SSR Chemicals Monthly – Deals Continue as Energy Advances, Manufacturing Rebounds

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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

April 18th, 2016

Chemicals Monthly – Deals Continue as Energy Advances, Manufacturing Rebounds

  • Action remains an imperative
    • SHW-VAL deal a clear example – coatings has been the best performing subsector over the past five years and fundamentals are arguably the best in the chemicals space – but consolidation continues. We think PPG will be a beneficiary of this move
    • AXLL’s rejection of an improved WLK bid is curious – we think AXLL is either making a mistake or has another bidder – the “go it alone” strategy will not work
  • Macro pressures have eased somewhat, perhaps only optically
    • Gas/oil spread has widened – talk of a production freeze has spurred oil bulls
    • Gas pricing up as well but less significantly with inventories at or above the five year range – ethane stronger than in the last two years because of exports
    • Global growth remains challenged and the IMF continued a recent trend of marking down forward GDP estimates
    • US remains a bright spot – PMI back in expansion, new orders strong
  • Ag commodity pricing is up but stocks are still down
    • Agricultural Chemicals is the only subsector to have underperformed the S&P since our last monthly report
    • Soybean pricing is up 8% in April so far (+12% YTD), corn up 2.5% (+5% YTD)
  • Since our last monthly publication we have written on:
    • Ethylene – examining the implications of above-demand capacity additions – consolidation, earnings estimates, future builds
    • LYB– borrow and buyback strategy may prove flawed if we are correct about ethylene weakness
    • PPG– return on tangible capital analysis supports our positive view on the stock
  • Our preferences in the sector are summarized in Exhibit 1
    • We are underweight the sector given the macro challenges facing the industry, but see pockets of opportunity
    • Ethylene and polyethylene remain strong but we still believe that Q2 will be the peak

Exhibit 1

Exhibit 2

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

Overview

Sherwin’s acquisition of Valspar helps confirm our thesis that we are in a period of time where everything (strategically) should be and probably is on the table. Coatings has been the strongest performing Chemicals subsector since the recession and there is arguably no better fundamental story in the space given the continued benefits of low input pricing and demand growth from structural trends that favor coatings – still there was an underlying impetus to make a deal. The acquisition itself seems expensive in our view, and is likely to receive significant regulatory scrutiny. We continue to prefer PPG in the coatings space and we think that the SHW/VAL deal will keep two potential bidders on smaller properties distracted for a while.

There could (and we would argue, should) have been another chemicals consolidation deal since our last monthly report – but AXLL summarily rejected an enhanced bid from WLK. This suggests to us that AXLL may have another suitor – or that the company is making a strategic error in the vein of DuPont’s efforts to drown out Trian. We are favorable on both stocks, but probably more on AXLL given that we think that Q2 2016 could be a peak for global ethylene and polyethylene margins.

From a higher level fundamental perspective, the situation is less grim than in recent months, though the changes have been mostly optical and the underlying data largely continues to show cause for concern. Gains in energy pricing are speculative and largely related to potential production freezes from Russia and Saudi Arabia – domestic stockpiles of crude reached another record high last week. Construction spending data in the US shows some seasonal weakness, and consumer spending is mixed (goods flat, services up). US manufacturing saw a boost in the most recent PMI reading and new orders surged. Globally, however, the situation remains disappointing and the IMF has again lowered estimates for global GDP growth. This has been a recurring trend over the past several years – Exhibit 3.

Exhibit 3

Source: IMF, SSR Analysis

Valuation

Exhibit 4 summarizes our valuation work and the subsector classifications are summarized in Exhibit 5. CF and MOS were the main drivers of negative Ag revisions. Positive revisions in the Commodity space came from OLN (+4.6%), WLK (+2.9%) and LYB (+1.9%)

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. Coatings valuations moved higher still with Sherwin’s buyout of Valspar. Every other subsector save Ag has grown modestly more expensive over the past month. We may be approaching a bottom in Ag but it is not clear what any catalyst for rapid improvement would look like.

Exhibit 6

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 7 – OLN has come off its lows but remains within 5% of its 10 year valuation low on normal earnings – we think that these lows could be revisited. Ag discounts are led by MOS and MON, both of which are also near the lows of the past decade.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 shows absolute and relative performance by subsector since our last monthly report. Only the Ag subsector has trailed the S&P over this time period. The Coatings result reflects the spike in VAL on the announcement of SHW’s bid. Strength was broad based in the Specialty group, with EMN, ECL, and IFF all significantly ahead of the market.

Exhibit 8

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 9 through 11 show profitability at the sector, subsector, and stock level. APD’s rapid improvement in return on capital has the company at an over-earning extreme. ECL and PPG are also at 10 year earnings highs though the divergence is not as extreme in standard deviations as for APD. In the case of PPG, we think returns can continue to trend higher as the company pursues bolt-on acquisitions – see recent stock specific research.

Exhibit 9

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 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 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).

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 – 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. These stocks have enjoyed a bounce off the lows, and the short stocks have capitulated somewhat, and the results in 2016 thus far are accordingly more positive than in ’15, though April’s results two weeks in are modestly negative.

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. 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. Negative revisions have limited this list in recent months and we have no stocks meeting the criteria for the second consecutive month.

Exhibit 12

Exhibit 13


Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Overall expenditures saw a modest sequential gain in the most recent month’s data – year over year growth of 2.8% was the highest since October 2015
  • Growth in goods (~34% of spending) continues to outpace growth in services (~66%), though the gap has narrowed in recent months – 12 month average year over year growth is 3.5% for goods and 2.7% for services
  • Spending on goods has stagnated recently but the year over year comparisons are still positive – growth in durable goods spending (+5% year over year) continues to outpace growth in nondurable spending (+2.4%)
  • Exhibit 14 summarizes personal consumption expenditures for goods and Exhibit 15 shows expenditures for services

Exhibit 14 Exhibit 15

Source: BEA

Construction

  • Construction spending saw a sequential decline in the latest data, but as with consumer spending the year over year growth figures are strong, +10% in the most recent reading and +9% in every month since last April
  • Spending flattened out in the second half of 2015 before a sharp rise in January – seasonality suggests we should see the upward trend resume as we move into the warmer months
  • 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

  • Agricultural commodity pricing has mostly continued to rise – soybean pricing has seen the largest gain (+8.1% in April to date, following a 3.6% gain in March)
  • Corn and wheat also saw strong gains in March (+3.2% and +5.3% respectively) and corn is up another 2.4% so far on the month, but this momentum has not carried over into April for wheat (down 2% two weeks into the month)
  • Corn is now 3% above prior year levels, and soybeans and wheat just 1% below, though all three commodities are nearly 50% off the 2012 highs

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • The PMI broke into expansion again after four months in contraction (below 50)
  • Inventories and production both continued to trend higher, but the real bright spot was in new orders, which spiked to 58.3 from the previous reading of 51.5

Exhibit 19 Exhibit 20

Source: ISM

Trade

  • Our trade balance exhibit remains the same from last month due to continued site maintenance at the US Census Bureau
  • The 12 month rolling average (dotted green line) is taking 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

Ethylene production is summarized in Exhibit 24 and operating rates are summarized in Exhibit 25. 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 24

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Stocks of commercial crude oil took a brief downturn in the first week of April but have since resumed the strong uptrend and are again at record levels – Exhibit 26. The total supply of crude and petroleum products has marched higher without pause – Exhibit 27. Natural gas inventories remain at or above the high end of the five year range – Exhibit 28. Despite elevated domestic supply levels, energy pricing has rebounded off the lows. Production freezes in major oil exporting nations (Russia and Saudi Arabia namely) have spurred bullish sentiment in crude. Gas pricing has moved higher as well but the 5% gain in April to date trails the 8.5% rise in Brent. Energy pricing is summarized in Exhibit 29. Ethane pricing is up – Exhibit 30 – but not evenly, as the Mont Belvieu-Conway spread is at the highest level we have seen in over two years.

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

Spot pricing has supported US exports of HDPE, particularly to Asia, but the spread of polyethylene to ethylene prices has been contracting according to data compiled by Wood Mackenzie. We are skeptical that there is sufficient demand for a polyethylene price increase to take hold beyond Q2 2016 (and only in Q2 because of support from planned plant shutdowns) and believe a further margin decline of 10-15 cents per pound is likely over the course of the next 12-18 months.

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:

  • Returns and valuations are more or less aligned in the Chemical subsectors – the outliers are the Commodity and Industrial Gas groups
  • Both of these subsectors are under-earning by nearly equivalent amounts, but valuations are implying very different outcomes
  • For the Commodity group, valuations are in aggregate anticipating further declines in earnings
  • Industrial Gas appears to be pricing in improvements in returns

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. Only SHW is near a skepticism extreme, within 10% of its all-time SI low, indicating market optimism that returns can be maintained.

Exhibit 41

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 Regardles

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

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