing has trended higher since the summer but remains 40-50% below the mid 2012 peaks

Exhibit 24

Source: Capital IQ, SSR Analysis

ISM

  • US manufacturing appears to be back on more stable footing following a fourth consecutive monthly gain that has the index in solid expansion territory at a level last seen in December 2014
  • Inventories were drawn down and production was up sharply
  • New orders also saw an impressive pickup, also to a level last achieved in late 2014

Exhibit 25 Exhibit 26


Source: ISM

Exhibit 27

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 fell sharply in the latest data through November after a few months of relative stability

Exhibit 28

Source: US Census Bureau

Exhibit 29

Source: Capital IQ, SSR Analysis

Exhibit 30

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Inventories grew slightly in December with LYB’s expansion at Corpus Christi aligning with the restart of CPChem’s Cedar Bayou facility to offset unplanned outages elsewhere. Operating rates rose above 90% and are expected to be in 92% range for January. Ethylene demand growth was estimated up around 2% in 2016, which is expected to rise to 4% growth this year.

Production and operating rates are summarized in Exhibits 31 and 32.

Exhibit 31

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 32

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

The OPEC output agreement has sent crude into the mid $50/barrel range, while natural gas pricing gave back some its recent gains and settled below $3.50 per mmBTU. For the year the pricing gains about offset, with a small contraction in the gas/oil ratio to the detriment of gas.

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. Given the more significant move in ethane relative to crude oil (despite crude’s recent rally), the US is losing some of its competitive edge in ethylene.

Exhibit 33                                                                            Exhibit 34


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

Exhibit 35

Source: EIA, SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37


Source: Midstream Business and SSR Analysis

Exhibit 38


Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 39


Source: IHS and SSR Analysis

Basic Plastics

Capacity continues to start up, to the north and the south – Nova completed construction of its facility in Alberta and production should start to ramp up by year end, while Braskem/Idsea has brought on both HDPE and LDPE facilities. 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 40

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 (41) summarizes the results and is a repeat of Exhibit 7.

Exhibit 41

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43


Source: Capital IQ and SSR Analysis

Exhibit 44

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 45 summarizes Skepticism Index values by subsector, Exhibit 46 shows the extent to which valuation is historically explained by returns, and Exhibit 47 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46

Source: Capital IQ and SSR Analysis

Exhibit 47

Source: Capital IQ and SSR Analysis

Exhibit 48 shows SI by company. No stocks currently show a skepticism extreme.

Exhibit 48

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

September 29, 2016 – Akzo: Underachieving – Need the PPG Path to Higher Valuation

September 23, 2016 – Trading Ethylene? Tread Carefully

September 14, 2016 – Change at Linde Suggests an Acquisition is Possible

September 6, 2016 – M&A in Chemicals: More to Come and Other Sectors to Follow

September 6, 2016 – The Olin Illusion

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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