Friday Findings – February 9th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
February 9, 2018
- Charts of the Week
- Packaging – Polymer Producers Are Passengers – For Now
- VNTR – Seen This Movie Before – Opportunity
- Weekly Winners & Losers
Despite the volatility in the stock market, we remain on one of the strongest upward revenue trends that the Industrials and Materials sectors have seen in recent decades, with the combination of strong economic growth and some raw material cost headwinds, creating pricing power in many subsectors. It is a broad improvement – of the companies reporting Q4 earnings thus far, more have shown positive revenue growth than in any quarter since 2010, and while the same cannot be said for EPS, the trend is rising quickly as volume gives companies pricing power. We include the second chart because for the second quarter in a row, more than 80% of companies reporting are beating already positive earnings expectations.
There is always a tendency to underestimate growth in a positive economic cycle, in part because you generally do not need to have overly heroic projections for companies to have a positive outlook – why call for 10% revenue growth when 5% already puts you above consensus?
These trends never last, and calling the point of infection is what separates the good analysts and money managers from the rest. Right now, all the economic indicators suggest that the trend can keep going, at least through 2018, but almost every time we see a trend like this we can make the same argument. With over 50 years of chemical industry data in our system, it is ALWAYS demand rather than supply that causes these cycles – above trend demand when the economy is strong and generally a sharp fall when something (almost always a surprise) goes wrong.
This is a near perfect market – all drivers are moving the right way for producers in most industries (it is shorter to list the weak industries than the strong ones; conventional power, Ag, maybe autos). Any stock that is pricing in more than this “perfection” is a major downside risk when the (inevitable) demand correction comes. We remain very cautious on the very expensive sectors – Conglomerates (Ex GE) and Capital Goods, in particular. There is much more opportunity in sectors with commodity pricing leverage – Metals, Paper and Chemicals.
On its 4th quarter conference call, DWDP was asked a very good long-term question, and replied with a short-term answer, and one which largely missed the point. The question was essentially “what are your thoughts on the moves to limit plastic waste”. DWDP’s answer was along the lines of:
- Polyethylene demand is strong and should stay strong in 2018 – largely correct in our view.
- Someone else will replace China as the recycling center – willing to take large volumes of waste plastic from Europe and the US – probably correct.
- It is mostly a European issue – grossly incorrect.
This week we have seen Dunkin Donuts announce that it will abandon foam polystyrene cups globally by 2020 – Dunkin is mostly a US business, so this is certainly not Europe focused. McDonald’s has made a similar decision about packaging – expecting to use only recycled packaging or packaging made from renewables – also by 2020. In the UK, frozen food chain Iceland has made a similar move on eliminating plastic packaging.
The plastic producers are not driving this bus, their customers are. This risk is they take bus in directions where we run out of road because they are making unilateral decisions that come with unintended consequences. Such as:
- It is possible that McDonald’s can only meet their mandate by buying all the food grade recycled polyethylene available – to solve the drink lid, straw and the paper cup lining issues – good for LYB potentially, but likely more expensive for McDonald’s and possibly impossible if others go the same route such that demand for recycled or renewable based polyethylene far exceeds supply.
- Paper cups, such as those used by Starbucks for coffee and others for soda need a polyethylene or other polymer lining/coating to prevent leakage – this layer/coating makes the cup very difficult to recycle effectively. You may meet the recycle/renewable target but you add to the waste issue.
- Dunkin is choosing a paper cup as a replacement – as discussed above – the coated paper cup may create as many problems as it solves.
- Sweden has gone to paper only cups – but they leak and absorb the liquid.
- Dunkin’s move is bad for expandable polystyrene demand, and we highlighted polystyrene as a polymer at risk – especially if we get a holistic response to plastic waste rather than a series of individual company moves.
A more robust and holistic approach to recycling is the most sensible way forward and it needs to focus on the following, in our view:
- Plastic standardization – a focus on limiting the number of different plastics used in packaging applications which contribute to most of the waste. PET, polyethylene and polypropylene should be able to meet every standard.
- Then in addition, standardization in terms of color – to reduce additives and increase the pool of recycled polymer that can be recycled to a food grade standard.
- Collection and separation
- Either through a deposit and return scheme focused on specific uses – such as PET bottles – here Norway is in the lead.
- Or through municipality led mandated segregated collection, again to increase the pool of material that is readily segregated for recycle – Germany in the lead.
- Co-located incineration with recycle, to take the materials that are either too mixed to recycle or the wrong polymer or color etc., and generate power.
- The technology exists to do this in a way that is environmentally friendly and the combination would create an almost closed loop with the collection and recycling operations.
Without these moves, we run the risk that the large packagers make decisions that they can control – because no one is offering them a solution that might make more practical and economic sense – but which become challenging to implement because of limited supply. High prices for recycled or renewable based material, as a consequence, could encourage some significant investment in renewable based production – which only makes sense in a very high polymer price environment, adding to a production capacity surplus as demand weakens. The big packaging plastic producers really must get involved here as a defensive tactic.
It is hard to draw any stock conclusions, and none that impact 2018. However, the emerging trends are likely bad for the polystyrene industry (the Dunkin Donuts decision is a direct blow to expandable polystyrene), which will eventually hurt TSE, and flow through to WLK and LYB as styrene producers. Polybutylene terephthalate is another likely casualty.
Worrying about the large seller overhang was the wrong decision with TSE and 1COV and we think it will be the case with Ventaor also. For both TSE and 1COV the stocks traded at significant discounts to their respective peer groups, despite improving fundamentals. Majority owner sales generated liquidity and increased the pool of potential buyers, resulting in significant upside for shareholders – we see no reason why things should be different here.
As shown in the chart, VNTR is the valuation outlier when we look at PE versus expected 2018 earnings growth. None of the TiO2 stocks fare that well, but VNTR looks like the bargain of the pack. With the economic momentum, and with China’s continued focus on pollution control, we would expect more upside risk to 2018 estimates than downside – some volume, but maybe also some incremental price.
In the second and third chart we show annotated stock progressions for both TSE and 1COV and in the last chart we show comparative valuation – with these two companies but also with TiO2 peers. The set up looks interesting.
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