Chemicals Monthly – More Concerns Than Opportunities

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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

October 16th, 2013

Chemicals Monthly More Concerns Than Opportunities

  • It has been a volatile month since our last report, but the Chemicals subsectors have done relatively well. All the groups have outperformed the S&P, which is up 1.8% since the middle of September. The Commodity subsector was the strongest with a 3.2% relative gain, but Specialty was also up nearly 3% versus the S&P. Diversified continues to lag – valuation is significantly trailing anticipated returns.
  • Agricultural Chemicals stocks saw positive revisions on the month and are the most attractive within the space from a pure valuation perspective. The Coatings subsector is still richly valued, though revisions have stabilized. Valuations within Commodity Chemicals are looking full as well, though perhaps not as full as the group’s above average returns might warrant.
  • Over the past month we published a detailed report on the state of the US Chemicals industry. Diversified is the only subsector that we would be overweight, though we offered favorites and concerns within each group – see Exhibit 1 below, repeated from our prior research. This exhibit will now be repeated in each monthly.
  • While we may be closer to a budget and debt ceiling resolution, which would be good, the general market (as well as our sectors) is rallying as if everything is fine. Some early earnings reports would suggest that growth is still hard to find and that emerging markets are concerning. We remain generally concerned about whether what is implied in valuation is really achievable.

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

As the markets lurched up and down amid the ongoing governmental pantomime (consult any older Brit for the intended definition of pantomime here), the Chemicals space continued to show relative outperformance. The group as a whole looks expensive, though most companies have above trend earnings. Revisions are quieting for the most part as 2013 winds down, but Agricultural Chemicals received a boost from a strong positive change for Mosaic (MOS). Note: we are very skeptical about MOS’ view of 2014 and would expect most of the potash producers globally to see volume declines in 2014 rather than gains (gains would only come as the result of much reduced pricing). The Commodity group was the only other subsector to see material revisions, but to the downside, most notably in AXLL (one of our highlighted concerns within this group).

As we have discussed in several reports this year and last, demand is not particularly robust; it is not really declining any longer on a global basis, but by the same token it is not growing either. This is not specific to the chemical industry as top line growth across the broader market has been almost nonexistent this year. The margin story is not improving any further in commodities and for the most part pricing is high so consequently we would not expect to see a material pick-up in demand if confidence recovers as few buyers will want to build inventories at these prices.

Outside the Diversified and Ag sectors, valuations in our view are generally discounting a plausible but unlikely future, and are richly valued both on an absolute and relative basis. This is reminiscent of prior cyclical peaks, although in past cycles this inflated value has occurred when the global economy has been strong or strengthening, and we are not there today. While we could certainly see a period of more positive general news flow, we believe that this would only serve to take already high expectations to even loftier and less likely levels.

Valuation

Exhibit 3 summarizes our valuation work.

Exhibit 3

The group composition is summarized below. As
noted in our piece on transformational change from August
, we have adjusted the group constituents, changing EMN from a Diversified to a Specialty company.

Exhibit 4

Exhibit 5 shows subsector discount from normal value in standard deviations.

Exhibit 5

Source: Capital IQ and SSR Analysis

In Exhibit 6, reproduced and updated from
our recent comprehensive Chemicals report
, we show company discount from normal value as measured on our framework. WLK, RPM, LYB, and ARG are outliers on the expensive side, each at a 10 year or all time valuation peak (PPG is within 3% of its 10 year high and is highlighted as well). On the flip side, only OLN is at an all time or 10 year valuation low.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibits 7 and 8 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our September Chemicals Monthly.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Monthly Topics: Included in Body of Report

New Section: Profitability

Exhibits 9 through 11, also repeated and updated from
our state of the industry report
, are new to the Chemicals Monthly and show profitability at the sector, subsector, and stock level.

In Exhibit 9 we have highlighted those companies at or near earnings highs – no companies screen at earnings lows on these time frames. WLK, ARG, and PPG were also highlighted in the corresponding valuation exhibit (Exhibit 6) – record valuations are at least partly justified by record earnings.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibits 10 and 11 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Portfolio Performance

The October selections are shown in Exhibit 12. DD remains attractive despite its recent performance, but this is partly because it is hard to find a cheap stock anywhere in the sector today.

These screens also confirm
our concerns about the Coatings subsector
.

Exhibit 12

Source: Capital IQ and SSR Analysis

We have back tested the methodology from April 2012; we show the results for the current year in Exhibit 13. Results have been mixed in recent months. In a pattern similar to that exhibited by our portfolio selections for the broader Industrial and Basic Materials group, year to date returns have been most robust for the overlap screen (13.0% in excess of the market, exclusive of transaction costs). The Skepticism Index screen has performed decently as well (5.9%), while the valuation screen has been essentially flat to the market (0.0%).

Exhibit 13

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • The most recent Consumer and Construction spending numbers are unavailable due to the ongoing government shutdown – the BEA and the Census Bureau are both affected by the federal deadlock.

Exhibit 14

Exhibit 15

Source: BEA

Construction

Exhibit 16

Exhibit 17

Source: US Census Bureau

Agriculture

Exhibit 18

Source: Capital IQ, SSR Analysis

ISM

  • The overall US PMI was strong again in the latest reading for September rising to its highest level since April 2011. New orders were off a bit after big jumps in July and August.
  • Inventories rose slightly but the production subcomponent held strong at levels not seen since early 2011.

Exhibit 19

Source: ISM

Exhibit 20

Source: ISM

Trade

  • As mentioned above, the government shutdown has affected the Census Bureau, leaving us without updated trade data.
  • The Japanese Yen and the Indian Rupee have suffered the most over the past year, each down over 25% versus the US dollar. Q3 2013 saw the dollar weaken versus the Euro by over 6% year over year – Exhibit 23.

Exhibit 21

Source: US Census Bureau

Exhibit 22

Source: IMF

Exhibit 23

Source: IMF

Commodity Fundamentals (unchanged from last month)

Supply/Demand

Please see our recent piece on US ethylene demand for our current perspective. We remain concerned that high absolute pricing for chemicals are constraining growth.

In both of the charts that follow we include IHS’ forecaster for the balance of 2013, and it is interesting to note that while production has picked up this year, operating rates are beginning to trend downwards, reflecting the capacity additions at the beginning of the year from DOW and WLK. We would not expect production in Q3 and Q4 2013 to be meaningfully impacted by Williams as the whole system has room to make up the gap – Exhibit 24. Given the better consumer spending numbers and the better housing numbers in the US we do see some support for the better production levels and without this spending increase we would be concerned that the extra production is going into inventory.

Operating rates are summarized in Exhibit 25.

While the current significant discount in NGL pricing in the US relative to crude oil gives a subset of US producers a meaningful cost advantage over any producer globally using an oil fraction as an ethylene feed, the higher cost producers in the US do not have costs materially lower than the higher cost producers in Europe, Latin America and Asia, at this time. While the plans to add NGL based capacity in the US is predicated on the idea that it should displace crude oil fraction based production outside the US, there is a risk that some of the early victims will be crude oil based producers locally. Looking back at the trade figures above – Exhibit 21 – until the last data point (which is only one month), we have not seen the lower cost base in the US turn into a meaningful improvement in exports. The trade data is volatile but it is hard to see a positive trend and if we do a 12 month rolling average the line trend is not compelling.

Exhibit 24

Source: IHS and SSR Analysis

Exhibit 25

Source: IHS and SSR Analysis

Pricing

Energy – Exhibit 26

The Middle East continues to dominate the crude oil story but Brent is off its highs and is bouncing round $110 per bbl. Natural gas has seen a recent spike based on cold weather and a surprising inventory number but remains relatively cheap.

Exhibit 26

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. Margins have now been negative for 11 months in a row – Exhibit 27.

Exhibit 27

Source: IHS and SSR Analysis

Butane continues on its more positive trend associated with the usual winter gasoline blending season and while propane is no longer declining relative to crude it is stable at an all time low. This propane value in the US continues to create great incentive to export US propane to Europe as an ethylene feed, where logistics and feedstock flexibility exist. Ethane is now by far the most attractive feedstock for ethylene production. Ethane has not weakened further relative to natural gas. The longer-term trend relative to crude remains negative – Exhibit 28.

Exhibit 28

Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing is stable in the US, with producers looking for increases in September, probably with the goal of holding prices steady. Markets are not significantly oversupplied, but there is no shortage of product and the overall demand picture remains weak, more so overseas than domestically. Unless we see some sort of pick up in global demand we would expect the price and margin lines in Exhibit 29 to start moving down more quickly from the relative stability so far this year.

Exhibit 29

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 (30) summarizes the results and is a repeat of Exhibit 1.
Exhibit 30

Valuation Charts – Exhibits 3133

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

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:

  • The Commodity and Diversified subsectors are both showing above average earnings that are not fully reflected in valuations – the difference is Diversified stocks are still below normal value whereas Commodity stocks have seen strong moves to the upside and are currently trading above historic norms. Ag’s skepticism value is entirely composed of valuation as earnings are right in line with trend.
  • CBT is over earning and slightly undervalued, and is the only Chemicals stock currently at an all time or 10 year skepticism index high. PPG and LYB are both at respective lows on the skepticism index, resulting from fuller valuations than even their already above trend earnings might justify.

Exhibit 34

Source: Capital IQ and SSR Analysis

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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 37 to 41.

Exhibit 37


Source: Company Reports and SSR Analysis

Exhibit 38

Source: Company Reports and SSR Analysis

Exhibit 39

Source: Company Reports and SSR Analysis

Exhibit 40

Source: Company Reports and SSR Analysis

Exhibit 41

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 41 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 1.

Exhibit 42A

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 42B

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

©2013, 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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