Chemicals Monthly – All Getting Too Pricey

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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

March 16th, 2014

Chemicals Monthly All Getting Too Pricey

  • Several Chemical stocks are at all time or multi-year valuation highs, having followed the markets to new highs. Each subsector has outperformed the S&P since our last report – Commodity Chemicals the strongest, Industrial Gases less so.
  • Crude oil is off marginally but the bigger story is natural gas. Inventories have been greatly reduced as the cold continues, and we anticipate that this will have a negative earnings effect on Commodity Chemical companies in Q1.
  • Not only will higher natural gas prices likely impact margins in Q1, but we also think that the extreme US winter will cut into demand – some of which may bounce back in Q2, but some of which will be permanently lost. High inventories could limit pricing opportunities in the seasonally strongest second quarter.
  • Since our last Chemicals monthly, we have published an update on DOW’s activist investor dilemma, offering our own optimal path, and also highlighted a potential pair trade in APD-PX.
  • Chemical sector preferences are outlined below at the subsector and stock level. Note that we no longer have a favorite in the commodity space, and are also more cautious on Agriculture. We are also less concerned about ARG given its very strong earnings momentum. AXLL is now less of a concern as well – adjustments to our model leave the stock looking much more fairly valued. ROC has outperformed considerably recently, and we have removed it from our Diversified favorites.
  • Note also that we have moved Commodity Chemicals to an underweight.

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

The Chemicals space is growing increasingly expensive – several notable companies sit at all time valuation highs, most without the corresponding returns to justify the premiums. Given these stretched stock prices, combined with our continued concern over weather related impacts on demand, we see meaningful risk of significant negative revisions as Q1 reports begin, and likely lowered guidance beforehand.

This has all the makings of a bubble, and in past cycles like this we have seen traditional holders exit, to be replaced with less forgiving momentum or growth buyers – a quick review of changes in holdings at the end of 2013 suggests that this happening now. To support current values for many companies, current peak earnings have to be sustained for several years and free cash has to be returned to the shareholders as ether dividends or buybacks. Consequently we have now moved the whole sector to an underweight and specifically have commodities and coatings as underweight. We would be active buyers of only a few names today – DD, HUN, PX, and maybe EMN and PPG.

Revisions have moderated as fourth quarter earnings reports and associated corporate guidance are now largely incorporated into estimates. The Commodity subsector was the only one to see a revision of any significance (-1.6%) but this did not stop the group from being the strongest outperformer within Chemicals.

For those with mandates that spread further than Chemicals, we would focus on the undervalued capital goods companies today, such as CAT and SWK, as well as DHR, MMM and GE and AA.

Valuation

Exhibit 5 summarizes our valuation work. The Coatings subsector has been expensive for some time, and we are waiting for a catalyst (perhaps an earnings miss or two) to bring about a reevaluation of what we believe are overoptimistic expectations.

Exhibit 5

Exhibit 6

Exhibit 7 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. Specialty chemical valuations are on the expensive side for most companies – CYT leads the way at 2.04 standard deviations above normal value, and ECL is also expensive at a significant level (+1 SD). 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 7

Source: Capital IQ and SSR Analysis

In Exhibit 8, 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 peppered with red, as many Chemical stocks have followed the S&P to all time valuation highs. A pair of Coatings companies holds the top two spots. LYB has a short history but has performed well lately and is at its highs as well. Of the highlighted companies, only PPG has returns that are also at record levels above trend.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibits 9 and 10 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our February Chemicals Monthly.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13, also repeated and updated from
our state of the industry report
, show profitability at the sector, subsector, and stock level.

In Exhibit 11 we have highlighted those companies at or near earnings highs – no companies screen at earnings lows on these time frames. VAL is the only Coatings company not at valuation high

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.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

The March selections are shown in Exhibit 14, and are unchanged from a month ago.

Exhibit 14

Source: Capital IQ and SSR Analysis

Our portfolios have had a rough first quarter of 2014 after a roundly positive showing in 2013. February performance was strong at the time of our last monthly but the short picks turned up and the longs gave back gains. Note that the 2013 cumulative figures are sums of the monthly returns for each screen, exclusive of transaction costs.

Exhibit 15

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures showed a slight increase in January, from a December level that was revised down. The December revision made that month the first since October 2012 where ependitures declined sequentially. Consumer spending on this metric grew 1.9% from January to December in 2013, matching the 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 16 Exhibit 17

Source: BEA

Construction

  • Construction spending hasn’t seen as smooth a rise as consumer spending, nor has it begun to even approach pre-crisis peaks, but the trends are broadly similar. November estimates were revised down slightly, but the December figure was up 1.2%. January saw a modest increase from December levels.
  • After bottoming out following a long period of decline in the aftermath of the housing crisis, construction rebounded at a 6.4% annual clip over 2011 and 2012. The upward lift for December brought 2013’s growth just above this level, at 6.6%, and the solid uptrend remains intact. At a 6% annual growth rate, we would not reach the 2006 construction spending peak until early 2018.

Exhibit 18

Exhibit 19

Source: US Census Bureau

Agriculture

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • US PMI stabilized in February after a sharp decline the previous month, popping back up to a sold expansionary level of 53.2. New orders rebounded as well.
  • Production continued its recent severe dip, and inventories grew, marking the first time since May 2012 that inventories outstripped production. The effects of the notably cold weather this winter have been much discussed but remain indeterminate.

Exhibit 21

Source: ISM

Exhibit 22

Source: ISM

Trade

  • 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 Russian ruble has been very weak, down 8.3% versus the dollar in February alone, as the country continues its political jockeying in Ukraine. Several emerging and frontier markets have also seen their currencies come under pressure lately with the realities of the post-taper landscape becoming evident. Thus far, Q1 2014 has seen the dollar weaker versus the Euro year over year by 3.6%– Exhibit 25.

Exhibit 23

Source: US Census Bureau

Exhibit 24

Source: IMF

Exhibit 25

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. Note that Wood Mackenzie expects almost no production growth in 2014 and declining operating rates.

US ethylene inventories remain very high and this is keeping downward pressure on spot ethylene prices.

Production is summarized in Exhibit 26 and operating rates are summarized in Exhibit 27.

Exhibit 26

Source: IHS and SSR Analysis

Exhibit 27

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 28

Russia now dominates the energy headlines, but there has not been much of a reaction in the crude markets – Brent oscillating between $105 and $110 per barrel. If there is any direction in March it is slightly negative. WTI is also slightly lower in March, but the gap with Brent has reduced. Natural gas’ recent spike based on cold weather and lower inventory numbers has eased, but prices remain well above last year’s levels. The US will need to rebuild a great deal of inventory over the next few months and prices may not slide back to lows of last year for a while as a result.

Exhibit 28

Source: Capital IQ and SSR Analysis

NGL pricing continues to track natural gas, at economics that cover variable costs for extraction facilities but do not cover cash costs. Ethane margins remain below break-even extraction costs for the average producer. While there has been a recovery from the low in June of this year, margins have now been negative for a year and a half and there is no expectation that this will change, as those operating fractionators are driven by the need to move ethane out of the gas stream rather than the economic benefit of the process itself – Exhibit 29.

Exhibit 29

Source: HIS, Mackenzie Wood and SSR Analysis

Propane prices have reversed quickly in the last month, dropping as much as $30 per gallon. Despite higher ethane pricing and lower propane pricing, ethane is still the preferred feedstock for ethylene by a wide margin. The chart below is a rolling average and the much lower march price for propane is still higher than the moth it replaced in the calculation, hence the continuing upward trend. The blending season for winter gasoline is coming to an end and butane prices are also lower, despite higher natural gas, though not as dramatically as propane. The propane value in the US continues to create incentive to export US propane to Europe as an ethylene feed, despite better prices in the US, where logistics and feedstock flexibility exist – this is expected to continue and put a floor under US propane prices well above its break-even as an ethylene feedstock in the US versus ethane. The longer-term trend relative to crude remains negative, but is turning and is unlikely get much lower – Exhibit 30.

One recent change that is relevant is the significant increase in ethane prices at Conway – tis impacts the mid-west cost for the units operated by LYB and WLK. March ethane prices in Texas are around 22% higher than December, whereas Conway looks like more than 75% higher. This is a small share of ethylene capacity for LYB and WLK, around 20% or US capacity for both.

Exhibit 30

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has risen in the US with a 4 cent increase pushed through in February, bringing integrated margins back to the level seen in November of 2013. The price increase was helped by weather related supply disruptions and may not last long if Q1 consumer demand was also weak because of the weather. High inventories at the customer will generally result in price weakness going forward.

It looks like polyethylene demand in the US and Canada barely increased in 2013 (see our views of on plastic demand and absolute levels of pricing. The overall demand picture remains weak, more so overseas than domestically.

Exhibit 31

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 (32) summarizes the results and is a repeat of Exhibit 5.
Exhibit 32

Valuation Charts – Exhibits 3335

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

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 36 and 37.
  • LYB remains the only company at its all time low SI value, as investors are discounting further improvements in already strong returns.

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 39 to 43.

Exhibit 39


Source: Company Reports and SSR Analysis

Exhibit 40

Source: Company Reports and SSR Analysis

Exhibit 41

Source: Company Reports and SSR Analysis

Exhibit 42

Source: Company Reports and SSR Analysis

Exhibit 43

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 44 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 44A

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 44B

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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