Chemicals Monthly – Pretty Quiet Month…

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 16th, 2015

Chemicals Monthly – Pretty Quiet Month…

  • We are very positive on the DOW-DD deal – see recent research – and believe the opportunity in the stocks is greater than any other within Chemicals, and the entirety of Industrials & Materials more broadly
  • Our preference here is partly informed by a very bleak macro outlook
    • Oil is continually lower, ag continues to search for a trough, emerging markets seeing sharp economic slowdowns – Dow/DD can offset the negative macro with synergies
  • Given this backdrop, further deals are likely
    • Air Liquide’s buyout of Airgas (ARG) underscored the environment of low industrial production growth
  • Energy markets are awash with supply
    • Natural gas broke below $2.00 per mmbtu as inventories remain above the 5 year range and near all-time highs – prices could drop sharply if storage limits are reached.
    • Crude similarly fell into the mid $30 per barrel range with US stocks hovering near a record 2 billion barrels
    • Though the fall in crude has trimmed the gas/oil spread, sub $2.00 natural gas is a boon for commodity producers as well as for PPG, a positive standout in an otherwise pricey sector – PPG should see further raw material cost reductions if oil stays this low
  • Year to date in 2015 only the Commodity and Specialty Chemical groups have stayed ahead of the S&P, but the valuation landscape is little changed from a year ago
    • Most sectors look fairly valued in aggregate – Coatings (expensive) and Ag (cheap) remain the outliers – every group could get cheaper if the macro story remains weak
  • Most of our research over the past month has focused on Dow and DuPont but we also published a piece on Industrial Gases, where we have moved to underweight
  • We are hard pressed to find a stock or sector that presents a better opportunity that the one in front of DOW/DD and would be long both names
    • We are now less positive on Industrial Gases – see recent research
    • Given the DOW/DD deal we are also less positive on MON, as we see the risk that the company overpays for a deal of its own

Exhibit 1

Exhibit 2

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

Overview

The bear case read of the Dow/DD deal is that it might signal the end of the innovation based growth of the chemical industry – is this two power houses throwing in the towel? We do not believe this, but given the negative guidance from DuPont it is easy to see how that view could develop. The reality is that we are in a deep and prolonged economic malaise, with a consensus view that it could last some time – the combination of slow global growth, a massively oversupplied China and lower energy supports a very bearish view. We concur that things look bad, and we would not be overweight chemicals or anything else we cover today, but we do not believe that the grim reaper is around the corner, nor do we believe that the Dow/DD deal is one of desperation – we think it is one of significant opportunity. These companies are merging from a position of strength rather than weakness. At the margin we think that Dow shareholders will get the better deal, but the deal is good for both sides. The ability to cut costs and the ability to realign (especially in Ag) is significant.

That said, this deal is not a panacea for the two companies – the economic pressures do not go away and it is worth remembering that products commoditize much more quickly in an economic slowdown that when growth is strong and top line growth is helping everyone grow earnings. We like the deal, but we would love the deal if we felt that the largest business (Materials) was going to run with a cost and value focus rather than the “value add” strategy that both companies have tried in the past and failed at. If the “value add” strategy did not work when you had growth as a support, it has very little chance of success in a no growth world. Dow will likely lose share to the likes of Lyondell, Ineos, Exxon and others if it does not get its cost base right here.

Energy prices remain pressured as inventories remain historically elevated – gas in storage is above its 5 year range and just off an all-time high (Exhibit 3), while crude stocks are pushing the storage limits as well (Exhibit 4). The decline in crude pricing has been optically more pronounced but in actuality both Brent crude and Henry Hub gas are off roughly the same 30% versus December ’14.

We would highlight PPG as a notable non-commodity beneficiary of the lower energy price dynamic. The stock is shading barely on the cheap side of fair value but represents the best value in a sector that is seeing historical premiums, and revisions are positive at a time when they are negative for most others in the space.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: EIA, SSR Analysis

Despite volatility throughout the year, the Chemical sectors are ending 2015 very much the way they started it – Exhibit 5. Coatings is marginally less expensive, but retains the largest premium in the group. DD is actually still below the price at which it ended 2014, and the entire Diversified subsector is slightly cheaper. Gases and Commodity are little changed, but this belies the significant volatility in commodity names through the year, as well as the dispersion within the group (LYB and DOW at premiums, OLN, HUN, AXLL discounted). Commodity Chemicals is actually the best performing of the Chemicals subsectors year to date, but the move is less significant than it would be for others given the group’s historical volatility. Specialty Chemicals has been the second best performing subsector, but this too is a disparate result – ECL and IFF up, EMN down. Ag has trended weaker as market conditions remain challenging.

Exhibit 5

Source: Capital IQ, SSR Analysis

Valuation

Exhibit 6 summarizes our valuation work and the subsector classifications are summarized in Exhibit 7. Revisions trickled in mostly to the downside, with the exception of the specialty group where estimates have held in the best of any sector over the past several months. Macro headwinds should lead to continued negative pressure on EPS estimates absent further deals.

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. Most Chemical sectors are approximately at fair value – Ag and Coatings remain the cheap and expensive outliers respectively.

Exhibit 8

Source: Capital IQ and SSR Analysis

At the stock level – Exhibit 9 – MOS remains at an all-time valuation discount, and EMN is holding in near its lows as well. PX is less cheap than it has looked recently – see recent research – but continues to look cheaper than it has been at any point during the last 10 years. MON similarly is at a 10 year valuation low. On the expensive side, SHW is within 5% of its recent all-time valuation peak. The buyouts of CYT and SIAL have been completed and we have removed the stocks from our index.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 shows absolute and relative performance by subsector in 2015 year to date. Only the Commodity and Specialty groups have stayed ahead of the market. Diversified Chemicals is down significantly as the largest component stock, DD, is still below the level it started the year at. Weakness in PX and APD has more than masked the buyout pop in ARG. Coatings stocks have come in a bit – within this group only SHW is a relative outperformer.

Exhibit 10

Source: Capital IQ and SSR Analysis

Profitability

Exhibits 11 through 13 show profitability at the sector, subsector, and stock level. Two Coatings companies (SHW and VAL) and two Industrial gas companies (APD and ARG) are sitting at peak return levels for the second consecutive month. Noting the buyout premium in ARG’s valuation, these stocks are all showing valuation premiums reflecting these earnings and the expectation that there are further improvements.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibits 14 and 15 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. The past few months have seen a quick move down off the peak from earlier in the year, but profitability remains historically elevated and the rolling average continues upward. Diversified looks like the primary contributor to the sector’s overall deterioration in net income – most subsectors have seen margins continue to trend higher, particularly in Coatings and Industrial Gas.
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. That DOW and DD screen as unattractive is mostly a function of the inexpensive nature of the sector overall, and does not accurately reflect the massive opportunity in front of the companies.

2015 has not been 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 have been mainstays on the long screens and this has been a yearlong headwind for the selections.

We also 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. Chemical stocks that meet these criteria are shown in Exhibit 16 – the negative revisions picture continues to shorten this list.

Exhibit 14

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • Personal consumption expenditures flattened sequentially in October but year over year growth remains firmly positive – 2.7% growth marked the first month below 3% since July 2014
  • Growth in goods (~35% of spending) continues to outpace growth in services (~65%) – 12 month average year over year growth has been 3.9% for goods and 2.9% for services
  • Further segmenting the goods component, durable goods have averaged 6.5% year over year growth during the past year, compared to 2.6% average growth for non-durables
  • Exhibit 17 summarizes personal consumption expenditures for goods and Exhibit 18 shows expenditures for services

Exhibit 17                                                                                              Exhibit 18

Source: BEA

Construction

  • The latest month of construction spending data (October) showed the fifth consecutive month of 13% year over year growth and a strong sequential improvement
  • If growth slows to just half of the sequential rate seen over the past year, we would reach the 2006 spending peak in mid-2017
  • Most of the remaining slack in construction markets is in the residential sector – nonresidential spending is nearly back at pre-crisis levels
  • Exhibit 19 shows the long term trend in US construction spending and Exhibit 20 shows the trend over the past several years

Exhibit 19                                                                                              Exhibit 20

Source: US Census Bureau

Agriculture

  • Agricultural commodity pricing appears to be stabilizing – Soybeans and corn saw minimal movement over the past month and wheat was up 3%
  • Year over year prices are down double digits for soybeans and wheat, down 6% for corn

Exhibit 21

Source: Capital IQ, SSR Analysis

ISM

  • The PMI fell to contraction levels in the latest reading – new orders dipped below 50 as well
  • Dwindling inventories offer some hope that the dip in industrial activity will be short lived, though customer inventories remain more elevated – lower energy costs should also support manufacturing activity

Exhibit 22                                                                                               Exhibit 23

Source: ISM

Trade

  • The US Chemicals trade balance (ex. Medicinal & Pharma) remains volatile, rebounding from the previous month’s sharp drop in the latest data through October
  • The 12 month rolling average (dotted green line) is taking on a more pronounced downslope – a sustained period of lower oil prices does not help the case for US chemical exports

Exhibit 24

Source: US Census Bureau

Exhibit 25

Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Ethylene production is summarized in Exhibit 29 and operating rates are summarized in Exhibit 30. See prior ethylene-specific research for more detail on our views.

Ethylene production is expected to rise significantly in 2016, with January’s production estimate greater than any monthly total from 2015. Planned outages will be higher than in ’15 but several of the restarts entail capacity expansions. Ethylene demand is expected to grow 3% in ’16, with similar demand growth rates for HDPE and LLDPE.

Exhibit 27

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 28

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Stocks of crude oil are hovering near the two billion barrel mark – Exhibits 29 and 30. Natural gas inventories have broken above the high end of the five year range – Exhibit 31. Natural gas had fallen below $2.00 per mmbtu as of this writing – Exhibit 32. Steady declines in crude pricing continue. Brent broke $40 per barrel amid a global glut of nearly 3 billion barrels (~one month’s demand).

Exhibit 29                                                                                               Exhibit 30

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

Exhibit 31

Source: EIA, SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Ethane and propane prices in Q4 have been marginally higher than in Q3 but thus far in December we have seen a move back to the year lows seen during the summer.

Exhibit 33

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 34

Source: IHS and SSR Analysis

Basic Plastics

The oversupply of NGLs has kept ethylene margins strong even as oil has taken another leg lower. Year over year margins are down however – not surprising given that spot ethylene was nearly 72 cents per pound in September 2014 and has fallen close to 20 cents per pound today. This fall in pricing has supported continued high margins for PE, though at a lower level than seen during the summer.

Exhibit 35

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 (36) summarizes the results and is a repeat of Exhibit 6.

Exhibit 36

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38



Source: Capital IQ and SSR Analysis

Exhibit 39



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 40 summarizes Skepticism Index values by subsector, and Exhibit 41 shows the extent to which valuation is explained by returns:

  • The Specialty group shows a much better balance of valuation and returns following the removal of SIAL and CYT
  • Only the Coatings group (and Commodity Chemicals, to a lesser extent) shows a significant degree of skepticism
  • For Coatings, the group’s SI value is influenced by the recent rapid rise in returns that remain statistically elevated versus historical norms – valuations are elevated as well but not to the extent suggested by above trend earnings
  • The Commodity group remains split into beaten down small cap names with significant exposure to cheap Chinese competition that has had a major detrimental impact on returns (OLN, AXLL) and larger cap ethylene names (LYB, DOW), with better current return profiles and valuations to match

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42 plots the individual SI components, valuation discount and deviation from return on capital trend, for each of the Chemical subsectors. Most sectors are stacked around the SI equalization line where returns and valuation are aligned – Coatings is the obvious outlier.

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43 shows SI by company. Highlighted in green are companies that are at all-time or 10 year peaks in skepticism. OLN has a high skepticism value because it is currently inexpensive and its return on capital is reflecting the inclusion of DOW’s chlor-alkali business, giving the appearance that the company is over earning – this will likely moderate when we adjust the capital base for 2015 actual data.

Exhibit 43

Source: Capital IQ and SSR Analysis

 

2015 Chemicals Research

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)

September 17, 2015 – APD Materials Spin: The Right Strategic Move, But Not Much Value Add (blog)

September 10, 2015 – DuPont: Has the Third Envelope Gone Back in the Drawer? We Hope Not!

August 17, 2015 – Ethylene: Not Ground into the Floor by China but Losing Steam Quickly

July 29, 2015 – DuPont: Investor Exodus (blog)

July 29, 2015 – Eastman: The Silver Lining of the Propane Cloud (blog)

July 28, 2015 – LyondellBasell: Hard to Fault (blog)

July 28, 2015 – Dow Chemical: Neither Fish nor Fowl (blog)

July 8, 2015 – DuPont and Chemours: Strategically Challenged

July 6, 2015 – Agriculture Musical Chairs, But With Different Music

June 5, 2015 – DuPont Question 2: Chemours is a No Win Scenario

June 5, 2015 – Skepticism + Positive Revisions = Outperformance

May 27, 2015 – DuPont – Question 1: Is the Return on R&D Investment Positive?

May 13, 2015 – The DuPont Vote – Short Term Noise – Change is Coming Either Way

May 12, 2015 – Corporate Complexity – Less Is More

May 6, 2015 – EMN – Time to Focus on the Shareholders

April 27, 2015 – DD and DOW – Backing The Activists

April 20, 2015 – Air Products is Running Out of Gas – Praxair is Refueling!

March 9, 2015 – Prices Falling, Dollar Rising – Stocks Defying Gravity

February 9, 2015 – Industrial Gases – Pricing Coming and Good for All

January 27, 2015 – US Ethylene – Who Will Blink First

January 13, 2015 – Own Goal Investing – EMN Presents Another Opportunity

January 12, 2015 – Favorites for 2015 & Industrials & Materials Methodology Review

January 5, 2015 – The Ethylene Conundrum: EMN the Value Play

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 44 to 48.

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

Exhibit 48

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 49 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 49A

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 49B

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

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