Chemicals July – No Story, No Gain

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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

July 16th, 2017

Chemicals July – No Story, No Gain

  • Similar to the pattern we observed in Industrials, the top performing Chemical stocks year to date all have some sort of change or positive story ongoing – mostly mergers or business simplifications
    • Top performers include several with pending or recently completed M&A – HUN, SHW, DOW, DD, PX, WLK
    • ALB simplified its story by divesting Chemetall and is benefitting from the Lithium tailwind
    • Conversely, APD, facing strengthened competitors, the upper limits of a multi-year cost program, and a lack of remaining portfolio adjustments, symbolized the laggards in its dearth of options and lack of credible narrative
  • Sector valuation positioning is little changed from the start of the year
    • Coatings and Ag Chem are the outliers at the expensive and cheap end of the spectrum, respectively, with each close to an extreme since 2010
    • The Diversified group also screens at an expensive extreme, but much of this is driven by DD which, at its all-time high, only looks expensive without the benefit of expected DOW synergies
  • Research since our last monthly has included work on:
    • PX/Linde – we see potential for the combined entity to win the bulk of available projects, taking cost-based share from APD and Air Liquide
    • Clariant – our concerns about the complexity of the HUN/Clariant tie-up have been echoed by activist investors who see the deal as a move away from the specialty portfolio Clariant has sought to create
    • FUL and SHLM – these two early (under) reporters appear to us to be companies moving in opposite directions on the optimism spectrum, as evidenced by the reaction of the share prices
    • Nitrogen Fertilizers – while the smaller players (LXU, UAN) could be challenged in an environment of lower-for-longer fertilizer pricing, CF looks well equipped to withstand a prolonged downturn and we continue to view the stock as one of the best values in the space
    • EMN – the stock rallied after Blackstone and Celanese agreed to combine their filter tow businesses, but in our view the move simply highlighted EMN’s lack of creativity and proactivity
  • 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

We noted in our Industrials monthly report that the top performing stocks through the first half of 2017 had a much higher frequency of significant changes – M&A, new CEO, activist interest – than the worst performing stocks. In the Chemicals sector, too, it has paid to have a story year to date – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis

Of the major outperforming Chemical stocks:

  • HUN has the Clariant deal – although the performance in the stock came before the announcement and was likely driven by the expectation of a deal once it became clear that the TiO2 exit was on track
    • We are unconvinced that this deal with Clariant makes sense and no longer have HUN on our preferred list – the risk being that the combined company trades closer to HUN’s multiples than Clariant’s
  • ALB streamlined its operations with the sale of Chemetall to BASF, closed in December
    • Plus the Lithium kicker
  • SHW recently completed the VAL acquisition
  • WLK is still digesting AXLL (the same could be said of OLN and the acquired DOW assets)
  • DOW/DD, and PX all have pending mega-mergers

Conversely, if we look at the laggards, Ag troubles aside:

  • APD is something of the poster child for “companies without viable options” – strengthening competitors, cost opportunities behind them, and no tangential businesses left to sell or spin; we are concerned about its suggested off-piste capital deployment strategy
  • FUL is struggling to meet its 2020 growth targets organically; we see a risk that company turns to acquisitions to try to meet top line targets (one recently announced) – we see the same risk at Akzo as the company attempts to meet targets suggested in its defense against PPG

The trailing performance of LYB and CF only adds to the eventual value opportunity in these stocks, in our view.

Valuation

Exhibit 4 summarizes our valuation work and the subsector classifications are summarized in Exhibit 5.

Exhibit 4

Exhibit 5

In Exhibit 6 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 7 shows discount by company.

The current sectors at each end of the valuation spectrum, Coatings and Ag Chem, are both near their extremes since 2010. The Diversified group is also at an extreme, driven largely by DD’s move to an all-time high. We note that with the benefit of the estimated synergies from the DOW deal, the premium in DD is significantly lower (the same came be said of DOW).

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 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Profitability

 

Exhibits 9 through 11 show profitability at the sector, subsector, and stock level. Returns help to explain the valuation discounts seen in the fertilizer stocks and the thirst for M&A in the peaking Coatings space.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 and 11 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 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 12 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 started out strong in 2017, turned mixed in March through May, and have recovered in the past two months, particularly in the overlap group which continues to produce the most robust returns – Exhibit 13.

We also include a screen based on prior analysis combining these valuation and skepticism components with earnings revisions –Exhibit 14. The addition of the revisions metric provides a momentum style factor. The revisions picture has trimmed this group from six stocks last month to three this month (WLK, EMN, MON). Slightly negative revisions for LYB and more meaningful ones for OLN have these two dropping off the list. Exhibit 15 shows the historical performance results for stocks falling in various ranges of these highlighted metrics.

Exhibit 12

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

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 May
  • Year over year growth remains stronger in goods (+3.7%) vs. services (2.2%), with the durables component of good spsending continuing a run of 7% year over year gains

Exhibit 16 Exhibit 17
Source: BEA

Construction

  • Construction spending has paused in the latest data through May – the second consecutive month of modest sequential declines and the first month since last August that year over year growth in construction spend has fallen below 5%
  • Exhibit 18 shows the long-term trend in US construction spending and Exhibit 19 shows the trend over the past several years

Exhibit 18 Exhibit 19

Source: US Census Bureau

Exhibit 20

Source: US Census Bureau

Agriculture

  • Soybeans are the only major crop showing month over month price gains in July to date, despite an expected significant soybean harvest in Brazil that threatens to weigh on prices throughout the summer
  • Corn pricing is seen as likely to be firmer in the coming months, with potential for lower yields than in recent years

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • Strong rebound in the ISM’s PMI reading after several months of decline – 57.8 level last seen in November 2014
  • Inventories were drawn down and production increased
  • New orders remain healthy – Exhibit 24

Exhibit 22 Exhibit 23


Source: ISM

Exhibit 24

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 has come off its recent highs (levels not seen since 2013) in the latest data through May. 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 25

Source: US Census Bureau

Exhibit 26

Source: Capital IQ, SSR Analysis

Exhibit 27

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene inventories continue to grow and are expected to do so through the summer before peaking in August. Output in June represented the second consecutive monthly production record. With several companies confirming completion of PE facilities, demand should pick up in 2H.

Production and operating rates are summarized in Exhibits 28 and 29.

Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Output reductions have not broken the downward trend in crude pricing – Exhibit 33 – 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 approaching $3.50 earlier in the year, driven by expectations of an export pull – net long natural gas positions have been trending higher and are currently at the highest level since 2014. Gas in storage remains above the seasonal norm of the past five years but could be drawn down quickly as (if) the weather heats up.

Exhibit 30 Exhibit 31


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

Exhibit 32

Source: EIA, SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34


Source: Midstream Business and SSR Analysis

Exhibit 35


Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 36


Source: IHS and SSR Analysis

Basic Plastics

Polyethylene demand is picking up, with June expected to show a 2% year over year increase and slightly higher increases expected for the summer months. Inventories have been drawn down, from a peak of 37 days in May to 31 days as of June.

Exhibit 37

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 (38) summarizes the results and is a repeat of Exhibit 4.

Exhibit 38

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40


Source: Capital IQ and SSR Analysis

Exhibit 41

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

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45 shows SI by company. Only ALB currently sits at a skepticism extreme – the stock has moved strongly higher over the past month, and returns, while improving, remain sub-trend.

Exhibit 45

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 46 to 50.

Exhibit 46

Source: Company Reports and SSR Analysis

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

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 51A

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 51B

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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