Chemicals Monthly – Negative Revisions, Positive Performance on Par With Year of Trump

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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

December 16th, 2016

Chemicals Monthly – Negative Revisions, Positive Performance on Par With Year of Trump

  • Largely positive, plus-market moves for the Chemicals sector over the past month underscore the weakness in Coatings by contrast
    • PPG restructuring highlighted a concerning architectural paint market and a likely peak in autos
  • Inverse relationship between performance and 2017 EPS revisions post-election day indicate the rally is largely fueled by something outside of fundamentals
    • Notably, CF owns the worst EPS revision and the best stock performance over this time
    • MOS, WLK, OLN, and FUL similarly have outsized performance figures and negative revisions – all are would-be beneficiaries of pro-US trade/infrastructure policies
  • Macro offering glimmers of hope but significant uncertainties remain
    • Very robust US durable goods number (+8.3% year over year) – latest data reflects October spending, and consumer confidence readings have risen post-election
    • Higher oil pricing in the wake of the OPEC output agreement could alter the economics for US basic chemicals producers – rig counts steadily rising since the middle of the year – potential abundance of feedstocks against a higher global oil benchmark – LYB, DOW and WLK
    • Anticipatory stock moves leave open the potential for retracement if enactment of domestic policy is delayed, Brexit remains an overhang on Europe
  • Over the past month, we have written on:
    • LYB – margin umbrella sufficient to endure what is likely overstated weakness in the ethylene/polyethylene market in 2017, dividend and buyback offer valuation support
    • PX/Linde – deal might be the best of a bad set of options, but we prefer Air Liquide in the space – PX could be a great longer-term story but we foresee many near term hurdles
    • The paint market – PPG’s restructuring announcement seems to confirm prior concerns; SHW looks vulnerable still in our view on valuation and risk of multiple contraction as growth slows
    • DOW/DD – on the off-chance the deal dissolves; prefer DD due to its superior self-help/portfolio levers; the pending conversion of DOW preferred shares already discounted
  • 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
    • As we continue to wade through Trump possibilities this table may evolve quickly

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 post-election rally in the Chemicals space has not been, in aggregate, driven by positive revisions. CF, MOS, WLK, FUL, and OLN are the notable outliers but even excluding these stocks the correlation is generally weak. It appears that fundamentals are being put aside for the moment as optimism around the incoming administration’s trade/infrastructure policies drives these commodity stocks higher.

Exhibit 3

Source: Capital IQ and SSR Analysis

The business environment in the US is showing some signs of life, as reflected in the Fed’s rate hike and general optimism about the economy’s footing. Yet business spending on capital equipment remains weak with new orders showing year over year declines for the better part of the last two years. We see capital spending continuing to be restrained in the near term as companies assess the impact of the Trump presidency’s policies.

Exhibit 4

Source: Capital IQ and SSR Analysis

Consumers have been picking up the slack – despite a recent slowdown in services spending, consumption expenditures on goods remains strong, particularly durable goods, which posted a robust 8.3% year over year gain in most recent data point. This came pre-election, and since there have only been reports of increased consumer confidence.

Exhibit 5

Source: Capital IQ and SSR Analysis

Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7.

Exhibit 6

Exhibit 7

In Exhibit 8 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 9 we show discount by company. Relative outperformance had every Chemicals subsector trending more expensive over the past month, with the exception of Coatings, where the group’s premium moderated. Industrial Gases saw the biggest monthly move on normalized valuation as stocks were optimistic about the prospective PX/Linde deal – we are decidedly less so.

Exhibit 8

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 9 – we have only MOS within 10% of a 10 year valuation low following the strong Trump rally moves. DOW is now at an individual 10 year peak in valuation.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 shows absolute and relative performance by subsector since our last monthly report. Chemicals sectors largely benefitted from the Trump rally, with only Coatings trailing the S&P – PPG’s restructuring announcement was the headline but weakness extended to SHW and RPM as well.

Exhibit 10

Source: Capital IQ and SSR Analysis

2016 gains in the Chemicals space have been focused in the Diversified and Industrial Gas sectors. ALB benefitted from the lithium boost to drive the diversified group, while APD and PX each gained at least 15% in a +10% S&P environment. Coatings perhaps has seen its peak valuation and 2016 could represent an inflection point for the group if the weakness that drove PPG’s restructuring announcement and earlier guide down carries over into next year. Agricultural chemicals endured another year of underperformance but conditions appear to be improving in the fertilizer space and MON continues to have deal-related upside.

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 record growth despite the recent pause in the stock.

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 recent tick downward. We are seeing a possible sign of stabilization in Ag margins, while 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).

2106 results have been generally positive (particularly in the overlap group) and more in line with what was seen in 2013 and 2014 – Exhibit 16. 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. The November results in particular were very strong, boosted by 20% gains in CF and OLN. Halfway through the month, December results are roughly flat on average – 2016 will see strong aggregate results for these portfolios.

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 replaces MOS, joining holdover EMN – Exhibit 16.

Exhibit 15

Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • US personal consumption expenditures came in roughly flat in the latest data (through October), with strength in goods offset by weakness in services spending
  • Spending on services fell below 2% year over year growth for the first time since March 2014
  • Goods spending, meanwhile, saw year over year growth rise by more than a percentage point from the prior month, to 4.7% versus the prior year driven by robust 8.3% growth in durable goods

Exhibit 18 Exhibit 19

Source: BEA

Construction

  • Significant positive revisions came in for August (+1.1%) and September (+1.4%) estimated construction spending and a strong October figure has reversed the trend of slowing year over year growth
  • Exhibit 20 shows the long term trend in US construction spending and Exhibit 21 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

Exhibit 20 Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: US Census Bureau

Agriculture

  • Soybean pricing has been flat in December to date, but has seen the largest pricing gains on the year, +20%
  • By comparison, corn pricing is up 4% this month but is little better than flat for the year

Exhibit 23

Source: Capital IQ, SSR Analysis

ISM

  • US manufacturing appears to be back on more stable footing following a third monthly gain
  • New orders ticked higher to roughly the same healthy 53 level indicating solid expansion

Exhibit 24 Exhibit 25

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 been relatively stable in recent months after a sharp move higher, countering an extended downward trend in the 12 month rolling average

Exhibit 26

Source: US Census Bureau

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Delays in facility startups from LYB and CP Chem resulted in November production below expectations despite negligible unplanned outages. Production has been lower year over year in Q2 and Q3, but operating rates are expected to approach 95% by the end of December. Strong 7% increases in polyethylene demand in 2017 could keep ethylene tight.

Production and operating rates are summarized in Exhibits 29 and 30.

Exhibit 29

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 30

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

The OPEC output agreement sent crude into the mid $50/barrel range, while natural gas pricing rallied significantly on colder weather in the northern US, and inventories were drawn down within the five year range. For the year the pricing gains have about offset, with a small contraction in the gas/oil ratio to the detriment of gas (Henry Hub +50%, Brent +45%).

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 31 Exhibit 32

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

Exhibit 33

Source: EIA, SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Midstream Business and SSR Analysis

Exhibit 36

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 37

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 38

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 (39) summarizes the results and is a repeat of Exhibit 6.

Exhibit 39

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41



Source: Capital IQ and SSR Analysis

Exhibit 42



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 43 summarizes Skepticism Index values by subsector, Exhibit 44 shows the extent to which valuation is historically explained by returns, and Exhibit 45 plots the individual SI components, valuation discount and deviation from return on capital trend.

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46 shows SI by company. No stocks currently show a skepticism extreme.

Exhibit 46

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

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?

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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