SMID Cap Chemicals – Plenty of Interesting Ideas

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 7th, 2017

SMID Cap Chemicals – Plenty of Interesting Ideas

  • We apply and restrict the SMID analysis we previously published on the Industrials & Materials space to the Chemicals sector specifically.
    • While additionally we are looking for a commodity exposure screen (based on recent work) in this analysis this is generally picked up in the sales/employee metric.
  • After analyzing multiple currently relevant factors, alongside valuation and our 2017 fundamental framework we derive these higher conviction ideas:
    • On the positive side: CF and UAN, ASIX, TSE and WLK
    • On the negative side: FMC, PAH and SHLM
    • In general we are avoiding any company with less than 50% of sales in the US and we do not see Trump policies (as suggested so far) helping the Ag industry in any way.
      • This produces two problem stocks VSM, which we like and think can outperform despite its largely offshore sales and GRA, which is attractive in enough factors to earn a place in Exhibit 1 but has only 31% of sales in the US.
  • Our six dimensions of analysis are overlaid in each instance with valuation and growth metrics for reference (click to jump to a section):
  1. US sales focus – potential benefits from America First stimulus.
  2. High current effective tax rates – upside to lower corporate rates.
  3. High sales/employees (relative to the group) – less impact from potential wage inflation – more operating leverage – generally commodity names, which we like.
  4. Offshore cash–favorable repatriation terms could result in large buyback/dividend programs.
  5. Performance since Election Day – those that have been missed, are down on earnings, or have the most potential upside remaining.
  6. Optimism–tendency of corporate optimism to manifest itself in poor capital allocation decisions and underperformance is amplified in the SMID space.
  • We list our group of 32 SMID cap (<$10 billion) Chemical stocks on each of these dimensions.
    • Exhibit 1 summarizes the stocks that appear in the top 5 on the most lists.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We apply the same filters that we applied to the overall Industrial and Materials stocks to the 28 Chemical stocks that were in that analysis plus CC, TROX, KRO in the TiO2 space and CF, UAN and PAH, which we missed previously. We look at a number of factors to identify opportunities notwithstanding the following broad issues/concerns:

  • Most companies highly leveraged to an uptick in US infrastructure spending are already discounting prior peak earnings or better.
  • There have been rallies in stocks and sectors which have been plagued by high levels of cheap Chinese imports – in part because of reduction in Chinese material in the second half of 2016 but mostly because there is an expectation that the new administration will be harder on Chinese “dumping” than the prior administration. Furthermore, it appears that smog/pollution controls are limiting China production further – positively impacting commodity markets.
  • It is a little harder to play the offshore cash repatriation idea because it is unclear what constraints will be placed on the repatriated cash and it may take a while to get agreement on this through Congress.
  • The general rise in the market is probably more to do with expected lower taxes and higher buy-backs and dividends than it is general confidence in the new administration, but this policy change will also take time.

President Trump is already proposing a lot of changes and investors are going to have to come up with a set of assumptions around which of those ideas are likely to come to fruition and in what timeframe. In this SMID cap piece we focus on exposure – in an attempt to identify stocks that could benefit from any number of tacks that policy might take over the next year and have the valuation support to look like reasonable investment ideas. We provide all the factors that we have considered for all 30+ stocks so that clients can prioritize as they see fit. At the other end of the scale we look at stocks that are already pricing in too much – i.e. more positive impetus than their business mix and fundamental drivers justify.

We do not use our comprehensive “normal value” framework for most of the companies include in this analysis because many do not have the history to construct the model or do not have an obvious proxy. As a measure of value we look at free cash flow and valuation versus return on tangible capital (ROTC) – Exhibits 2 and 3. Despite its very strong performance in 2016, TSE is a standout as attractively valued when looking at ROTC. That may be in part a function of some fairly well depreciated assets but it helps to support our view that this stock still looks interesting despite its strong 2016.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

We like some of the fundamentals behind a few of the cheaper companies here, such as VSM and TSE, but they do not make the cut on this analysis because they have too much of their sales base outside of the US and are vulnerable both to trade policies and a strengthening dollar. Fundamentals and strategic actions may overcome the headwinds for both, but they do not tick enough boxes to make the cut in this piece.

We have included a very basic fundamental overlay which is as much subjective as it objective. On the positive side we have looked for companies with more than 50% US sales and likely to benefit from one or more of three things:

  • US infrastructure spending
  • US manufacturing growth
  • More limited imports of competing goods from China
  • Commodity exposure – given our more positive view or all commodity markets (this moves TSE to the left of the table)

On the opposite side of the fence we list companies with more limited US sales and that have little in their business mix which would benefit from the four factors above – Exhibit 4.

Exhibit 4

Source: SSR Anlysis

US Sales Focus

Roughly half of the group have more than 50% of their sales in the US, but only four have more than 75% including OLN, which we think is well placed because of Chlor-Alkali recovery, and ASIX because of its potential exposure to US construction/infrastructure. UAN should be positively impacted by rising Urea prices, though is not as attractively placed from a feedstock and leverage position as CF in our view.

Neither BCPC nor SMG are likely to see much benefit from proposed Trump policies based on their business mixes and end markets – unless of course we are all driven to smoke more pot, in which case buy SMG!

Exhibit 5

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

 

Tax Rates

The assumption here is that Trump will try to cut US corporate taxes and that those with the highest effective rates – often those with the highest concentration of US sales – will see the greatest benefit.

Tax rate concessions as well as repatriation of offshore cash (less relevant in the SMID space), will likely come with strings attached in terms of the proportion of new free cash that companies have to reinvest, but as we have seen in past attempts to stimulate growth in this way, companies find ways to funnel the cash to buybacks, dividends and M&A, where the M&A generally results in fewer jobs and lower new investment than the opposite.

Clearly some of the higher tax rates shown in in Exhibit 6 are the result of special circumstances – either reflecting a translation – or lower reported income but taxes based on a GAAP income. This is certainly true for any company paying more than 40% tax in the last 12 months. Those with the higher US sales in Exhibit 5 are likely the companies with the most to gain long-term from sustained lower US tax rates.

Exhibit 6

Source: Capital IQ and SSR Analysis


NOTE: n/a indicates estimates not available, NM indicates a negative measure

Sales/Employee

We are using this measure as a sign of leverage – companies with high sales per employee often have the highest incremental operating leverage, benefiting the most from incremental sales. In addition, should Trump policies lead to inflation and wage rises, these companies are less exposed.

Additionally, those with higher sales per employee in the chemical space tend to be those with more of a commodity mix to the business – something we like today. While NEU is in the top 5, its predominant overseas business mix would not get our attention, and neither would its valuation.

While UAN looks like the most interesting company on this list and others we would focus our nitrogen fertilizer attention on CF which has more leverage to a recovery because of capacity expansions but also has a much better aggregate cost base than UAN. The most levered name in the space is LSB industries (LXU) – very small cap and in the middle of a broad strategic review managed by Morgan Stanley. LSB could double or triple in value if ammonia and urea have a real recovery and would have been a Chapter 11 candidate without any recovery in our view.

UNVR is a distribution company – sales to employee numbers are high but margins low.

As indicated in prior research we would rather play TiO2 through HUN than CC because of litigation risk at CC.

Exhibit 7

Source: Capital IQ and SSR Analysis


NOTE: n/a indicates estimates not available, NM indicates a negative measure

Offshore Cash

The potential repatriation of offshore cash holdings has received attention and there are a number of SMID cap chemical companies with significant cash in foreign jurisdictions. In Exhibit 8 we have expressed the amount of offshore cash as a percentage of the company’s current market cap – equivalent to a special dividend or the potential reduction in share count if the repatriated funds were used to buy back stock. We assume a 15% repatriation tax.

With the exception of PAH and ASH none of these companies has much overseas, and those that do tend to have the larger overseas revenues exposure, which would be an offset. ASH would be the exception with the offshore cash likely more a function of what the company used to look like (with Valvoline) rather than what it looks like today. ASH appears towards the top of two of our tables and is not expensive.

Exhibit 8


Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Performance since Election Day

This is in part a momentum indicator, showing what stocks have run post-election in anticipation of gains derived from Trump policies – those are the companies at the bottom of the table. As habitual seekers of value we are more interested in those that have not run, hence the upside down table. It is important to note that there are likely no companies on any lists here likely to see direct earnings gains from anything the new Administration does before, at the very best, Q4 2017. Consequently, for the outperformers there is a risk that expectations get ahead of what is practical and we see some earnings misses before we see the gains.

Of the poor performers only ASH looks interesting given end market exposure (unless you go back to the

“pot” idea). Most of what we like has done well so far and we would expect those names to continue to perform well. We would be concerned about PAH – particularly given FMC’s Q1 guidance.

Exhibit 9

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Optimism

We often reference our work on corporate optimism as a complement in our process of identifying investment opportunities – simply put, those companies that habitually guide to realistic earnings expectations and subsequently over deliver not only predictably outperform, but have been shown to exhibit expanding returns on capital relative to their more overly-optimistic peers – they make better capital allocation decisions – Exhibit 10 shows the gap between the most conservative and the most optimistic. In the Chemicals SMID space the results are exaggerated compared to the large cap group, where underperformers are more readily identified and held (sometimes forcefully) accountable. In Exhibit 11 we show the most conservative companies in the group – those that have consistently over-delivered and the measure is by how much annual earnings have beaten expectations.

The measure is called “Optimism” but we are actually looking for the least optimistic companies and the indicator can be confusing in its labeling if you have not followed our work here – in Exhibit 11 WLK has most consistently overdelivered and by the most significant level.

For this group a measure of the returns on investment differences – optimist versus conservative – is shown in Exhibit 12.

This analysis makes us more comfortable with our preferences for CF and WLK, and probably HUN. It is a concern for ASH and OLN, although OLN’s guidance for 2017 looks more conservative than prior years.

Note that there are a number of companies for which we do not have enough history or enough credible data to run this analysis yet – we would note that TSE has been conservative since going public – PAH has missed a few times and CC has had some wins and some losses.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

NOTE: n/a indicates estimates not available, NM indicates a negative measure

Exhibit 12

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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