Chemicals Monthly – Albemarle Active, Gases Gain

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

July 15th, 2014

Chemicals Monthly Albemarle Active, Gases Gain

  • Albemarle’s acquisition of Rockwood Holdings was the news of the day, and while ALB was a surprising buyer for us, ROC was not a surprising seller – the writing has been on the wall there for a while. If there are real synergies it is an interesting story as neither stock was expensive.
  • Air Products has been the best performer in the Chemicals space over the past month, rising on the announcement of a new CEO, and making Industrial Gas the only subsector to outpace the S&P during that time – we view PX as best in breed in this group, and, with the valuation divergence between APD and PX now back at an extreme, continue to see the opportunity for a pair trade.
  • Diversified Chemicals, the worst performing subsector since June, has been dragged down as a group by the near term, preannouncement related weakness in DuPont. We continue to believe there is long term value to be unlocked in DD, and there is historical support for buying the stock on an earnings related dip.
  • Year to date, 2014 has seen momentum continue for the recently strong, expensive groups (Commodity, Specialty, and Coatings), as well as for the recent laggards (Ag and Diversified). Commodity stocks have been the strongest, beating a strong S&P by more than 13%.
  • Natural gas pricing has trended downward after ending April above $4.80 per MMBtu and now stands just over $4.00inventories are still in the process of being replenished from the winter, and while they remain at an extreme deviation from the 5 year average, on a 10 year time frame the discrepancy is not so severe.
  • Chemical sector preferences are outlined below at the subsector and stock level. DD remains a favorite despite the Q2 guide down. Note that we have moved the Commodity group to underweight, but move AXLL to our preferred list within the subsector. WLK has been removed from our Commodity concerns following the Vinnolit acquisition and MLP announcement. We remain positive on MON despite the problems at FMC and DD.

Exhibit 1

Source: SSR Analysis

Exhibit 2

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

Overview

The Q2 earnings season could see a number of disappointments, as there is increasing concern that weak economic data from early 2014 was more than just weather related. Consumer spending has sputtered rather than accelerated out of the winter, with April and May marking the first consecutive months of decline since the spring of 2012; construction spending has also been stagnant thus far in 2014.

A few chemical companies have guided down in advance of earnings. FMC and DuPont’s preemptive guide down was due to weakness in their respective Ag segments. AXLL announced a slower than anticipated ramp up of a facility that had been in repair, trimming 16% off of its full year estimate. Revisions elsewhere in the chemical space have been modest in anticipation of upcoming earnings reports.

The commodity space has seen a quarter of production problems, mostly outside our group of producers, drive ethylene inventories to historic lows and curtail polyethylene exports. Neither of the big Q2 ethylene expansions – Lyondell and Williams – is on line yet and other producers have seen outages. Despite this there is clearly the anticipation that the market is going to move long quickly, as, while ethylene spot prices have moved much higher in July, there is anticipation that contract prices will also increase in July but then fall again in August. Given the ethylene shortages, we would expect June and July trade statistics to show a slowdown in ethylene derivative exports from the US. There is a positive spread supporting exports of LDPE from the US, but not for either HDPE or LLDPE.

The deal between ALB and ROC is not contingent on the approval of Rockwood’s pending divestment of its TiO2 business to Huntsman, which is interesting as in our view the TiO2 business has been an impediment to sale for both ROC and HUN over the last couple of years. All parties must be confident that the ROC/HUN deal will pass EU scrutiny without any major hurdles.

If the lackluster US growth story is correct, while we might not see material Q2 misses, we might see negative 2H guidance.

Exhibit 3

Source: EIA

Valuation

Exhibit 4 summarizes our valuation work. Negative revisions in the Commodity space primarily reflect the AXLL guide down and the subsector as a whole remains on the expensive side with several constituents (WLK, LYB, and DOW) at multi year highs. DD’s pre announcement contained a less severe revision (-6.6%) but has significantly raised the discount for both the stock and the Diversified group, on which DuPont weighs heavily. We expect earnings for the company to remain strong and believe this short term dip only offers a new entry point into a name where we still see value.

Exhibit 4

The subsector classifications are summarized in Exhibit 5.

Exhibit 5

Exhibit 6 shows subsector discount from normal value in standard deviations.

The discount in the Diversified group is mainly a function of DD. Of the Coatings stocks, RPM (2.54 SDs above normal) screens as most expensive on our framework, but SHW (1.76 SDs) and PPG (1.35 SDs) are up there as well – see Exhibit 7 below. VAL (0.58 SDs) is the most conservatively valued.

Exhibit 6

Source: Capital IQ and SSR Analysis

In Exhibit 7 we show company discount from normal value as measured on our valuation framework. The left side of the chart is stacked with red (companies at all time valuation highs). PPG is within 3% of its all time valuation high and we have noted it as well. LYB has a short history but has performed very well of late and the stock continues to make new highs.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibits 8 and 9 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our June Chemicals Monthly. Industrial Gas rode the strength of APD on a new CEO announcement. The Diversified lag was driven by DD’s dip.

Year to date the Commodity group has shown the greatest strength, outpacing an up market by over 13%. The other expensive looking sectors, Specialty and Coatings, have been the only other subsectors to beat the S&P – momentum has continued in both these recently strong groups, as well as the recent laggards (Ag and Diversified, the cheapest and worst performing Chemical subsectors year to date).

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.

In Exhibit 10 we see VAL and IFF are the only companies currently at over-earning peaks. Interestingly, VAL is the only Coatings company that is not currently receiving a premium valuation.

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.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Portfolio Performance

The July portfolio selections are shown in Exhibit 13. DD rejoined the long side valuation screen, after its preannouncement dip. On the short side, DOW flipped over to the valuation screen from the SI screen, while SHW is back in the overlap short group; RPM appears on the short valuation screen as well, reflecting our concerns about the Coatings sector.

Exhibit 13

Source: Capital IQ and SSR Analysis

Our portfolios continue to disappoint in 2014, after solid performance in 2013. Our portfolios work as value gains relative to momentum, and year to date in the Chemicals space the expensive subsectors (Commodity, Specialty, and Coatings) have continued to see support, while the cheaper spaces (Ag and Diversified) remain laggards.

Exhibit 14

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures declined for the second month in a row. A number of consumer driven companies have noted the tepid retail environment they are facing.
  • Stagnant wage growth and a declining unemployment rate that largely reflects a lower labor force more than increasing employment remain causes for caution.

Exhibit 15 Exhibit 16

Source: BEA

Construction

  • Construction spending figures were revised back through 2008 in accordance with the results of the Census Bureau’s Annual Capital Expenditures Survey. The intermediate and long term trends remain consistent.
  • With the revised data, 2013 now shows a stronger year over year growth rate than 2012 (8.9% vs. 8.0%) – previously this had been reversed, with 2012 above 2013 by roughly 100 basis points. 2014 year to date has seen a flattening of the recovering uptrend.

Exhibit 17

Exhibit 18

Source: US Census Bureau

Agriculture

  • Ag pricing has been markedly weak over the past month. Soybean pricing has fallen off a cliff, down 18.3% since June, but is only down 5% year over year.
  • 2014 has seen wheat and corn pricing down over 20% versus 2013 levels. These weak farm economics explain some of the lack of support for the Agricultural Chemicals sector.
  • Refer to our blogs on potash – we remain quite negative in terms of the longer-term pricing outlook.

Exhibit 19

Source: Capital IQ, SSR Analysis

ISM

  • ISM’s Purchasing Managers Index was little changed in May, off only 0.1 point. New orders came in at the highest level in 2014, which could portend increased activity in the second half of the year.
  • Production ticked down but remains comfortably above inventories, which have held stable for the past five months.

Exhibit 20

Source: ISM

Exhibit 21

Source: ISM

Trade

  • We have updated our trade chart to exclude Medicinal & Pharmaceutical products from the broader Chemicals categorization – this more accurately reflects the companies in our coverage. The resulting chart still shows significant volatility, but also a high level of surplus – including Medical & Pharma, the balance has been bouncing between surplus and deficit. The dotted line in Exhibit 23 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years.
  • The dollar has depreciated 11.8% versus the British pound year over year. The Euro has also gained versus the US dollar, a comparatively modest 4.4%. The Russian ruble’s depreciation versus the dollar has moderated over 2014, and the currency is now just 3.5% below its relative value from a year ago. The Chinese continue to keep their currency in a tightly pegged band – Exhibit 23. The Euro was 5% stronger versus the dollar quarter over quarter in Q2 2014.

Exhibit 22

Source: US Census Bureau

Exhibit 23

Source: IMF

Exhibit 24

Source: IMF

Commodity Fundamentals

Supply/Demand

Please see our
December piece on US ethylene demand
for our recent more detailed perspective. We remain concerned that high absolute pricing for chemicals are constraining growth.

Note that we have made a change to our external data source in 2014 and that we are now using chemical market data from Wood Mackenzie. The supply/demand data for 2013 is very similar to that of IHS and we have not changed our historical data.

Capacity is expected to grow by more than 2 billion pounds in 2014 versus 2013, which means that demand needs to grow by more than 3.5% in 2014 just to maintain current operating rates. However, as is shown in Exhibit 27, the second quarter will show quite low operating rates as a number of facilities are closed, not just for annual maintenance, but also to tie in expansions. Despite the added capacity, it is noteworthy that Wood Mackenzie expects almost no production growth in 2014 and declining operating rates year on year in the second half. We would concur that demand growth is lackluster at best in the US and exports are opportunistic, such that the ethylene market could be quite oversupplied from June with inevitable consequences for pricing.

US ethylene inventories are now very low, having dropped quickly from highs at the end of Q1 because of both the planned and unplanned outages. Because of the unplanned production outages and the rapid drop in inventories, US ethylene spot prices have responded quickly in July, rising from a June average of around 56 cents per pound to a recent record of 76 cents per pound. June ethylene contract prices rose from 47 cents per pound to 47.75 cents per pound and will likely rise again in July. Assuming all facilities that have been offline come back on line as expected, it is likely that the pressure will ease and that prices will come down again in August.

Production is summarized in Exhibit 25 and operating rates are summarized in Exhibit 26.

Exhibit 25

Source: IHS and SSR Analysis

Exhibit 26

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 27

The oil market has been very stable since 2011, with Brent essentially in a 5-10% range centered around $105 per barrel and WTI similarly range bound but at a discount to Brent. Crude oil has not been this consistently priced for this long since the mid-90s. However, in recent weeks we are seeing more volatility in oil pricing, mostly driven by swings in the level of unrest in the Middle East and North Africa.

Natural gas is discussed in more detail in the overview.

Exhibit 27

Source: Capital IQ and SSR Analysis

NGL pricing continues to track natural gas, but ethane has weakened over the last couple of months and the discount of extraction value has reopened back to the levels seen at the end of last year. This is a function of significant ethane oversupply and high levels of rejection. Today this is both a supply and demand problem, with supply continuing to climb as new natural gas liquids gas wells are brought on line, and demand is weak because of the high number of current ethylene plant shutdowns. Ethane extraction units are currently at break-even on a marginal cost basis only. With the ethylene expansions expected later in the quarter, ethane demand will pick up, but we expect the oversupply to continue and pricing should remain very weak relative to Natural Gas – Exhibit 28. What is different is that the Conway ethane advantage has reappeared meaningfully from the low in February – Exhibit 29. This difference was a major benefit for Westlake and Lyondell in Q4 2013 as both operate ethylene units in the Mid-West.

Exhibit 28

Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 29

Source: Midstream Business and SSR Analysis

Propane and Butane prices are a little weaker in May than in April, but have been fairly stable since a significant step down in February. The longer-term trends relative to crude appear to be stabilizing somewhat as alternative values are reached for both. The swing in Propane is a function of real oversupply a year ago that has been quickly corrected through exports and current pricing reflects export netbacks – mainly from Europe – Exhibit 30.

Exhibit 30

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is relatively stable, all over the world, though the US has seen some significant differences in production in the first quarter of 2014 with high density polyethylene production down by more than 5% while other grades saw increases. This is partly a function of plant and ethylene availability in Louisiana, but it is interesting that pricing has not moved materially as a result of the lower supply.

Exhibit 31

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 (32) summarizes the results and is a repeat of Exhibit 4.
Exhibit 32

Valuation Charts – Exhibits 3335

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Skepticism Analysis

We apply the framework from our skepticism analysis on the broader Industrials and Basic Materials sectors to the Chemical space – see
our past research for more detail
. The primary conclusions are:

  • Diversified Chemicals has the highest skepticism index value of the subsectors – this is driven by DuPont, which has the highest skepticism value of all the companies in our Chemical universe. Ag Chem remains undervalued as earnings are slightly below trend, and expected to worsen. Conversely, Specialty is being granted a premium valuation that is discounting a rise in returns from current levels that are largely in line with trend.
  • In Exhibit 39, note that LYB is no longer at its all time skepticism low as earnings continue to rise in support of a healthy valuation. POL remains at its 10 year SI low and is highlighted in red. PPG is near (within 5.7%) a skepticism low as forward estimates are not currently supportive of the premium being afforded the stock.

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

June 16, 2014 – European Basic Chemicals: There Is Life In The Old Dog Yet!

June 2, 2014 – DuPont: A Cost Initiative Could Be Substantial

May 15, 2014 – Chemicals Revisions: Not Positive Enough and Not Supportive of Values for Many

May 13, 2014 – DuPont: The Case for $85 – But Why We May Need to be Patient

April 29, 2014 – Dow vs. Lyondell: Bet on the Company with More Levers to Pull – DOW

April 28, 2014 – US Natural Gas: Not Out of the Woods Yet!

April 25, 2014 – Air Products and Praxair: A Tale of Two Strategies

March 31, 2014 – Petrochemical-Fest: A Summary of the Texas Gathering

March 24, 2014 – Seeding a Better Investment

March 23, 2014 – Why the Basic Chemical Investments in the US Will Likely Disappoint

March 19, 2014 – Peak Valuation in Some Commodity Chemicals – Something to Watch

March 5, 2014 – APD: Time to Move to the Sidelines – PX More Interesting

February 24th, 2014 – Dow: A More Optimal Path, But a Hard Destination to Reach

February 17, 2014 – Dow: Loeb versus Liveris – Watch From A Distance

February 9, 2014 – Rising Natural Gas Prices and Rising Commodity Chemical Company Estimates: How Can This Be?

January 9, 2014 – Chemicals Companies in 2014

December 30, 2013 – DD: Still An Interesting Investment

December 16, 2013 – US Ethylene: The Case for a Better 2014

December 10, 2013 – Exporting Shale: A More Logical Perspective

November 18, 2013 – The Recommendation Signal: Another Reason to Look at DuPont

November 7, 2013 – Lyondell: Growth or Income, Both Have Risk

November 7, 2013 – DuPont: An Unusual Stake in the Ground (blog)

October 29, 2013 – PPG: What Do You Have to Believe

October 21, 2013 – Common Sense Restructuring: Some Money to Be Made

September 23, 2013 – The State of the US Chemical Industry

September 15, 2013 – Optimism and Forecasting in the Chemical Industry

August 5, 2013 – Understanding Transformational Change: The Eastman Example

August 5, 2013 – Potash: Breaking Up Apparently Isn’t That Hard to Do
(Blog)

July 25, 2013 – DuPont: Getting Appropriate Value for the Growth Engine

June 19, 2013 – Complexity, Volatility, and a Market Where Neither Extremes Work Well

June 14, 2013 – Ethylene: Unlikely to Be a Quick Fix for Williams

May 13, 2013 – DuPont: Betting the Farm – But Perhaps a Need to Crop the Portfolio?

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 2.

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

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