Chemicals Monthly – The Deals Keep Coming – Expect More

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Graham Copley / Nick Lipinski



June 16th, 2016

Chemicals Monthly – The Deals Keep Coming – Expect More

  • Another month, another deal in the Chemical space
    • Axiall relented to Westlake after receiving an enhanced offer – the deal is very logical in our opinion
    • We also continue to believe a MON-BAYER deal will eventually be worked out
  • With natural gas pricing up ~20% since the end of May, expect ethane to rise in tandem, further pressuring US ethylene margins at a time when planned spring outages are coming back online – see recent research
    • This move comes despite gas inventories that continue to track the high end of the multi-year range, suggesting a supply shock is being preemptively priced in
    • Higher natural gas also works to flatten the urea cost curve – a negative for CF
    • Companies are still expecting gas prices to remain below $3.00 through 2016, as per a KPMG survey of energy executives (as of late May) – we disagree
  • Ag again the best performing Chemical subsector – mostly due to MON’s gains on continued Bayer speculation
    • Continued gains in crop pricing – soy and corn each up 10% since the end of May on bad weather in South America and lower ending stocks predicted by the USDA
    • Negative revisions for CF as gas pricing rose
  • Our Chemicals research over the past month has included work on:
    • DOW/DD – with DuPont apparently employing a “go-it-alone” strategy, we examine what Dow could possibly do
    • FMC – an intriguing takeout candidate, possibly worth more in pieces
    • Finding the right price for the potential MON-Bayer deal
    • The impact of rising natural gas on US Chemicals
    • CE and EMN – similar portfolios and traditional valuation metrics but EMN has greater potential on normalized earnings
  • Our preferences in the sector are summarized in Exhibit 1
    • We switched to overweight the sector in aggregate in our monthly report on the broader Industrials & Materials space earlier in the month given our positive stance on most of the large cap names in the space (DOW, DD, MON, PPG)
    • We have our concerns in most subsectors however, and at the subsector level would only be overweight Ag Chemicals

Exhibit 1

Exhibit 2

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


It has been another month of M&A activity in the Chemicals sector. After the brief appearance of a potential white knight in the form of its JV partner Lotte Chemical, Axiall relented to Westlake’s sweetened offer – we have noted that this is a very logical deal. The MON-BAYER deal is still likely to happen, eventually, in our opinion – we explored a possible fair price in recent research.

The challenging recent Ag market has been a major impetus for M&A in the industry, but fundamentals appear to be improving, evidenced notably by the strong move in crop pricing. Prices for corn and soybeans are now approximately at their 10 year averages, well off recent lows – Exhibit 3. The gains have been driven by poor weather reports in South America, as well as lower estimates of ending stocks of soybeans in the US. The impacts of the weather pattern transition from El Niño to La Niña is also generally bullish for crop pricing.

Energy pricing meanwhile remains volatile – natural gas has been the biggest mover in recent weeks. Towards the end of May, a KPMG survey of energy executives reported 92% expected natural gas pricing to stay below $3.00 per MMBtu in 2016. The Henry Hub price was $2.24 at the end of May – midway through June it is $2.68. As we wrote earlier this month, higher gas negatively impacts the Chemical sector from ethylene to urea (higher feedstocks).

The fact that gas pricing has risen so sharply so quickly even as inventories remain historically high – Exhibit 4 – suggests the market is pricing in a downside production surprise. We do not think a meaningful, further, price increase is necessary to support production – rig counts have in fact ticked up each of the past two weeks – Exhibit 5.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: EIA

Exhibit 5

Source: BHI


Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. Revisions were negligible outside of the Ag space – CF (-11%) and SMG (-6%) saw significant cuts to EPS estimates over the past month. MOS actually saw a modest (1.6%) increase, but the longer term trend over the past 3-6 months has been decidedly negative.

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. The Ag group continues to look cheap in aggregate despite MON’s recent pop while Coatings remains as expensive as it has looked in some time. Elsewhere in the Chemicals space, valuations are mostly close to normal value.

Exhibit 8

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 9 – EMN shows one of the largest discounts in the Chemicals space – see our recent research on the stock. MOS and CF, focus stocks for our recent work on fertilizers, both screen at all-time valuation lows on normalized earnings. SHW is driving the premium valuation in the aggregate Coatings space, though RPM is also at its own valuation extreme (note the buyout premium reflected in VAL). PPG’s valuation looks much more reasonable and this is our preferred play in Coatings.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 shows absolute and relative performance by subsector since our last monthly report. The Ag group was boosted mostly by MON (+10% versus the S&P) as MOS was flat to the market and CF down a relative 5%. SHW (-2.5%) drove the Coatings result as PPG and RPM were flat to the market.

Exhibit 10

Source: Capital IQ and SSR Analysis


Exhibits 11 through 13 show profitability at the sector, subsector, and stock level. All of the Coatings stocks with the exception of RPM remain at 10 year earnings extremes. APD continues to earn well above its long term return on capital trend – this extreme figure is partly explained by the historical stability of the industrial gas industry, which for APD results in one standard deviation in ROC being small in absolute terms compared to more volatile industries (i.e. Commodity Chemicals). On the opposite end of the spectrum, ALB’s return on capital is depressed from the Rockwood acquisition, but the stock has performed well on strong Lithium results.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 12 and 13 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. Commodity margins appear to be turning over near historical peak levels and Ag margins have room to come down further to prior troughs.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 14 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).

2015 was not a successful year for these selections across the board, though results for the skepticism and overlap portfolios had been robust in 2013 and 2014, and 2016 has seen generally better results to date – Exhibit 15. 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 somewhat different story as commodity stocks have enjoyed a bounce.

AXLL boosted the long results over the past month as the stock rose sharply on the WLK deal, though its small cap weight muted the impact. MOS and OLN (each +2.5% versus the S&P in June to date) have also contributed to gains for the long side 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. When revisions are positive while the valuation and skepticism components are also positive, the risk-reward profile is very attractive, and improves at greater levels of discount and skepticism. The number of stocks making this list is expanding again after negative revisions limited the composition earlier in the year. Currently we have a group of eight stocks including OLN, AXLL, HUN, WLK, MON, LYB, POL, and ASH, listed in valuation order most to least inexpensive – Exhibit 16.

Exhibit 14

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures showed strong gains – 0.64% sequential growth was the highest since August 2014 and 3% year over year growth marked the first such month since last September
  • Spending on goods drove much of the upside gains – 4% year over year growth here was about half a percentage point above the 12 month average of 3.5%
  • Spending on services meanwhile held steady at recent year over year growth rates around 2.5%

Exhibit 17                                                                              Exhibit 18

Source: BEA


  • Construction spending was revised up significantly for March (1.6%), which likely contributed to a weak April number (“just” 4.5% year over year growth compared to a 12 month average of 11%)
  • The sequential decline in the April spending figure was the largest since January 2011
  • Exhibit 19 shows the long term trend in US construction spending and Exhibit 20 shows the trend over the past several years and highlights the lack of recent sequential momentum compared with the 2012-2014 period

Exhibit 19                                                                              Exhibit 20

Source: US Census Bureau


  • Several factors have contributed to strong gains in soybean pricing (+35% YTD, +10% in June to date) – bad weather in South America as well as lower USDA-predicted stockpiles
  • Corn pricing has shown strong gains in June (+11.5%) after several mixed months – pricing is 21% higher since the start of the year

Exhibit 21

Source: Capital IQ, SSR Analysis


  • The PMI rose above 51 in the latest reading, providing some breathing room after April’s figure was barely above the neutral 50
  • New orders held steady at a bullish 55.7 level that was nearly idential to what was seen in the previous reading
  • Inventories appear to be in a healthy position and there is plenty of slack in productive capacity

Exhibit 22                                                                              Exhibit 23

Source: ISM


  • 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 24 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 24

Source: US Census Bureau

Exhibit 25

Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ

Commodity Fundamentals


The spring season saw minimal unplanned outages in North America, particular compared with 2105 and the planned downtime appears to have been managed well with inventory builds. Ethylene production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28. Capacity increases are set to vastly outpace demand growth over the next three years – see our recent research on this topic and its implications.

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis


Energy prices continue to rise off the lows from earlier in the year even as record energy stockpiles, of both gas and oil, remain in the US – Exhibits 29-31. The gas/oil spread has narrowed a bit with the strong move higher in gas pricing outstripping the modest continued gains in crude – Exhibit 32. Ethane pricing has continued to trend higher with natural gas – Exhibit 33.

Exhibit 29                                                                             Exhibit 30

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

Exhibit 31

Source: EIA, SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Midstream Business and SSR Analysis

Exhibit 34

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 35

Source: IHS and SSR Analysis

Basic Plastics

Ethylene derivative demand growth has been strong, both globally and domestically. HDPE and LDPE exports out of North America are up significantly versus the prior year (+34% and +15% respectively) while LLDPE has shown stronger demand domestically.

However, we remain skeptical that there is sufficient demand for a polyethylene price increase to take hold in the second half of 2016 and believe a further margin decline of 10-15 cents per pound is likely over the course of the next 12-18 months.

Exhibit 36

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

Exhibit 37

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

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

  • Valuation and returns are mostly in line for the Chemical subsectors
  • Where there are divergences, they are on the positive (skeptical) side – Commodity and Ag chemicals are cheaper than they are under-earning, while Coatings continues to over-earn by more than its valuation premium would indicate

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44 shows SI by company. No companies are currently near all-time skepticism extremes on either the high or low end.

Exhibit 44

Source: Capital IQ and SSR Analysis


Recent Chemicals Research

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 45 to 49.

Exhibit 45

Source: Company Reports and SSR Analysis

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

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 50 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 50A

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 50B

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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