Chemicals Monthly – Treading Water

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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

June 16th, 2015

Chemicals Monthly Treading Water

  • The last month has been a quiet one in the Chemicals space, without major news driving delta in oil, currency, valuation or revisions. The group has mostly been treading water with only a handful of exceptionally good or bad performances.
  • Without another move upward for oil, our Commodity names saw more muted gains. The outage situations in Europe and Asia continue and the export opportunity exists, especially in Asia. We remain concerned about second half polyethylene pricing should today’s outages be rectified as planned. However, it is a pretty safe bet that European ethylene/polyethylene profitability in Q2 could be the best in more than a decade – good for DOW and LYB.
  • US cash costs improved further over the last month with both propane and butane declining by double digit percentages. Oversupply concerns drove propane under 40 cents per gallon while ethane has stayed flat for three months in a row. This collapse should favor propane based production as margins expanded from their parity levels with ethane last month.
  • AXLL was the most interesting of the Commodity names this month as activists have emerged, calling for a sale or break-up. News of an SEC investigation into allegedly improper spending by the CEO at DOW have also sent shares up (though an improving Europe was also a support).
  • Coatings remain the most expensive group in our chemicals coverage. Negative revisions over the last month illustrate potential cracks in the facade of the group but there is not yet an obvious catalyst to drive downside.
  • Our favorite names have not changed despite slight changes in valuation and the global growth outlook. EMN could be the next target of an activist given its low multiple and complex business, DD has a tremendous cost opportunity that seems to be getting attention at Chemours and PX can be paired with APD to capitalize on valuation dispersion in the Gases.
  • Research since our last monthly has included a piece on DD’s lack of returns on its R&D spending, a piece on the implications of the Chemours spin-off and a piece analyzing how the Skepticism Index interacts with cyclicality.

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.

OverviewFew Ducks on the Pond

The Chemicals space stands close to where it did last month after taking one step forward and one step back. Oil has turned from driver to passenger for the time being but another potential activist narrative has emerged at Axiall amidst poor performance associated with struggling global vinyls and caustic markets. The activist story remains an important one in this space and we expect to see more headlines to that end in the coming months.

In the past, we have written that
regardless of the outcome of the proxy vote
, DD has upside. However, this assumes that there is meaningful change at the company. Change must come to both the manner in which the company manages its cost structure and the manner in which it treats its R&D. The market is now more aware of the company’s complexity and cost opportunity but greater scrutiny is, in our opinion, insufficient if it does not spur meaningful changes to the way that the company is managed.

For DuPont, since 2000, for every dollar spent on acquisitions, CapEx and R&D and repurchases, shareholders have only seen 50 cents of return generated – Exhibit 3. While distracted by its acrimonious dispute with Trian, DD’s management has possibly missed another opportunity on the Ag front and gave investors further concern that they do not have the tools to deliver greater returns.
Shares of DuPont still drift lower and have seen anemic performance since the date of the vote in May. A recent presentation by the company’s chief executive did little to assuage the worries of investors that the changes suggested by Trian and
supported by our calculations
will never see the light of day. We have been patient with this name to date but a better signal from management regarding commitment to cost is needed to keep our conviction.

Exhibit 3


Source: Company Reports, Industry Sources, SSR Analysis

The other notable piece of research that we published since our last monthly was a
piece on our Skepticism Index and its relationship with the cycles that drive the broader industrials and materials space
. While this piece focused primarily on the capital goods space, the analysis has application in Chemicals companies as well and is an area for further analysis. We noted EMN in the piece and believe that, if our rationale and analyses are correct, the company may enjoy some multiple expansion in anticipation of higher growth in 2016 and beyond.

Since we last wrote, oil and natural gas have not made any particularly exciting moves as concerns of oversupply kept oil in check and natural gas has not yet seen a benefit from apparently weakening production in the Marcellus and a streak of warm weather across parts of the country. The case for trade remains stable as outages in Europe and East Asia create an opportunity in polyethylene. Partially offsetting falling natural gas and stable oil is the dollar which modestly strengthened against the Euro. Despite this, the better arbitrage opportunity was in East Asia to begin with and economics still favor that trade.

Our
preferred names
have not changed despite recent headlines and volatility. We like DuPont because we believe that the
cost opportunity is large
and elevated
scrutiny of management lends itself to a leadership change and possible reduction of complexity
. However,
downside may exist if the company cannot improve its R&D programs
or if it ignores
its cost opportunity
.
EMN
due to its
inexpensive valuation though its complexity may weigh on shares
; and PX, based on valuation, pricing improvements coming across the gases names plus a history and outlook based on excellent cost and capital management.
PX has already fully priced in its downside and the opportunity is compelling at this price
. Recent work on both
dividend policy
and
buyback opportunities
suggest that both EMN and DD have alternative possible strategies that would likely result in greater shareholder returns.

Valuation

Exhibit 4 summarizes our valuation work and the subsector classifications are summarized in Exhibit 5. Revisions were uniformly negative over the last month, though only modestly so. Coatings saw the most negative revisions, the first time that this has happened in well over a year. Still, the Commodity group has had the worst revisions over the past year with Diversified following closely.

Exhibit 4

Exhibit 5

In Exhibit 6, we show sector discount from normal value as measured by our valuation framework, and in Exhibit 7 we show discount by company. The subsectors remain similarly valued relative to each other with no sector becoming significantly more expensive or inexpensive over the last month. Valuation dispersion within subsectors has continued with SHW expensive vs. PPG, MOS inexpensive vs. SMG and PX inexpensive vs. APD. Ag names remain the least expensive. Coatings are still the most expensive with SHW marked in red due to its 10 year valuation high in Exhibit 7. SHW’s steep valuation is driven by both its above trend earning and its falling capital base. SHW is driving much of the sector premium in Exhibit 6 while PPG is more favorably valued. Both NEU and CYT are still trading near valuation highs.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibits 8 and 9 show absolute and relative performance, respectively, of the Chemicals subsectors since the publication of our May Chemicals Monthly. No subsector saw an absolute or relative move greater than 1% despite the volatility seen over the last 30 days. The outperformance in the Coatings group was driven by PPG while SHW and RPM. These moves are consistent with our view of the sector. With oil largely flat over the last month despite some volatility, the Commodity group’s rally came to a halt. They still appear expensive as a group as illustrated in Exhibits 6 and 7. A dearth of headlines kept most names flat as concerns about Greece and the global economy have put a lid on performance.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis
Profitability

Exhibits 10 through 12 show profitability at the sector, subsector, and stock level.

In Exhibit 10, we highlight several companies in green – all are at 10 year or all time peaks in return on capital. SHW and CYT therefore have some earnings support for the valuations in Exhibit 7. HUN is still inexpensive and overearning and therefore makes our Exhibit 1 screen. Coatings as a group are overearning which explains, at least somewhat, their steep valuations.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibits 11 and 12 show the net income margin for the Chemicals sector as a whole and for the individual subsectors, respectively. After a downward move last month, the Chemicals sector level profitability has bounced upwards and remains elevated compared to its 5 year rolling average.
Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Portfolio Performance

The last month’s portfolio selections are shown in Exhibit 13. In a volatile but ultimately flat month, our performance more or less met the market’s. Including SHW in our short basket had a positive impact for the first month in many though CYT and CF offset the gains from the other names in the short group. On the long side, ARG and MOS outperformed while the remainder did not generate alpha over the past month. Historically, the names with favorable readings in terms of valuation and
our Skepticism Index
have produced alpha – Exhibit 14.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

Industry Driver Summaries – Data/Anecdotes Behind Exhibit 1

Consumer Spending

  • April’s consumer spending was more or less flat – Exhibit 15. Revisions have been mixed but very little change has been made to numbers from January through March.
  • Even as the weather turned in April, data remained sluggish. If we follow the (seemingly unfounded) logic of the past several months, then this is attributable to rising oil. However, we are skeptical of this theory and posit that little or no spending growth is due to at times questionable economic fundamentals.

Exhibit 15 Exhibit 16
Source: BEA

Construction

  • Strong revisions for the second month in a row brough March’s numbers up by about $20 billion to $983. The significant bump to March and a second month of upward revisions show construction in a more positive light.
  • Giving some credence to recent strong forecasts for construction was April’s figure which topped $1 trillion for the first time since 2008. This marks a 4.76% increase over April 2014 and 2.24% gain from March’s revised number. The strong uptick is shown below and brings construction back to on-trend levels after a disconcerting dip for several months.

Exhibit 17

Exhibit 18

Source: US Census Bureau

Agriculture

  • Crops were mixed over the last month. While soybeans and corn were down roughly 1.5% each, wheat was up almost 5% in defiance of recent forecasts for higher supplies. These forecasts are the most significant factor leading to the declines in corn and soybeans. The May 12 USDA World Agricultural Supply and Demand Estimates report provides a more detailed outlook for each crop.

Exhibit 19

Source: Capital IQ, SSR Analysis

ISM

  • May marked a departure from the recent downward trend in the PMI, coming in at 52.8. New orders ticked up from 53.5 to 55.8 but production decreased from 56 to 54.5. Inventories were up to 51.5 from last month’s contractionary number of 49.5. The slide in the PMI is over for the time being but we await an eunexpectedly important June number before making further judgment.
  • Growth around the world remains very variable. With the dollar recently stabilizing (Exhibits 23 and 24), it is possible that North America will get more active in export markets while remaining a target for foreign capital seeking superior returns. Europe has seen growth divergence resume between Northern and Southern economies with Greece’s credit concerns coming to a head. The Chinese outlook remains uncertain with recent “good” news about the property market partially offsetting forecasts of a missed growth target for the full year.

Exhibit 20


Source: ISM
Exhibit 21

Source: ISM

Trade

  • The green line in Exhibit 22 is a twelve month rolling average. Cutting through the month to month volatility, we see Chemical trade volumes have been flat for the past several years. The case for US exports remains elevated compared to earlier in the year with henry hub natural gas now trading for roughly $2.60/MMBtu and oil hovering near or over $60/barrel.
  • Trade plummeted in April in a manner that is not explainable by normal volatility. This figure, the most recent, places the chemicals trade balance at a level not seen since 2009. As we have written previously, we believe that the USD and low oil act against US exporters.
  • The USD has held steady over the past month and volatility in global markets has not eroded its strength. The Ruble remains 40% off against the dollar while the Real is down over 41% year over year. The Euro has remained week with Greece weighing on the currency. The USD is 19.6% stronger versus the Euro in 2Q15 vs. 2Q14 – Exhibits 23 and 24. We expect currency headwinds to cause sales and earnings downside for the full year 2015 across our space.

Exhibit 22

Source: US Census Bureau

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ

Commodity Fundamentals

Supply/Demand

Please see our
December 2013 piece
for the way in which we think about ethylene supply/demand and our more recent
September update
. We remain concerned that high absolute pricing for chemicals are constraining growth, and this is evident in the very slow growth from 2012 to 2014 and the slightly better market we see today.

We have written about the oversupply in propane previously but prices finally succumbed to fundamental pressure over the last month. With propane inventories at record levels and storage hubs struggling to handle inbound cargoes, propane could not maintain its $0.50/gal+ pricing and now sits at roughly $.37/gal. We previously mentioned declines in propylene pricing as a result of numerous refineries coming off of turnarounds earlier in the year but we believe that, even with lower co-product credit values, propane should gain share of the US feedstock mix as propane based margins expand from their ethane-parity levels of last month.

Outages in East Asia continue to constrain supply and pricing in HDPE has benefited as a result. Similar dynamics have prevailed in Europe. The case for trade has strengthened as the Asia arbitrage has opened and the USD has not strengthened recently as it did earlier in the year. Should international crackers successfully restart in the second half of the year, the PE trade window may close.

Both the vinyls chain and the chlor-alkali space remain weak as a result of global oversupply. There have been several deals in the space but we do not necessarily see this as a signal of improved fundamentals so much as it is a signal of certain companies exiting the space at the cost of fetching a low multiple for their businesses.

Ethylene production is summarized in Exhibit 25 and operating rates are summarized in Exhibit 26. Note that at no point in the forecast period do we see operating rates that would suggest a tight market as in 2000 and briefly in 2005/2006.

Exhibit 25

Source: IHS, Wood Mackenzie and SSR Analysis

Exhibit 26

Source: IHS, Wood Mackenzie and SSR Analysis

Pricing

Oil has become less intensely focused on inventories so much as the generally oversupplied state of the market. Even with the collapse in rig counts in the US, the global market remains oversupplied and concerns are mounting about certain international players reentering the market. Libya and Iran could collectively add over 700,000 barrels per day to a market that is already oversupplied by over 1 million barrel per day. At the same time, questions are emerging about the price level at which the marginal US producer resumes production. It is unclear if that price is $55/barrel or $70/barrel but the debate is renewing fears that the oil rally is pricing fundamentals that do not exist. The brief halt in US inventory gains has ended as inventories have risen from mid-May, though only modestly – Exhibits 27 and 28.

Exhibit 27

Exhibit 28
Source: EIA, SSR Analysis Source: EIA, SSR Analysis

Natural gas production in the Marcellus actually fell over the last month– Exhibit 30 and 31 – but remains near all-time high levels. Storage has continued building as we come out of the winter – Exhibit 29. Despite production questions, prices have tumbled back towards $2.80/MMBtu after breaking the $3 mark last month. A streak of warm weather and decreasing production in the Marcellus should push pricing higher but this has not been the case. Similarly, flattening production per rig in the Marcellus points towards high prices in the longer term as an oversupplied market moves back towards equilibrium. Inventories are in the middle of the five year range and are neither a threat to pricing nor do they offer much support.

Exhibit 29

Source: EIA, SSR Analysis

Exhibit 30
Exhibit 31

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

Exhibit 32

Source: Capital IQ and SSR Analysis

Ethane is flat for the second month in a row with a gallon trading for $0.17 to $0.18. However, overwhelming propane supplies have pushed pricing down to about $0.37/gal. Incremental demand in the form of several new crackers is expected to drive up ethane pricing in the longer term but with propane taking the hit it has over the last month, it is possible that flexible producers will favor it over ethane for the near term. Propane’s collapse was due to the inventory problems that we mentioned
last month
, a problem that is not likely to go away with any immediacy. Ethane’s low cost basis has become less relevant as propane tumbled, especially given the latter’s co-product credits. The Conway – Mont Belview ethane spread has held steady over the last month and though it is now wider than it was from December through April, the spread is not wide enough to warrant discussion of serious inventory / supply and demand dislocations – Exhibit 34.

Exhibit 33


Source: IHS, Mackenzie Wood and SSR Analysis

Exhibit 34

Source: Midstream Business and SSR Analysis

Propane and butane remain attractive feedstocks in the US, especially in light of propane’s recent decline. This is less obvious in Exhibit 35, which uses a 12 months rolling average. As mentioned on the previous page, propane is trading at around $0.37/gal in the US Gulf and has collapsed as a result of oversupply and building inventories. Propane inventories hit another record earlier this month and the EIA states that they are roughly 60% higher than they were a year ago. We expect more propane to enter the feedstock mix after this most recent decline despite falling propylene credit values. We give less attention to butane but it has also tumbled, down almost 10% at Mont Belvieau over the last month. We expect that this decline should also see a greater share of production based on Butane.

Exhibit 35


Source: IHS and SSR Analysis

Basic Plastics

Polyethylene pricing has continued higher even as oil has slipped on its own slick. Ongoing disruptions to production in Europe and East Asia have caused price spikes with US spot/export pricing approaching $0.70/lb. The question of how much demand growth can we expect has not yet been answered but it appears that, at least in the short term, supply, or lack thereof, is dictating pricing. Strong international pricing explains the uptick in HDPE prices at home but the obvious risk is still that capacity comes back online. We believe that the companies including DOW and LYN may benefit in their 2Q results due to this strong European pricing environment. As we progress into the second half of the year, it possible that the margin gains illustrated in Exhibit 36 will unravel should the US increase exports to capitalize on temporary arbitrages from these supply disruptions.

Exhibit 36

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 (37) summarizes the results and is a repeat of Exhibit 4.
Exhibit 37

Valuation Charts – Exhibits 3840
Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39


Source: Capital IQ and SSR Analysis

Exhibit 40

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:

  • Exhibit 41 shows each subsector’s Skepticism Index value. Since we last wrote, all subsectors but the Commodity group have seen their skepticism index values increase. Diversified has replaced the Coatings group as our most skeptical as the Coatings names did not see PNE expansion like they have over the past several months. Exhibit 42 shows R2 by subsector, measuring the extent to which valuation is explained by return on capital. Exhibit 43 shows that the Specialty subsector has the widest divergence between ROC and PNE. In Exhibit 44, HUN remains the company with the highest SI while CBT and ARG are at or near 10 year SI highs. SHW and NEU are at or near 10 year SI lows. Both NEU and SHW are overearning but are very expensive.

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

 

Recent Chemicals Research

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

December 9, 2014 – Weaker Global GDP Suggests Some Heroic Expectations/Assumptions

December 8, 2014 – LYB and DOW – A Holiday Present From Europe With Interesting Implications

December 4, 2014 – LyondellBasell and Westlake – Not Yet!

November 24, 2014 – Praxair – An Unusual GARPY Opportunity

November 11, 2014 – Eastman: A Good Story, But At Risk Of A Complexity “Own Goal”

November 6, 2014 – Capital Allocation – Why The Activists Are Where They Are

October 31, 2014 – The Power of Positive Thinking – APD and the DD read-through

October 16, 2014 – Commodity Chemicals – Overdone? Maybe Not

October 2, 2014 – DuPont Can Be a Bad Stock: If Trian is Right, But Gives Up

September 23, 2014 – Why 2015 Could Be a Short Sharp Storm for US Ethylene

September 17, 2014 – Rising Dollar and Falling Crude: Bad For Commodity Chems

September 11, 2014 – Oil: The Big Uncertainty for US Chemicals
(blog)

September 9, 2014 – Marcellus Opportunity: Why We Should See More Chemical Investment

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 45 to 49

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

Exhibit 49

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 50 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 50A

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 50B

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

©2015, 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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