Chemicals and Cash Flow – Place Your Bets

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 26th, 2018

Chemicals and Cash Flow – Place Your Bets

  • As the US chemical industry moves through a period of maximum/peak earnings and cash flows, there is cause for celebration, but equally there is cause for concern. The Industrials and Materials sectors have not been great stewards of capital in the past – will that change?
    • In Exhibit 1 we show the average and range around TSR less discretionary spending in any given year, normalized by dividing by market cap.
    • The negative extremes can be driven by large acquisitions but more often stock falls.
  • The chart ranks companies by their average – from 2000 – shorter for companies like LYB that do not have the history. It looks like close to a zero-sum game for the industry with everyone hugging the zero line
    • Lots of money being spent – not a lot of value being created – the chart in Exhibit 2 shows the averages only – only a few covering cost of capital on average.
  • 2017 was a good year for the sector from a stock appreciation perspective so it should not be surprising that for most 2017 was better than average.
    • FUL has pulled down its average with the poor showing in 2017 – following the acquisition of Royal – but did not have a great average before.
    • RPM had little to no real stock appreciation in 2017 and spent on acquisitions.
  • In Exhibit 3, we show a risk adjusted analysis; one standard deviation of volatility for each company, using both market cap and revenue as denominators. Historically, the poor capital allocators are those to the right in Exhibit 1. Adding the volatility measure these are the companies to watch very carefully as they make decisions around their ample cash:
    • DWDP – especially in the Materials and Specialty businesses.
    • ALB – a lot of money going into lithium and lots of competition doing the same.
    • EMN, OLN, HUN and PPG – could ruin stories with expensive acquisitions.

Exhibit 1

Source: Capital IQ and SSR Analysis

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

The Good, The Bad and The Volatile.

Note that the underlying assumption behind all of this analysis is that everyone has plenty of cash – some are paying down debt, but all have or will soon have ample opportunity to deploy cash either well or poorly.

In Exhibit 2, it is only the three companies to the right that are creating a strong shareholder return on the money they are choosing to spend – i.e. covering the cost of capital. However, in all three cases it has been an extremely volatile journey and while the averages might look good, the swings (mostly share price but also spending) have been unpredictable in terms of both timing and magnitude.

While LYB looks like a better bet – high average and lower volatility – it is important to note that LYB has less history than many, and it is only in 2018 that the company has begun spending on things that investors do not like – a good recent history but a less certain future.

Had we done the analysis five years ago Dow and DuPont would have looked much worse.

In Exhibit 4 we plot the volatility against the average and show our Good (circled in green), Bad (circled in red) and Volatile (circled in black) groups – the companies in the green circle are the safer bets.

Exhibit 4

Source: Capital IQ and SSR Analysis

In an attempt to look for misalignment with valuation we have divided the y-axis in Exhibit 4 by the x-axis and plotted against valuation – Exhibit 5. On the positive side of the chart we get what we would expect, with WLK, LYB, HUN and MOS looking quite cheap – POL and possibly ALB a little expensive. On the left-hand side of the chart, things are changing at DWDP and the last three years have been very positive – if the old strategies reemerge the stock is probably fairly valued, but this is not likely. EMN and OLN, while inexpensive, have the same teams that have made the wrong cash decisions in the past, but are otherwise inexpensive – FUL is expensive. In Exhibit 6 we show the company by company data in detail with comments.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Sanity Check – The Dividend Growers

In our work on what makes a good company and other work we have done separating winning strategies from others, there is overwhelming evidence that companies with consistent dividend growth tend to outperform those without. In Exhibit 7 we show the average dividend growth for each company for the last five years. This analysis would make us more interested in POL and SHW and less interested in HUN and PPG. Note that DWDP is missing from the chart – the new DWDP dividend is a decline on the old DOW dividend and a slight increase on the old DD dividend. This was one of the more disappointing moves the company made post-merger in our view as there was ample cash flow to maintain or even increase the DOW dividend.

Exhibit 7

Source: Capital IQ and SSR Analysis

Methodology

For regular consumers of our research the methodology will be familiar. We take all of the elected cash deployment decisions made by a company – R&D, CapEx, M&A and Buybacks – and we compare this to what you actually got as a shareholder – dividend plus stock appreciation. The time sequence for a pro-forma DWDP is shown in Exhibit 8. We show DWDP because it had been one of the worst examples – recovering from 2014 – and has the worst average in the analysis above – destroying value over time rather than creating it. In Exhibit 9 we show the components of the period analyzed. The exact same analysis has been conducted for each of the companies in the analysis. We are not tax adjusting R&D spend, which we probably should be, and consequently the analysis shows a slightly rosier picture than it should – but it is a consistent analysis across all companies.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

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