Weekly Findings – October 7th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

October 7th , 2018

Weekly Findings – October 7th, 2018

Thought for the week: “Industrials are being pulled up more by the broader market rally than Materials – setting up for trade – but maybe not quite yet”

  • Chart of the Week – A Compelling Materials vs Industrials Trade – Almost
  • RPM – If It Wasn’t Broken, There Would Be Nothing To Fix.
  • A Very Expensive Train Set!
  • Ethylene – Total/Nova/Borealis – Brave or Foolish
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – A Compelling Materials vs Industrials Trade – Almost

While it may not feel that way too many investors, almost everything is getting pulled up in absolute value terms in Industrials and Materials, while still generally underperforming the “F.A.N.G.” (etc.) driven broader indices. In the chart of the week, we show the fifteen companies most expensive on an EV/EBITDA basis, versus a 12 years history and the fifteen least expensive on the same basis. The fifteen least expensive are the only 15, out of 120 companies, that are below average – everyone else is above. There is a very strong bias towards Industrial companies in the group on the right-hand side of the chart, with only one Materials company, ECL. The left-hand group is also well represented by Industrials companies. However, when you look at the aggregate groups, Industrials have done much better than Materials. On a relative basis that difference is shown in the discount from normal summary in the first exhibit – with the materials sectors on the right-hand side of the chart and showing the largest current discounts. Both the chart of the week and the chart below were taken from our industrials monthly – linked here.

In absolute terms, neither sector is keeping up with the S&P500, first and second chart below, but Industrials is clearly doing better – and better again in September. If we plot the two sectors together we see the widening gap – third chart, but there is not enough information in that chart to tell us whether we have a compelling investment opportunity, even though we have included the “gap” between the two multiples in the third chart; and it looks high.

To take the analysis further we have looked at the statistical significance of the gap between the two multiples in the fourth chart.

  • The premium in Industrials versus Materials is statistically significant – above 1 standard deviation and you have generally made money overweighting Materials and underweighting Industrials when this has happened in the past.
  • However, there have been occasions where the discount has increased before it has corrected, and this may be the case today.
    • We do not have consistent data for an index based on a large group of companies that extends far enough back to capture the Tech bubble and we may revisit this in separate research if we can find company groupings that make sense – much easier in Industrials than in Materials.
  • Fundamentals remain shakier for Materials – creating greater investor nervousness driven by:
    • Higher energy prices – leading to higher raw material and conversion/extraction costs.
    • Trade – more of a general concern for materials – especially metals and chemicals – rather than stock specific as it is in Industrials – e.g. OSK.

We think the analysis is interesting and while we continue to have a bias for Materials today, we would note that this has been our position all year and it has not worked. However, we do think that the discount can increase because of the greater fear factor in Materials today – especially if we get a series of earnings misses/negative guidance over the next few weeks because of higher input costs – mostly focused in basic chemicals, but as RPM has shown this week, it can happen broadly.

We remain focused on mid-cap intermediate chemicals – especially on any earnings-related weakness as we have high conviction that M&A is going to pick up. Plus, almost anything in Paper and Packaging as well as PX and AA.

  • RPM – If It Wasn’t Broken, There Would Be Nothing To Fix.

There are a number of companies that we like because a change in strategic direction and/or M&A should create opportunities for growth and better earnings that is not reflected in share prices today. This list would include, KWR, FUL, DWDP (notwithstanding the ethylene pressure today), SWK and RPM. With the change in leadership at GE this week there are those who would add GE to the same group – we would not.

In all M&A and new leadership/strategy stories, you have to buy-in for the longer-term, unless you get lucky with an immediate transaction: this is certainly the case with RPM. While some sort of sale or merger might be the end-game for RPM, investors, including the activist, would likely be giving up significant value selling today rather than selling once the company has been restructured and the costs lowered, and margins improved – one of the key tasks is to lower an inflated SG&A cost – first chart – by restructuring the way the company is run and dismantling the “holding company” structure to drive cost efficiency. It is highly unlikely that RPM would find a buyer today who would pay enough for that opportunity.

In the meantime, the business fundamentals – such as raw materials pressures – will continue and cannot be corrected or mitigated overnight – this is exactly the same issue that FUL has as it drives synergies from the Royal acquisition. While the companies may be implementing plans to lower costs, to restructure raw material contracts and drive higher margins, they cannot protect themselves from short term noise. If you are buying these stories you are buying better long-term trends and should expect some near-term volatility.

However, it is reasonable to ask the companies for more appropriate guidance and better forecasting of their quarterly performance – part of building investor trust around a new strategy is building a better dialogue around how the business is operating and we would encourage RPM (and FUL) to overcommunicate and minimize surprises over the next couple of years rather than do what both have done recently and simply miss numbers. As shown in the second chart, RPM is an optimist, overestimating earnings consistently, albeit not a terrible optimist (there are many who have average earnings misses of much more than 3%). The company needs to turn this around, as under promising and over-delivering is the way to gain investor trust and reflects in higher shareholder returns.

We still think that both the FUL and RPM stories will work, for the patient. RPM is all about changing an inefficient business model – before a possible sale. FUL is all about integrating a large acquisition effectively, also before a possible sale. In both cases there is always the upside risk that a buyer could appear quickly, especially if they believe they can get the improvements/synergies better than the companies can alone today. SWK would be a “left field” acquirer of RPM – same business model – lots of SKU’s sold into big box retailers and a very good integrator of acquisitions. BASF or “New Dow” would be likely buyers of FUL – or EMN potentially.

  • A Very Expensive Train Set!

Transports in general are having a very good year, and, as shown in the first exhibit, September was no exception. In the chart of the week, there are a number of transport companies in the top fifteen expensive stocks. The rally in transports is focused in trucking and rail rather than the delivery service group – UPS/FDX etc., and the rail specific relative valuation is shown in the second chart. Note that the group is expensive on a relative basis versus an expensive overall market – so consequently more expensive versus history on an absolute basis. As shown in the third chart, which shows a negative skepticism index (SI), this is happening without forward earnings support – i.e. the premium valuation is discounting a major improvement in profits, not yet reflected in consensus, rather than reflecting an already higher level of earnings. Rails is the only sector within Industrials and Materials today with a negative SI index.

On an unweighted basis, average EV/EBITDA is well above normal – exhibit below – more so than for Industrials as a whole, and probably a clearer underweight signal than the broader space, though not as obvious as it was in 2016, suggesting that the outperformance could continue a little longer. All the rail stocks are up again this week, more than the market, though not enough to make our weekly winners list. As shown in the second chart – CSX is the valuation outlier today (versus its own history), with NSC and UNP reflective of the average chart. The smaller cap names look more undervalued and more interesting. This is better reflected in the third chart which show current standard deviations above/below average EV/EBITDA multiples.

  • Ethylene – Total/Nova/Borealis – Brave or Foolish – Or Too Late

This week the JV between Total and Nova/Borealis announced that the final investment decision had been made to build its new polyethylene complex in Texas. The move appears either brave or foolish as we have no record – in 40 years – of anyone making an investment decision anywhere in the world in basic chemicals when the margins at the time of the decision did not support the investment. US ethylene margins are below zero for the 4th month in a row – first chart – and integrated polyethylene margins – second chart are at their long-term average and do not come close to creating a return on the capital required to build both ethylene and polyethylene. Margins would need to be above 35 cents per pound to generate an adequate return on an integrated ethylene/polyethylene complex – versus less than 14 cents today.

The reality is that the joint venture likely does not have a choice. While we would be a little surprised if this was the case, it is possible that the ethylene plant associated with this polyethylene plant is beyond the point of postponement and/or cancellation – i.e. too much capital has already been committed – at least in the eyes of the partners – either on site preparation or on long-lead items. (Note that in the 1992 to 1994 period a couple of ethylene plants were cancelled at a more advanced stage than the Total/Nova/Borealis facility is today).

While the “too far along” argument may be the case, it is more likely that, having spent a great deal of time and effort creating the JVs (there are two) and because all three companies are thinking about “shared risk”, no one is willing to examine the possibility that the decision should be revisited. Also, from Nova’s perspective, not building the polyethylene facility would only create a larger headache given the ethylene surplus that the company acquired with the Williams purchase.

But maybe the brave will be the winners – the first recent wave of ethylene investment in the US – those facilities that have started in 2017/18, and where investment decisions were made at the margin peak in 2014, are all losing money today. The real winners in this industry, and there are very few, have the guts to invest (build or buy) counter-cyclically – i.e. invest at the bottom of the cycle. Perhaps, if they stick to their plans, Total, Nova and Borealis will look like heroes if the ethylene and polyethylene markets are very profitable 3-4 years from now.

In our view – see research published earlier this year – the odds of a strong ethylene market diminish with each year as you pass 2021/2, given the continued willingness to build in the US Gulf based on NGLs and the inevitable push from oil companies and refiners to look for demand in chemicals as demand for gasoline and diesel peaks. The IEA has published a very detailed report on oil and petrochemicals this week and we have included a link below – it is a MUST READ in my view for anyone active in the sector. Their supply forecast syncs very well with what we wrote back in April, but in our view their demand forecast is way too bullish for a variety of reasons that require more complete analysis than we can get into in our weekly forum – but we will.

https://webstore.iea.org/the-future-of-petrochemicals

  • Weekly Winners and Losers

We still believe that the confidence rally in GE is misplaced and that as capable as Mr. Culp may be, he will be limited by the hand he has been dealt – we would be sellers of GE on strength.