Chemicals Monthly – Weathering the Storm Well

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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

May 16th, 2014

Chemicals Monthly Weathering the Storm Well

  • Chemical companies in large part overcame weather related headwinds in Q1, and several were propelled back to valuation highs on the strength of earnings reports. That said, the group on average has seen more negative than positive revisions year to date.
  • The Commodity group has been the standout performer over the past month, outpacing the S&P by 4.5% on strong gains from DOW, LYB and WLK. Despite higher natural gas prices in Q1, all were able to offset costs with higher production and pricing in the case of WLK, better international results DOW and LYB, refining, LYB and cost cutting DOW.
  • Natural gas inventories have begun to increase but remain well below historical levels for this time of year. In our view the rate of inventory rebuild is not yet fast enough and we still see some upside risk to natural gas pricing.
  • Over the past month we have highlighted two sets of possible pair trades (preferring PX to APD, and DOW to LYB), and published updates to our past thematic work on natural gas and DuPont – we see a long term possibility for DD to reach $85. We have also looked at revision trends and valuation divergence within the group.
  • Chemical sector preferences are outlined below at the subsector and stock level. Note that we have moved the Commodity group to underweight, but move AXLL to our preferred list within the subsector. Our agriculture related work has also made us more positive on MON.

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

Q1 earnings reports for the Chemicals group (as well as
other Industrial & Basic Material sectors
) indicated a reasonable consensus that Europe is improving, but the messages around both China and the US were mixed. In the case of China some sectors appear to be growing well and others much less so. This is partly a function of a changing pattern of consumer spending – with Dow and DD both indicating the more “value added” businesses did better in Q1. In the US it is almost becoming a case of “all mouth and no trousers”. Companies are talking about how the manufacturing environment is improving, but it is really not reflected in numbers and it is not driving upside surprises outside energy and natural gas levered businesses – this is not a chemicals specific comment, as we are seeing similar patterns in other groups.

Natural gas pricing has come off a bit as we have moved through May, and while inventories have begun to build, they remain well below the seasonal norm. In the most common depiction (Exhibit 3) we see the start of a recovery in inventories, but this is too simplistic to us and Exhibit 4 shows the number of standard deviations the inventory level is below normal. This shows that the situation is getting worse rather than better and for this reason we still see risk to the upside for natural gas pricing.

Exhibit 3

Source: EIA

Exhibit 4

Source: EIA and SSR Analysis

The extreme winter certainly affected more than a few Chemical companies, but most were able to overcome the headwind. We still believe we will see some Q1 sales pushed into Q2, while some sales will be lost altogether. Again, many of the companies did a reasonable job of telegraphing the issue and the stock market did not seem to care. One of the bigger offsets in Q1 was Europe, and there is almost unanimous agreement that Europe was a positive swing in Q1. This is better for businesses with more stable pricing and good operating leverage than it is for commodities in general as European commodity margins are very low, and are likely to remain so.

Finally, we highlight the continued outperformance of PX since we first noted its
relative attractiveness to APD
. We still see further upside in this trade – see our note from
April 25th
. PX is under-earnings relative to its history (based on a return on capital measure) and probably has more leverage to a US manufacturing recovery than any other large cap chemical stock (ARG would be more of a pure play here). PX did well in Q1 without using weather as an excuse and this is perhaps a sign of the leverage that the company can show going forward.

Exhibit 5

Source: Capital IQ, SSR Analysis

Valuation

Exhibit 6 summarizes our valuation work. Revisions in the commodity group were down mainly due to AXLL (-15% on the month, -25% over the past three) which outweighed more optimistic expectations for DOW and LYB. Performance for this group has been the most robust in the Chemicals sector since our last monthly report. Coatings companies have outperformed the market as well and the group continues to look expensive, with SHW and RPM each at valuation highs.

Exhibit 6

The subsector classifications are summarized in Exhibit 7.

Exhibit 7

Exhibit 8 shows subsector discount from normal value in standard deviations.

Coatings and Ag Chem remain the expensive and cheap outliers, respectively, and Diversified remains inexpensive by virtue of DuPont’s relative attractiveness. Of the Agricultural stocks, MON and MOS are each roughly 1 SD below normal, SMG is the polar opposite at 1 SD above norm, and CF is about fairly valued.

Exhibit 8

Source: Capital IQ and SSR Analysis

In Exhibit 9, reproduced and updated from
our past comprehensive Chemicals report
, we show company discount from normal value as measured on our framework. The left side of the chart is once again stacked with red (companies at all time valuation highs), even as a few companies (PPG for one) have retreated from their all time or 10 year valuation highs. SHW and WLK have had strong months and are back at their respective highs. LYB has a short history but has performed very well of late and the stock continues to make new highs.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 and 11 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our March Chemicals Monthly.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 12 through 14, also repeated and updated from
our state of the industry report
, show profitability at the sector, subsector, and stock level.

In Exhibit 12 we highlight PPG and VAL as companies at or near earnings highs; IFF is within 2% of peak earnings and we have highlighted it as well. No companies screen at earnings lows at this time.

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.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Portfolio Performance

The May selections are shown in Exhibit 15. DD is now just outside the top five in the long side valuation screen. DOW has entered the short side skepticism screen – valuation has advanced ahead of returns that are strong, and expected to increase. In other words, Dow will need to keep delivering upside surprises to support higher values.

Exhibit 15

Source: Capital IQ and SSR Analysis

Our portfolios have produced largely disappointing results thus far year to date. May performance has been solid, notably the overlap portfolio, and we will need a few more months of similar results to bring 2014 gains up to par with 2013. Our portfolios work as value gains relative to momentum.

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • The extreme winter weather did not deter consumer spending – January and February figures were marked up marginally, suggesting consumers braved the cold or shopped online. Some purchases do seem to have been delayed, however, as March showed the strongest month over month increase since 2005.
  • Personal consumption expenditures were up 2.2% January through December 2013 versus a similar 1.9% gain in 2012. The post crisis trend has seen PCE rise at a 2.4% compound annual growth rate, compared with a 3.6% CAGR from 1999 to 2007 – Exhibit 18.

Exhibit 17 Exhibit 18

Source: BEA

Construction

  • Construction spending has plateaued in recent months. Figures for January and February were revised down, likely the result of disruptive weather. The preliminary March estimate showed a modest increase and this should continue into the spring as projects delayed by the snow begin or resume.
  • After bottoming out following a long period of decline in the aftermath of the housing crisis, construction rebounded at a 6.4% annual rate over 2011 and 2012 – most of this growth came in 2012 when spending rose 8.1%. The growth rate for 2013 was 7.1%, and the long term uptrend remains intact. At a 7% annual growth rate, we would not reach the 2006 construction spending peak until fall of 2017.

Exhibit 19

Exhibit 20

Source: US Census Bureau

Agriculture

  • Ag pricing moderated slightly after jumping last month on prospective planting data. Corn intended acres planted came in lower than estimated, at the lowest level since 2010 – this will still be the fifth largest corn crop since 1944. Pricing has encouraged farmers to shift acreage away from corn and towards soybeans, and indeed soybean acres came in at a record level, though also below consensus. Soybeans, corn and wheat were all down 1-2%.
  • See our colleague Rob Campagnino’s work on the implications of the EPA’s renewable fuels mandate with respect to ethanol.
  • Also see our blogs on potash, where we remain quite negative in terms of the longer-term pricing outlook.

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • At this point it appears the early 2014 dip in the US PMI was influenced by the weather – the April reading was the consecutive month of increase, coming in at a firmly expansionary 54.9. New orders were unchanged on the month.
  • Production held stable after bouncing strongly off of recent lows that dipped the sub-index into contractionary territory. Inventories ticked up. We would expect indicators to remain strong in Q2 given the pent up demand that het notably harsh winter likely fostered.

Exhibit 22

Source: ISM

Exhibit 23

Source: ISM

Trade

  • Note 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 24 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.
  • Year over year the Russian ruble has been the hardest hit of major currencies, down 15% versus the dollar – continuing sanctions in the aftermath of the Crimea grab have exacerbated this decline. Fellow BRIC currencies, the Indian rupee and Brazilian real, have also devalued by over 10% each over the past year. Midway through May, the second quarter of 2014 has seen the euro 5.7% stronger year over year versus the dollar – Exhibit 26.

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: IMF

Exhibit 26

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 remain very high and this is keeping downward pressure on spot ethylene prices despite the significant current outages. While ethylene contract prices fell significantly in March they recovered some of the decline in April, and spot prices are higher during this period of extreme production cutbacks.

Production is summarized in Exhibit 27 and operating rates are summarized in Exhibit 28.

Exhibit 27

Source: IHS and SSR Analysis

Exhibit 28

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 29

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.

Natural gas is discussed in more detail in the overview.

Exhibit 29

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 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 30. What is different is that the Conway ethane advantage has reappeared meaningfully from the low in February – Exhibit 31. This difference was a major benefit for Westlake and Lyondell in Q4 2013 as both operate ethylene units in the Mid-West.

Exhibit 30

Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 31

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 32.

Exhibit 32

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 33

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 (34) summarizes the results and is a repeat of Exhibit 6.
Exhibit 34

Valuation Charts – Exhibits 3537

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

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 Chemical companies are over-earning by roughly one standard deviation, yet are some of the cheapest in the Chemicals space, giving the group the highest Skepticism Index value – most of this is driven by DuPont. Agricultural Chemical stocks are only slightly under their historical earnings trend but investors are discounting a fall in returns. The Specialty group is being afforded a high valuation premium despite earnings that are actually slightly below the long term trend. See Exhibits 38 and 39.
  • LYB is the only company currently at an all time Skepticism Index high – POL is at its 10 year high and we have highlighted it as well – Exhibit 40.

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 40 to 41.

Exhibit 41


Source: Company Reports and SSR Analysis

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

We have then grouped the categories into buckets for which we can measure growth drivers. Those groupings are summarized in Exhibit 45 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 46A

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 46B

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

©2014, 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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