Chemicals Monthly – A Few Cheap Stocks with Housing/Construction Exposure

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

March 15th, 2013

Chemicals MonthlyA Few Cheap Stocks with Housing/Construction Exposure

  • We have a mixed picture for Chemicals as while many of the key indicators are green, a number are moving in the wrong direction, which may be more important from a stock perspective. Oil may be a negative, but while it is a constraint on global growth, it supports the margin umbrella for US producers able to base businesses on Natural Gas.
  • But valuations in a number of sectors reflect the positive more than the negative, and we are seeing more negative revisions than positive revisions today. These are mostly driven by a weaker global view rather than a weaker US view.
  • The exception is the Commodity group, and the TiO2 producers in the Diversified group. Here we have relatively attractive values (outside the natural gas pure play names) and Skepticism. Moreover, there is significant exposure in both groups to US housing and US construction in general.
  • Our valuation screens continue to highlight DD, but both ROC and HUN look interesting unless there is another (unexpected) downward leg in TiO2. The other interesting name is APD, which looks attractive on our normal value screen – an unusual situation for an Industrial Gas company.

 

Exhibit 1

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

Overview

The conclusions from this month’s analysis are as follows.

  • Overall, the sector is not cheap relative to the market and will find it hard to keep up in a market that is rising but without a heavy “risk on” bias to sentiment.
  • We continue to get reminders of how weak the global economy is today and is expected to be for the rest of the year. The expectation is now for very limited economic growth in the first half of 2013.
  • We have highlighted the risk to this group in recent work that stagnant economic growth can mean declining chemical volumes and increased price competition. Volumes in general may be fairly stagnant, but the sector is positively oriented towards the two drivers of enthusiasm that dominant the headlines today – US natural gas and US housing.
  • The Diversified and Specialty groups continue to see negative revisions, partly based on declining price forecasts for TiO2 and partly because of lower economic forecasts, but beat the market in recent weeks despite that, which might suggest a valuation floor has been reached for some companies (most notably DuPont). Commodities saw the most positive revisions, driven for the most part by ever improving Gulf Coast production economics.
  • Our model portfolios delivered mixed performances through mid March; our long picks are working and outperforming the short picks, but not enough to beat the stronger overall market.
  • NGL prices remain weak and now Butane appears to be joining the party. As the winter gasoline blending season ends, butane prices are down 10% in only a couple of weeks. If butane needs to compete for room as an ethylene feed, it has much further to fall.

Valuation

Exhibit 2 summarizes our valuation work. The extreme in valuations for the
Coatings group is something we have written about at length
– and we can partly explain the premium to normal with the current very high level of earnings.

We repeat the comments that we made last month as we think they remain very relevant.

The commodity group shows the investor dilemma, as the economics in the US are extraordinary and should result in very high earnings and cash flows. These have been further emphasized by recent announcements by LYB and DOW around increasing the return of cash to shareholders. The negative is the global economic picture, as this is a subsector that never does well in a weakening economy as more subdued demand almost always results in price pressure and lower margins. Today that is definitely the case in Europe and Asia, where pricing is bouncing along close to the break-even cost of production for many. Those companies with larger portfolios outside the US are clearly suffering as a consequence and this is offsetting the US advantage.

Exhibit 2

The group composition is summarized below.

Exhibit 3

Exhibits 4 and 5 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our
February Chemicals Monthly
. The charts show a better performance than the prior period, with the group overall beating the broader market slightly. The Diversified and Specialty sectors did well despite negative revisions and the Commodity sector did well, probably because of positive revisions.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Monthly Topic: Research and Development

This month we wrote a comprehensive piece on R&D within Industrials and Materials, concluding that no subsector and few companies generate any sort of measurable positive return from R&D. We also showed an inverse correlation between the amount of spending per patent filed and the long-term growth in return on capital.

In the charts below we show the results of the analysis for the Chemical sector. While Chemicals does not show a negative correlation between PE and R&D spend as a percent of earnings, the best fit line is barely positive and there are plenty of companies in the wrong quadrant – low PE high R&D spend – Exhibit 6.

We also get a slight, but unconvincing, positive fit line when we look at R&D spend versus trend in return on capital, with most of the high spenders in the wrong corner – Exhibit 7 .

Exhibit 6

Exhibit 7

Source: Capital IQ and SSR Analysis

Not surprisingly the Ag Chemicals companies are the big spenders and the Industrials Gases companies are the low spenders. Commodity and Diversified are pulled up in part because of the Ag components at DOW and DD respectively – Exhibit 8. If we aggregate the sectors and re-plot Exhibit 6, we get a picture that we would expect – Exhibit 9. The exhibit emphasizes how little value (if any) is being granted to the Ag R&D platforms at DuPont and Dow Chemical

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

R&D is not driving earnings growth (Exhibit 10), it’s not really driving more SG&A spending (Exhibit 11) and if anything it is inversely correlated with capital spending, which seems counter-intuitive (Exhibit 12).

Exhibit 10

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

The average cost per patent analysis is a little more interesting, though we are limited by the number of companies with robust patent data and enough R&D to be relevant. For example, Dow is the only member of the commodity group with a good history of data. As we indicated in the broader analysis, there is not much to be drawn from Exhibit 13. There is more to be learned, however, when we plot cost per patent against trend growth in return on capital – Exhibit 14. We do not have many data points – perhaps too few to draw any real conclusions, but we do get the same shape and the same trend that we had for the broader group. Here perhaps we can go out on a bit of limb and suggest that the market is miss-valuing, on this analysis alone, DuPont, relative to Dow Chemical. DD has a relatively low cost per patent filed and a 10 year improving return on capital trend. DOW has a relatively high cost per patent filed and a negative return on capital trend. While there could be a host of circumstances other than R&D efficacy to explain this, we make the comparison anyway.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

The full March selections are shown in Exhibit 15. DuPont and Rockwood are the most interesting names as they screen on both valuation and skepticism – both partly as a result of uncertainty in the TiO2 market. All three TiO2 exposed stocks appear in the skepticism index suggesting that in all cases investors expect earnings and returns on capital to fall near-term. It is very unusual to see an Industrial Gas company screen attractive in the normal value framework and APD has now been there for a couple of months.

Generally our longs have done better than our shorts this year, but generally both groups have appreciated and consequently our hedged portfolios have underperformed the very strong S&P. It has been our contention for some time that our sectors are not cheap, and the normalized value work supports that. In a rising S&P world, we would expect Industrials and materials to underperform.

Exhibit 15

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April 2012; we show the results for the current year in Exhibit 16. We generated good results for the overlap group through mid-September, and after a period of underperformance from October through November, the portfolio returned to profitability in December and January. Midway through last month our portfolios were underperforming but rebounded in the latter half of January to post solid performances on all three metrics. Results have been mixed thus far in Q1 2013, and the overlap strategy has been virtually flat to the market.

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Increased payroll taxes did not hinder consumer spending, as personal consumption expenditures were slightly higher in January, and are up over 2% year over year. October figures were revised down nearly insignificantly, while November and December figures were revised up similarly.
  • Pent up demand in the auto industry and optimistic forecasts in the housing markets have bolstered expenditures in spite of the payroll tax hike and government spending cuts. With incomes dropping, it will be interesting to see if this can continue as we move forward in a still uncertain macroeconomic environment.

Exhibit 17

Exhibit 18

Source: BEA

Construction

  • Construction spending fell off in January, but the data for November and December was revised up considerably.
  • This unexpected decline was due to budget constraints at both the state and federal level, but the consensus outlook for the mid-term remains positive.

Exhibit 19

Exhibit 20

Source: US Census Bureau

Agriculture

  • Soybean and corn pricing were little changed, up and down 1%, respectively month over month. Wheat was the big mover, dropping 8% since our last report.

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • The PMI reading continued to trend higher in February, for the third consecutive month, and has not been this high since April of last year – Exhibit 22.
  • Production is increasing at a much faster rate than inventories, which flattened out in the most recent data – Exhibit 23.

Exhibit 22

Contraction

Expansion

Source: ISM

Exhibit 23

Source: ISM

Trade

  • Chemical trade volumes again dropped to a deficit in January – Exhibit 24.
  • The dashed line in Exhibit 24 is a rolling 12 month average that cuts through the monthly volatility. If the US is going to get real advantage from its lower natural gas prices, we should expect to see this line trend upwards.
  • The Euro gave back some of the gains it had recently made on the dollar. Thus far through Q1 2013, the dollar is weaker year over year by 1.2%.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: IMF

Exhibit 26

Source: IMF

Commodity Fundamentals

Supply/Demand

Ethylene production is increasing in the US and while the first quarter of 2013 is an easy compare because of plant outages last year, the production numbers are the best we have seen since the economic downturn in 2008. Part of the production story is new capacity from DOW and WLK, but these are small increments relative to the total – Exhibit 27. Given the better consumer spending numbers and the better housing numbers in the US we do see some support for the better production levels and without this spending increase we would be concerned that the extra production is going into inventory. Trade data does not suggest an increase in US exports.

Operating rates are also up, even with the higher capacity – Exhibit 28.

While the current significant discount in NGL pricing in the US relative to crude oil gives a subset of US producers a meaningful cost advantage over any producer globally using an oil fraction as an ethylene feed, the higher cost producers in the US do not have costs materially lower than the higher cost producers in Europe, Latin America and Asia, at this time. While the plans to add NGL based capacity in the US is predicated on the idea that it should displace crude oil fraction based production outside the US, there is a risk that some of the early victims will be crude oil based producers locally. Looking back at the trade figures above – Exhibit 24 – we are not seeing the lower cost base in the US turn into a meaningful improvement in exports. The trade data is volatile but it is hard to see a positive trend and if we do a 12 month rolling average the line trends is only barely positive.

Exhibit 27

Source: IHS and SSR Analysis

Exhibit 28

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 29

Brent prices have been fairly stable over the last few weeks, but have had a positive trend. WTI prices have been more stable at the gap with Brent has opened further albeit only slightly.

Natural Gas has recovered a little from the lows in February, but is bouncing around the $3.50/MMBTU level.

Exhibit 29

Source: Capital IQ

NGL pricing remains very weak; even with improved ethylene production, the increased availability is swamping the market. Supply is rising as more and more new wells are drilled in the “wet gas” regions of the West Marcellus and as logistics help increased crude shipment from the Baaken shale play in The Dakotas, Wyoming and Montana. This crude has high levels of associated gas in many locations. Ethane margins remain below break-even extraction costs for the average producer in January, and have now been negative for three months – Exhibit 30. Part of the problem for ethane producers is the price of propane which remains very depressed and makes propane as attractive to many ethylene producers as ethane – this keeps the squeeze on ethane.

Making matters worse, as the winter gasoline blending season ends, butane pricing is also weakening. Butane has fallen 10% over the last month and while it remains an uncompetitive feed relative to propane there is the added risk that it falls until it finds demand support. Watching this dynamic over the last year (Exhibit 31), we cannot help but wonder whether natural gasoline is next? Again, production increases as crude and natural gas production increases. Natural gasoline has blending demand for gasoline, but enough of a surplus could cause a disconnect from crude – effectively making advantaged feedstocks available to all US ethylene producers.

Exhibit 30

Source: IHS and SSR Analysis

One thing that we continue to see is the price of NGLs fall relative to crude – Exhibit 31. In Q1 2013 this is coming more from the strength in crude prices, but we are now at all time lows for ethane, propane and normal butane.

Exhibit 31

Source: IHS and SSR Analysis

Basic Plastics

Lower input costs and possible polyethylene prices in Q1 2013 have lifted polymer margins further – Exhibit 32. International polyethylene pricing remains weak (and weaker than US pricing), but above break-even for most local producers.

Exhibit 32

Source: IHS and SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (33) summarizes the results and is a repeat of Exhibit 1.
Exhibit 33

Valuation Charts – Exhibits 3436

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We have updated the charts and tables from the Skepticism work that we completed in May – see
our past research for more detail
. The primary conclusions are:

  • Specialty, Ag Chemical and Coatings continue to have valuations that discount an increase in return on capital from current levels but with the underperformance of the last four weeks that expectation has decreased further for Ag and Coatings– though only slightly. The other subgroups all have values that anticipate a fall in returns on capital – Exhibit 37
  • The gross margin trend analysis suggests that this expected decline is probably appropriate for commodity chemicals based on historic volatility, but not based on the widening oil and/gas ratio that we see today.
  • Gross margin analysis calls into question whether the coatings sector should be discounting further improvements in returns on capital as the sector is already over-earning. As discussed in previous research, the Coatings sub-sector has consensus estimates for 2013 that do not support the return on capital gains discounted in valuation. Furthermore, the sub-sector has a very good track record of accurate forward earnings projections– Exhibit 38

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

March 6, 2013 – R&D in Industrials and Basics – Just Not Effective

March 5, 2013 – Low Cost US: The Shift is Underway, SLOWLY Reversing a 40 Year Trend
(Blog)

February 12, 2013 – US Basic Chemicals Economics: It Can’t Get Much Better Than This

January 25, 2013 – DuPont: The Uncomplicated Story and The What If?

January 10, 2013 – A Lesson In Expectations: Is There A Bubble In My Paint?

January 3, 2013 – 13 Attractive, Bad or Overhyped Ideas for 2013, Assuming No Macro Change

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 39 to 43.

Exhibit 39


Source: Company Reports and SSR Analysis

Exhibit 40

Source: Company Reports and SSR Analysis

Exhibit 41

Source: Company Reports and SSR Analysis

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

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 44 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 1.

Exhibit 44A

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 44B

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. We will test this more empirically in the coming months.

Appendix 2

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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