Chemicals Monthly – Commodity Rally Likely Unsustainable

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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 17th, 2016

Chemicals Monthly – Commodity Rally Likely Unsustainable

  • Amidst a rebound in commodity pricing, the macro picture/sentiment has brightened somewhat 
    • ISM pushing back towards expansion, US construction and consumer spending strong
    • Despite the recent recovery in energy pricing, record US crude stocks and natural gas inventories tracking the high end of the five year range suggest the rally could be short lived
  • Subsector performance has been mixed over the past month
    • Coatings remained strong (+4% versus the S&P over the past month), while traditional safety plays in Industrial Gas (-5%) were laggards as the outlook improved
    • Revisions continued to come in to the downside, notably in the Commodity (AXLL, WLK) and Ag groups (CF, MON on reset of guidance)
    • The Commodity subsector outperformed regardless – DOW and LYB were strong and AXLL bolstered by deal prospects despite significant negative revisions
    • Performance in the Ag space (flat to the market) also defied revisions
  • Sasol’s announced delay for parts of its Gulf Coast investments underscores our conservative view on when planned projects will actually come online
  • Since our last monthly publication we have also written on:
    • Monsanto – risk/reward compelling given industry consolidation and the expectation we are near the trough of the cycle
    • Westlake and Axiall – we see plenty of rationale for the proposed deal and are positive on WLK regardless
    • DowDuPont – trough earnings analysis shows attractive risk/reward proposition even assuming worst case scenarios across the board
    • Eastman – we outline our suggestions for the company to improve its messaging (and accordingly its stock performance)
    • The broader theme of consolidation/action in the industry – assessing the impacting factors, where the opportunities are, and which companies are addressing the issues
  • Our favorites in the sector are shown in Exhibit 1
    • We have recently addressed most of these stocks in specific research (see above)
    • PPG is the exception – see our piece from January for our full thesis

Exhibit 1

Exhibit 2

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

Overview

In our comprehensive piece on the chemical industry earlier this month we highlighted a range of factors impacting the current competitive landscape. The differences of this cycle compared to prior cycles, unprecedented new capacity amidst global competition, changing business models and the need to effectively convey the nuances of the added complexity of those models – all emphasize the need for action. We have seen this played out in the market, with stocks that have addressed or are addressing the relevant issues outperforming those that are operating under the status quo.

Dow and DuPont have been our best recent examples of adapting to the new dynamics and over the past month we have also written on several other companies that could or should adapt in kind (Monsanto, Westlake/Axiall, Eastman). Albemarle (ALB) presents another example in an earnings context. Exhibit 3 summarizes the Q4 earnings season for the Chemicals sector, including those who had not reported as of our last monthly (ALB for one). The company was one of the few to beat expectations on both the top and bottom line, partly due to ongoing synergies with the acquired Rockwood business – savings came in 20% beyond what was initially expected.

If we take the recent commodity rally with a grain of salt, the companies that will outperform moving forward are those that successfully identify the dimensions that are impacting their business and adjust accordingly – be it via acquisitions, divestitures, rationalizations, changes in capital allocation or messaging. Indeed, with crude and natural gas stocks at continually elevated levels and metal pricing trading on the whims of the Chinese, any quick recoveries like the one we have seen recently should be viewed with caution.

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Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: EIA, SSR Analysis

Exhibit 5

Source: EIA, SSR Analysis

Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. Revisions remain broadly negative but the biggest moves have been concentrated in the Commodity and Ag subsectors. The revisions figures in Exhibit 6 are simple averages, which is important to note as AXLL (-46% over the past month) and WLK (-15%) are driving the Commodity result – estimates for LYB and DOW are little changed. There have been pockets of strength and weakness in the Ag space as well – CF (-24%) the biggest negative influence, MOS (-3%) and SMG (+1%) more subdued.

Exhibit 6

Exhibit 7

In Exhibit 8 we show sector discount from normal value as measured by our valuation framework, and in Exhibit 9 we show discount by company. The Coatings sector had been slowly moving toward fair value, but a month of group leading performance (+4% versus the S&P) has made the premium more significant. The discount in the Ag group has been relatively stable in recent months – it may be too soon to call a bottom in the Ag cycle but we are particularly intrigued by Monsanto (see recent research).

Exhibit 8

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 9 – OLN remains at its extreme 10 year low, joined on this basis by MON this month. Last month it was MOS at a 10 year discount but the stock is off its lows, though still within 5%. EMN still shows a value opportunity as the stock is within 10% of its 10 year low. Conversely, SHW retains its record premium, and DOW is near its 10 year high as well, though we remain positive on the stock ahead of the merger with DD. ALB looks significantly less expensive after updating with 2015 data, given the jump in the capital base from the Rockwood acquisition.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 shows absolute and relative performance by subsector since our last monthly report. Overall performance has been roughly in line with the market – winners have been Coatings, Diversified and Commodity, Ag has been about even with the S&P, and Industrial Gases and Specialty Chemicals laggards.

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level. ALB is now most below return on capital trend, which has been updated for Rockwood’s acquired capital base. PPG, ECL, and APD remain at 10 year earnings peaks.

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. Net income margin for the group in aggregate ticked higher driven by the Diversified group’s turn off the lows and continued gains in Coatings and Industrial Gas. Commodity margins appear to be turning over near historical peak levels and Ag margins have room to come down further to prior troughs.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Portfolio Performance

Exhibit 14 summarizes the top five 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 15. 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.

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 currently there are no stocks that meet the criteria.

Exhibit 14

Exhibit 15


Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Through the first nine months of 2015, expenditures were up 3.2% year over year (+3% in every month) but this slowed to 2.6% in Q4
  • Year over year growth came in at 2.9% in January in the latest preliminary data
  • Growth in goods (~35% of spending) continues to outpace growth in services (~65%) – 12 month average year over year growth has been 3.6% for goods and 2.7% for services
  • The pace of spending on both goods and services increased in January, with durable goods in particular showing strong (6%) year over year growth following a 3% figure in December
  • Exhibit 16 summarizes personal consumption expenditures for goods and Exhibit 17 shows expenditures for services

Exhibit 16 Exhibit 17

Source: BEA

Construction

  • Construction spending remains strong – December estimates revised up half a percent and January figures showing a return to 10% year over year growth after two months just below, and a strong 1.5% sequential gain
  • Most of the remaining slack in construction markets is in the residential sector – nonresidential spending is nearly back at pre-crisis levels
  • Exhibit 18 shows the long term trend in US construction spending and Exhibit 19 shows the trend over the past several years and highlights the lack of recent momentum compared with the 2012-2014 period, despite last month’s gains

Exhibit 18 Exhibit 19

Source: US Census Bureau

Agriculture

  • Agricultural commodity pricing has seen solid gains recently – since the end of February, soybean pricing is up 4%, corn pricing up 3% and wheat up 5.6%
  • The year over year price changes are moderating and prices are currently less than 10% below prior year levels for all three of these commodities

Exhibit 20

Source: Capital IQ, SSR Analysis

ISM

  • The PMI rebounded in the February reading but remains just below the breakeven 50 level for the fourth consecutive month
  • Inventories saw a modest rebuild and production edged higher
  • In a positive sign for US manufacturing, new orders held at 51.5 for the second consecutive month in 2016 after spending two months at contraction levels to end ’15

Exhibit 21 Exhibit 22

Source: ISM

Trade

  • Our trade balance exhibit remains the same from last month due to site maintenance at the US Census Bureau – we repeat our comments below
  • The US Chemicals trade balance (ex. Medicinal & Pharma) has continued its pattern of alternating up and down months, but volatility has been muted over the past three months compared to history
  • 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 23

Source: US Census Bureau

Exhibit 24

Source: Capital IQ, SSR Analysis

Exhibit 25

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene production is summarized in Exhibit 26 and operating rates are summarized in Exhibit 27. Sasol’s delayed start for parts of its Gulf Coast project underscores our conservative view of when the many planned ethylene investments will truly come online – see our recent blog on the topic. Near-term there are some supply concerns given the expectation for relatively heavy spring outages (an estimated 12% of supply versus 8% historically).

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Crude oil stocks in the US continue to trend higher and the most recent week ended with the highest level on record – Exhibit 28. Natural gas inventories are tracking along the high end of the five year range – Exhibit 29. Historically elevated inventory levels have been keeping prices subdued, but crude and gas have rebounded over the past several weeks. Gas pricing is just below $2.00 per mmbtu after ending February at $1.71, and crude is just below $40 per barrel after breaking $30 earlier in the year. Ethane and propane prices are up early on in March, but ethane pricing is still about 10% lower than the prior year’s levels, and propane about 15% below ’15 (per Midstream prices through March 8).

Exhibit 28 Exhibit 29

Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Exhibit 30

Source: EIA, SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 33

Source: IHS and SSR Analysis

Basic Plastics

Margins remain strong and, while pressured over the past month due to the Chinese New Year and the accompanying demand drop, are expected to rebound. Regional ethylene prices still favor North America and contribute to the continued profitability.

Exhibit 34

Source: Wood Mackenzie, Midstream Business, Industry Sources, SSR Analysis

Valuation Charts

The exhibits below show our mid-cycle “normal” valuation framework for the chemical sub sectors and the first exhibit (35) summarizes the results and is a repeat of Exhibit 6.

Exhibit 35

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37



Source: Capital IQ and SSR Analysis

Exhibit 38



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 39 summarizes Skepticism Index values by subsector, Exhibit 40 shows the extent to which valuation is historically explained by returns, and Exhibit 41 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
  • Coatings has the most significant Skepticism Index value as the constituent stocks continue to earn above trend by a margin that is not adequately reflected in what, in isolation, looks like a healthy premium valuation
  • Most Commodity stocks (except DOW) are trading below mid-cycle value, but DOW and LYB have held the group average return above the level implied by the discounts in AXLL and OLN

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42 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 42

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

December 14, 2015 – Dow/DuPont: The Very Best Looking Horse in the Glue Factory!!

December 9, 2015 – Dupont/Dow: The Considerable Value is All in the Execution

December 3, 2015 – Industrial Gases: Adapt to Slow Growth, or Underperform

November 17, 2015 – Monsanto: Left Out in the Cold? (blog)

November 5, 2015 – Eastman: Time to Change the Messaging (and Possibly the Strategy)

October 30, 2015 – Dow vs. DuPont: Dawn of Real Values!

October 13, 2015 – DuPont: Real Upside if New Management Brings Real Change

October 6, 2015 – DuPont: Is Some Sort of Breakup Now More Likely? We Would Own DD and DOW (blog)

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 43 to 47.

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

Exhibit 47

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 48 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 48A

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 48B

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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