Chemicals Monthly – Deals, Deals, 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

September 20th, 2016

Chemicals Monthly – Deals, Deals, Deals

  • M&A action continues in several segments of the Chemical industry
    • Industrial Gas – failure of PX/Linde combination leads to management shakeup at Linde and stokes possibility of future deal – APD a potential wild card
    • Ag – two deals apparently consummated with negative stock reaction: MON stock didn’t budge after Bayer deal confirmed implying the expectation that the deal will not pass the regulators; both POT and AGU traded down following confirmation of their merger as the uncertainty created seemingly outweighs the potential synergies and market impact
  • Cracks in the global macro heighten the importance of deal-making as a growth driver
    • Quick drop in the US PMI in August reflected the same sharp demand downturn A. Schulman (SHLM) indicated in certain basic industries of the European market
  • Mixed performance over the past month – six Chemical subsectors split evenly between out and under performers
    • Coatings the most significant laggard – weakness in SHW, continuing downward trend post-earnings and uncertainty over value of VAL deal
    • Only the Commodity group materially outpaced the S&P – strength in the ethylene pricing and stocks (DOW, WLK, LYB) offsetting continued weakness in OLN
  • Since our last monthly report, our Chemicals coverage has included work on:
    • M&A – assessing the rationale of recently completed and currently pending deals; ethylene seems a logical industry for future consolidation, possibly spurred by what is likely to be a weak market in 2017
    • Olin – stock screens well, but closer look at return on tangible capital, debt levels, and revision history dampens the appeal
    • AXTA – appears to have opportunities to sustain momentum for the next year and a half, though stock is not cheap
    • PX/Linde – proposed deal hints at the lack of strategic alternatives – management turnover at Linde after talks collapsed could pave the way for a future acquisition
  • 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, MON, PPG) but have concerns in most subsectors, and at the subsector level would only be overweight Ag Chemicals – in part because of valuations

Exhibit 1

Exhibit 2

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

Overview

Consolidation has been a yearlong theme and recent activity indicates there are more deals to come. The management shakeup at Linde in the aftermath of the failed Praxair (PX) deal suggests that another M&A attempt is forthcoming. Praxair remains a plausible partner but Air Products (APD), having just approved the separation of its electronic materials division (Versum), could be a wild card – APD has the better valuation and the better balance sheet and could afford to pay more than PX in our view. The risk here for PX and APD is a potential bidding war between them for the Linde assets.

The initial news of the proposed PX/Linde deal was somewhat unexpected given the significant regulatory (and other) hurdles necessary to gain approval. The market seems even more skeptical of the MON/Bayer deal, as even after confirmation from both companies, MON stock hardly budged from the $106 level that is roughly 20% below Bayer’s bid.

Elsewhere in the Ag space, the POT/AGU combination seems like a deal just for the sake of a deal, and investors are struggling to see the strategic rationale. Both stocks have traded down and the initial pop provided to other fertilizer companies (MOS and to a lesser extent CF) quickly faded as it became clear that a combined POT/AGU entity would do little to address the issue of potash overcapacity and general fertilizer price weakness.

The market likely sees these merger attempts for what they really are – an attempt to do something to stimulate EPS growth in a world of slow to slowing economic growth, where top line growth is hard to find. The market is viewing these deals as confirmation that the companies are pessimistic on organic growth and also are valuing the companies on the basis that the deals themselves face regulatory scrutiny and may not happen.

Ethylene is a bright spot, but in our view a short term distraction – the stocks are rallying on the idea of a better Q3 – prices higher and costs low – but looming Q4 and 2017 overcapacity is keeping valuations very depressed versus earnings. We see risk that the stocks are lower on December 31st than they are today so we would stay away.

The more interesting trend is Asia coal pricing – Exhibit 3 – as this is getting a lot of chatter and could result in higher power and coal costs in China – good for pricing of TiO2, Chlor-Alkali, Urea and other products in oversupply. Probably the most levered way to play this is in TiO2 (CC, HUN and TROX) if it looks like it is sustainable. The risk is the same as for iron ore – high prices quickly results in higher production and the rally fades.

Exhibit 3

Source: Capital IQ and SSR Analysis

Valuation

Exhibit 4 summarizes our valuation work and the subsector classifications are summarized in Exhibit 5. Revisions were mostly modest as earnings season wound down, though 2016 estimates continued to come down in the Ag space – CF (-2.2%) and MOS (-7.1%) the drivers.

Exhibit 4

Exhibit 5

In Exhibit 6 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 7 we show discount by company. The valuation landscape is little changed from a rankings perspective, but the aggregate Coatings valuation looks less expensive than in recent months (largely a function of SHW, down ~8% over the past month). There is likely further downside for the Commodity group if Q3 turns out to be as weak as we expect.

Exhibit 6

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 7 – disappointing earnings results drove record discounts for the unloved stocks in the space – OLN, CF, MOS, and EMN. On the expensive side, we think that ECL, IFF, APD and NEU are all very vulnerable to a European slowdown because of revenue exposure to Europe and the risk of translation effect if the Europe weakens. We would not own any of these names given their current premium to fair value.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 shows absolute and relative performance by subsector since our last monthly report. Ethylene stocks showed relative strength during the recent selloff to bolster the Commodity group while Coatings stocks showed weakness in the selloff, notably SHW and RPM.

Exhibit 8

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 9 through 11 show profitability at the sector, subsector, and stock level. Coatings and Specialty companies mark the top end of Exhibit 9, with above trend earnings, while fertilizer producers are prominent at the back of the pack. POT/AGU is unlikely to materially affect pricing or earnings in the fertilizer space. The divergence between PX and APD perhaps suggests why PX was seeking a tie up with Linde.

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 and continues to trend higher driven by the Diversified group’s sharp turn off recent lows and continued gains in Industrial Gas. Coatings margins also are trending higher though at a slower pace of expansion than seen recently. We are seeing a possible sign of stabilization in Ag margins, while Commodity margins continue to roll over near historical peak levels and this sector is the biggest near-term risk in our view.

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 – 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).

2106 results have been generally positive (particularly in the overlap group) and more in line with what was seen in 2013 and 2014 – Exhibit 13. Cheap commodity stocks AXLL, OLN, and HUN were mainstays on the long screens in 2015 and this was a yearlong headwind for the selections – 2016 has been a different story as commodity stocks have mostly enjoyed a bounce.

We also typically 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. The negative revisions picture has resulted in none of our Chemical companies meeting all three criteria this month.

Exhibit 12

Exhibit 13


Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures continue to trend higher, growing 3% year over year
  • Spending on goods continues to outpace spending on the larger services category – July’s spending gains (+3.8% for goods, +2.6% for services) were slightly above the respective 12 month average growth figures

Exhibit 14                                                                              Exhibit 15

Source: BEA

Construction

  • Growth in construction spending is slowing against the strong comparable figures of the prior year
  • US construction spending averaged 10% growth from April 2015 to March 2016, but slowed to just 1.5% in the latest data (July 2016)
  • Exhibit 16 shows the long term trend in US construction spending and Exhibit 17 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period

Exhibit 16                                                                                              Exhibit 17

Source: US Census Bureau

Agriculture

  • Corn and wheat showed modest prices gains over the past month but have continued a longer downward trend in 2016 – corn is down 6% year to date, wheat down 14%
  • Soybean prices have shown more strength, +13% in 2016, but have given back some of the gain’s from earlier in the year as yields remain strong globally

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • The US Manufacturing PMI showed a somewhat concerning drop in the latest reading, falling from a sold expansion level to just below the neutral 50 mark
  • The drop in new orders was even more extreme
  • Growth in inventories is threatening to overtake production

Exhibit 19                                                                                              Exhibit 20

Source: ISM

Trade

  • Our trade balance exhibit excludes medicinal and pharmaceutical products to more accurately reflect the composition of our chemical index
  • There was only a modest improvement in the trade balance in the latest data, and the 12 month rolling average (dotted green line) in Exhibit 21 continues to take on a more pronounced downslope – sustained lower oil prices are not helping the case for US chemical exports, but given that the measure is in $ rather than volumes (pounds or tons), lower energy pricing (and therefore product pricing) may account for the declining trend

Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: Capital IQ, SSR Analysis

Exhibit 23

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Unplanned outages in August combined with sustained solid demand contributed to a drawdown in ethylene inventories – for Q3 the total reduction in stocks is expected to be the largest since 1997. Available capacity will struggle to meet the 1H ’16 level of derivative demand.

Production and operating rates are summarized in Exhibits 24 and 25.

Exhibit 24

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Crude stockpiles remain elevated but are slightly off their highs. Commercial crude stocks saw their biggest weekly drawdown since late 2012. Crude pricing is little changed since the end of August, and has lapped the higher price comparisons from earlier in the year. Natural gas on the other hand is nearly 20% above prior year levels, at around $3.00 per mmbtu. We think the risk to natural gas is very much to the upside given low (though rising) rig counts – at least in the near-term.

Exhibit 26                                                                              Exhibit 27

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

Exhibit 28

Source: EIA, SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Midstream Business and SSR Analysis

Exhibit 31

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 32

Source: IHS and SSR Analysis

Basic Plastics

The Braskem/Idsea startup has helped balance the HDPE market, somewhat offsetting unplanned outages in ethylene. Export demand remains strong, notably in LDPE (export volumes +11% in 2016 to date). Ineos/Sasol is expected to start up HDPE capacity by the start of 2017.

Exhibit 33

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

Exhibit 34

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36



Source: Capital IQ and SSR Analysis

Exhibit 37



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 38 summarizes Skepticism Index values by subsector, Exhibit 39 shows the extent to which valuation is historically explained by returns, and Exhibit 40 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41 shows SI by company. No stocks currently show a skepticism extreme.

Exhibit 41

Source: Capital IQ and SSR Analysis

 

2016 Chemicals Research

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

September 6, 2016 – The Olin Illusion

August 30, 2016 – AXTA: Not Cheap but 18 Months of Momentum

August 18, 2016 – MON: How Patient Are the Shareholders, Especially the New Ones

August 17, 2016 – PX/Linde: Are Desperation and Boredom Bigger Drivers Than Anything Else

August 16, 2016 – A. Schulman: A Personal Problem or A Leading Indicator

August 15, 2016 – Coatings: Developed Markets Peaking – China and M&A Can Keep Select Momentum

August 8, 2016 – CF: Analysis Suggests Dividend Can Be Sustained – Attractive Long Term Buy

August 1, 2016 – Eastman: A Bus Business, a Bad Strategy, or a Bargain?

July 19, 2016 – Monsanto: “A Bird in the Hand” – Hit the Bid – Now!

July 5, 2016 – Ethylene: You Can’t Fight the Fundamentals

June 24, 2016 – DOW/DD: We’ve Discussed the Upside, Now What Are the Risks?

June 22, 2016 – Agriculture: Likely at a Low, Seeds and Fertilizer Look More Interesting Than Equipment

June 14, 2016 – CE vs. EMN: Similar Current Valuations but EMN has the Potential

June 7, 2016 – Natural Gas Rising as Inventories Build: Not Got Good for US Chemicals

June 7, 2016 – Axiall: Don’t Listen for the Fat Lady Quite Yet! (blog)

May 31, 2016 – DuPont Adopting a “Go It Alone” Strategy, Which Raises Interesting Questions, Such as: What is Dow Doing/What Could Dow Do?

May 25, 2016 – MON-BAYER: What Price is Right?

May 23, 2016 – FMC: Can it Survive the Consolidation Wave? Should It Try?

May 16, 2016 – Monsanto Multiple Choice: Going it Alone, Merging, Selling, Spoiling?

May 16, 2015 – Nitrogen Fertilizer: Just Like Ethylene, but Different

May 5, 2016 – Fertilizer: Looking for Green Shoots

April 26, 2016 – Dow DuPont: So Many Scenarios, Few Companies Unaffected

April 19, 2016 – BASF: Trapped from the Inside and the Outside?

April 11, 2016 – PPG: Historical Anchors Away

March 29, 2016 – Lyondell: Over-Optimistic on Ethylene Means Over-

March 29, 2016 – Ethylene: Rewind to the 90s

March 15, 2016 – Sasol Delays Ethylene Plant: Axiall, Westlake and Eastman Should Be Paying Attention (blog)

March 14, 2016 – Monsanto: A Round-Up of Opportunities

March 6, 2016 – Enter BASF! Spoiler or Another Consolidator? We Think the Latter More Likely

March 2, 2016 – DowDuPont Trough Earnings: Risk/Reward Stacked to the Upside

February 25, 2016 – WLK + AXLL: A Deal Makes Sense – WLK Attractive Regardless

February 22, 2016 – Eastman: Should You Try for 2nd Base?

February 9, 2016 – Polyethylene: The Fragile Last Line of Defense!

January 27, 2016 – Coatings (PPG) A Safer Bet than Industrial Gas

January 13, 2016 – Dow/DuPont: So Far Not So Good – But Now More Compelling

January 6, 2016 – PPG: The Best of the Bunch (McGarry) for 2016

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 42 to 46.

Exhibit 42



Source: Company Reports and SSR Analysis

Exhibit 43

Source: Company Reports and SSR Analysis

Exhibit 44

Source: Company Reports and SSR Analysis

Exhibit 45

Source: Company Reports and SSR Analysis

Exhibit 46

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 47 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 47A

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 47B

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

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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