Industrials/Basic Materials

Keeping DuPont Together – Corporate Denial or Corporate Vision?

Written September 17th, 2014 by

With Trian Capital’s letter to DuPont yesterday we formally open a debate that has been expected for some time – whether DuPont can create more shareholder value in pieces than it can as a whole.

At the 64,000 foot level there is empirical evidence that the market is penalizing business complexity more today than in the past – see chart – and this is a subject that we have written about in the past.  This alone is a reason for DuPont to listen to the arguments that Trian is making.

Trian is focused on costs as much as alignment and simplicity and the driver is the a number of “low cost” businesses that have outperformed, such as LyondellBasell, which has a much lower cost structure than for example Dow, while in many of the same geographies and businesses.   See our research for more on this subject.


DuPont is separating its performance chemicals business – and the plan is much evolved at this point, but Trian’s view is that this is not enough.  Their position is that only DuPont’s agriculture and nutrition businesses are truly specialty and require a significant R&D focus, with the rest better run at much lower costs and focused on cash generation.  DuPont has repeatedly maintained that there are significant R&D synergies and opportunities that cross the boundaries between Ag, Nutrition and Materials, driven by bioscience and that is why the businesses should stay together.

The battle lines are now drawn and the question is the one posed in the title.  DuPont needs to provide investors with more concrete evidence that what is so far only an R&D assertion, has some real legs – but now the clock is running.  Working against DuPont are a couple of historic realities:

  • The chemical industry has a history of overestimating the value of businesses as they fall to generic competition, and generally makes divestments a few years later than would have been optimal.  DuPont has done a better job of divestment than most.
  • Company managements often really struggle with the idea of shrinking a company – overvaluing the notion of size.
  • The chemical industry does not generate a return on R&D spending in aggregate and while DuPont claims that it has developed a way to measure R&D returns it has not shared this with investors, perhaps because the results are not what they want.  DuPont has shown better R&D returns than most of its peers, however.

If DuPont is going to win this battle/debate, they will need to do a couple of things in our view:

We would continue to own DuPont here as we think there is substantial upside either from what the company achieves internally or what can be driven through a restructure.

Oil – The Big Uncertainty For US Chemicals

Written September 11th, 2014 by

Oversupply in the oil markets has driven pricing lower over recent weeks with Brent hitting lows not seen in many months, and breaking below previous resistance levels.   Oil is the big risk for the recovering US energy and chemicals sector as it is the price difference between oil and US natural gas that drives all of the competitive advantage in the US and is driving the high levels of investment.

Oil can fall much further before most of the initiatives in the US begin to look much more marginal and investment returns are driven to lows that would cause pause for some of the investors.  However, there is a hierarchy of returns already based on the nature of some of the investments and the ones that require the most significant oil/natural gas spreads are probably already being questioned.

We have written extensively about the production costs opportunity in the US, the opportunity for European producers looking to exploit US costs and more recently on the potential advantage of building chemical capacity in the Marcellus rather than the US Gulf.

As oil falls relative to natural gas, not only do we risk the returns, simply from a relative price perspective, but we also risk natural gas production itself as the key incentive to drill in the Western Marcellus, for example, is based on the co-product values of both propane and butane, both of which are priced relative to an export netback, driven by international crude prices.   The most recent data in the chart showed the crude/nat gas ratio expanding as natural gas fell from its winter peak.  The last data point reflects Brent at $98 per Barrel.  This ratio needs to remain above 3.0 for every proposed investment to make sense – including exports of Ethane to Europe.  However, as the ratio falls we would expect US producers to lose margin.  For many products, global markets are oversupplied and it is only the US cost differential that is supporting US profits.

Brent to Nat Gas


Strong Manufacturing – Buy Industrial Gases

Written September 2nd, 2014 by

Industrial Gases generally and Praxair specifically are being left behind by the manufacturing related rally that has boosted values for many industrial and material names over the last two years.  Arguably, both Praxair and Airgas, through their extensive US packaged gas and merchant gas businesses should see more leverage to better US industrial production and manufacturing, than many other sectors and companies.  This logic applies also to Air Products, but to a lesser degree given its lack of packaged gas in the US.

Both this year and last year we have been disappointed with results from all three companies given the improved economy in the US, but the operating leverage is real – particularly for PX and ARG – given underutilized assets in the US and very high potential incremental margins.  Praxair’s return on capital is expected to return to its long-term trend assuming estimates are appropriate for the next 12 months (PX estimates are historically conservative) – see chart – but the opportunity is to return to the more recent trend – post the reshaping of the company in the early part of the last decade.  There is enough leverage in the US focused business to achieve this as demand improves.


Despite the improving trend in the chart above and even assuming the lower “normal return on capital” trend, PX is out of favor, with attention focused on APD and the new management.  As we have written in prior research PX is very cheap versus APD (second chart) – despite having the greater US manufacturing leverage.

In our view the opportunity today is in PX. ARG offers a more focused US exposure without the risks of Asia, Europe and Latin America, but does not have the valuation discount.


SWK – Business Momentum to Continue

Written July 28th, 2014 by

“We have a history of, if we can’t fix something in 18 to 24 months, we usually do something else with it. And we don’t fall in love with anything that isn’t earning its cost of capital.” – Stanley Black & Decker CEO John Lundgren

When we wrote about SWK in early April, we noted its indirect leverage to various housing and construction markets. With these markets hardly busting down the doors in 2014 year to date, it is all the more impressive that Stanley was able to post the strong Q2 that it did.

The company has shown a clear ability to control costs, and this has contributed to strong operating leverage – in the Industrial segment, notably, a 3% increase in volume translated into a 22% increase in operating margin. SWK management sees momentum in this segment continuing in Q3.

With the polar vortex winter cutting into the outdoor products selling season, CDIY volumes were flat but margins rose to a post Black & Decker merger high. The company gained share in Europe and expects mid single digit volume growth to resume in the second half of the year.

The Security segment importantly saw sequential improvement. It was noted on the conference call that the vertical security solutions are gaining traction in North America and COO Jim Loree indicated “we have some wins on the horizon that I think will be eye-opening in size.” This system is still a quarter or two (or three) away from being implemented in Europe, where attrition rates continue to moderate in the wake of the Niscayah acquisition from Securitas. Significantly, it was noted that Spain and Italy (representing 10% of European Security sales) are the main drags on performance there, with the company’s other 12 markets in the region seeing a turnaround.

The above quote from CEO John Lundgren likely also encouraged investors. The Security division has been a distraction from and a drag on a group of otherwise strong, cash generative businesses with stable return profiles and improving market shares.

All in all, this is still an inexpensive company with a very healthy stable of brands in the CDIY segment, exposure to the still strong OEM atuo market in the Industrial & Automotive Repair segment, and an improving story in the Security segment. It seems that in the latter segment, the trends will remain on a positive trajectory, and if some markets scuffle, the company has not ruled out cutting their losses. Acceleration in the housing and construction markets could provide an additional tailwind. The company felt comfortable raising their full year EPS range – the previous high end of $5.50 a share is now the lower bound with $5.60 the top end. We think SWK now has considerable business momentum and would expect the company wide margin improvements seen in Q2 to continue in Q3 as Security incrementally improves and the other segments benefit from operating leverage given the demonstrated commitment to cost control. Our valuation model has SWK fairly valued at over $120 per share, representing more than 33% upside from current levels.


Lyondell Numbers and Very Weak NGLs Bode Well for Westlake

Written July 25th, 2014 by

Lyondell reported very strong earnings this morning, beating consensus estimates by more than 10%.  The strength of their US olefins and polyolefins business was notable, given that the company has experienced a meaningful delay in restarting its La Porte (Tx) ethylene facility following substantial expansion work, as well as other operating constraints in the quarter.  Other businesses at LYB were strong, but in aggregate not much different to Q1 2014 and the approximate 37% sequential quarterly earnings improvement was focused in the US operations – and helped by a 4% lower share count.  The gains in the US for LYB were largely a function of the natural gas and NGL price movement down from the Q1 weather driven spike.

Estimates for Westlake, which is essentially a pure play US story, anticipate 24% sequential improvement.  To the best of our knowledge Westlake has not suffered any meaningful operational issues in the second quarter and should benefit from the same raw material cost reductions.  On this basis, perhaps Q2 estimates are conservative for WLK.  In its vinyls business Q2 has seen marginally higher values both for PVC and for the chlor-alkali business.  The company did mention an inventory cost headwind for the second quarter, but this could be more than overcome by higher prices and lower costs.

Even if Q2 is not a meaningful earnings beat, WLK should be quite bullish on Q3.  LYB has talked down the quarter a little based on the continued delays to the restart of the La Porte facility.  But LYB’s problems and delays to the restart of the Williams complex in Louisiana have a silver lining for WLK and for LYB.  NGL pricing generally has weakened over the second quarter, but ethane pricing has collapsed in recent weeks because of over-supply – lack of demand from LYB and Williams being part of the problem.  For LYB and WLK, who both operate ethylene plants in the Mid-West we have the added benefit of a reopening of the spread between Texas and Conway pricing for ethane – see chart.

Both LYB and WLK look expensive based on historic average profitability, but neither looks expensive on current earnings, though LYB trades at a 3x multiple discount to WLK today.   We prefer the focus at WLK, the MLP initiative and the move into Europe and would prefer WLK at the margin to LYB today even with the multiple premium.


Dow – Good Quarter Understates Potential – Particularly If Dow Can Stick To the Path

Written July 23rd, 2014 by

Dow Chemical managed to show growth in Q2 2014 despite a couple of headwinds, some of which were discussed and some were not.  Weaker crop markets and plant closures were discussed but the company also raised a second issue that was not really quantified but could be meaningful.

Dow is spending a great deal of time and money working on divestments and working on new builds in the US and in the Middle East.  We know from DuPont how much it is costing to carve out Performance Chemicals (well over $100m) and these costs are likely to be higher for Dow given the more integrated nature of facilities. This is not the only divestment that the company is talking about and so this is also elevating costs.

Consequently – SG&A and other costs at DOW are likely well above trend today and will come down significantly once these moves are made. The company talks about productivity gains and it is likely that costs are coming down at the operating business level and have scope to come down further – as we have discussed in the past, DOW probably has an overall cost cutting opportunity that would be similar to DuPont. The real operating cost run rate could be as much as $200-250 per year lower than it is today, before any major cost initiative. Unlikely that we would see any of this before the divestments are completed – so before end-2015.

Separately, Dow continues chase gains from divestments and Andrew Liveris made some interesting comments today suggesting that Dow is interested in coming to the negotiating table to talk about further consolidation within Ag.

We have suggested more than once that an open and candid conversation between Dow and DuPont might yield some interesting solutions for both companies:

  • A Morris Trust type transaction involving Dow’s chlorine business and DuPont’s Performance Chemicals business.
  • A JV on Ag.

In our comparison between LyondellBasell and Dow Chemical, published in April, we suggested that DOW has far more available levers to pull than LYB and in work published in February we come up with an $80 value per share if Dow could get it all right.  The risk is the same as always – every time that Dow has moved to an improving return on capital trend over the last 40+ years something has happened to cause a correction back to a very poor trend.  Some causes have been macro and others have been “own goals”.   It is hard to see that risk today, particularly with the focused message, but it was equally hard every time in the past also.


Aluminum – A Short Term Bubble or the Real Thing

Written July 11th, 2014 by

Aluminum pricing has continued on the upward trend begun in late 2013 and frankly has moved further than we had anticipated.  While we are quite bullish on the space and have written positively in both the metal and Alcoa, we have not expected the price to move as quickly as it has so far this year – see chart.


Demand is increasing rapidly and pricing in 2013 dropped far enough to make it very difficult for all but the very best to generate positive cash flow.  Consequently we expected supply curtailments to help pricing bounce off the bottom.  What we have not seen, and this may represent a near-term risk, is a supply response to the higher recent prices.  We would have expected some operating rate increases and perhaps some plant restarts, particularly in China, and it is not clear that this is occurring – yet.   Chinese exports of Aluminum parts continue to trend upwards, suggesting that global demand continues to grow and perhaps this is enough on its own to keep Chinese operating rates high enough to prevent price competition – it is not clear how robust China domestic demand growth has been year to date but it is possible that this has soaked up much of the China surplus.


If this is the case the only supply response can come from outside China – from facilities shuttered by western producers as prices fell.  We would not expect this to happen until prices have both moved higher than they are today and have either shown some consistency or accelerated because of real shortage.  In either case prices have much further to go and Alcoa can keep appreciating from here.

The risk is that there is a China supply response waiting around the corner.  Our guess would be that if it coming it is imminent and if we do not see it by the end of the summer we have a sustainable broad market recovery in front of us – as much as 12-18 months earlier than we had originally expected.

DuPont – Lower Guidance But Big Savings Ahead

Written June 27th, 2014 by

DuPont lowered its guidance for 2014 by around 6% last night, citing slower than expected demand in the corn market – too much to offset gains in soy.  Unlike FMC it appears that the DD problems were focused in the US rather than in Brazil.  There was additionally some weakness in the herbicide market due to weather.  Lastly the company has seen sales below expectation in the refrigerants sector of performance chemicals – mainly in the US.  We would offer the following takeaways:

  • It does not matter how robust your agriculture portfolio is, you cannot protect earnings and sales from movements in the two things that you do not control – weather and commodity prices.  DuPont’s CEO expressed disappointment here, which perhaps suggest some of the issues were within the company’s control.  At the end of the day you have to manage the things you can manage.  Weather is not one of them – at least as far as we know.

o   The agriculture business will always have a degree of unpredictability to it, but it should be nothing like the swings in the historic more commodity like segments where you have risk of losing both volume and price.

  • The core businesses are reportedly doing very well and continue on the growth path that has been evident for the last 12-18 months.  This is the future DuPont and it is doing OK.

Coincident with the earnings warning, DuPont chose to put more color around the cost initiative that the CEO outlined when speaking at a recent investor conference.   At that time she indicated that more details would be coming later in the year, so the release of more detail yesterday may have been accelerated slightly, to perhaps soften the blow of the guidance.  In recent research we suggested how this cost initiative might evolve and how large it might be.   We got the overall magnitude right, but we underestimated how much might be achieved within 18-24 months.

  • If DuPont can really pull as much as $650 million of costs out by the end of next year it will do have achieved several things: first it will spin out a performance chemicals business with a very competitive cost structure.  Second it will eliminate all potential stranded costs and third it will lower the cost base of the residual DuPont meaningfully also
  • Moreover, the new DuPont is not a commodity company – this is not about keeping up with declining cost curve and therefore giving all the savings to the customer.  These cost reductions should fall to the bottom line.
  • Even in the performance chemicals business DuPont should keep most of the savings as the company defines the low end of the cost curve and pricing will only come down if the companies at the top end of the curve cut costs.

Bottom line, the earnings guidance is unfortunate, but the core story is unchanged.  Historically, buying DuPont on an earnings related dip has been the right move – we see this as no different.


APD – A Wise, But Not Long-Term, Compromise

Written June 18th, 2014 by

It is evident that APD has struggled to find the right candidate to replace John McGlade as CEO.  The search has taken longer than would have been expected – suggesting that multiple candidates were screened/approached.

It is a shame that APD could not find the right younger guy with the time and the willingness to execute the 8-10 year plan that we think is required, but the company has made the right compromise by bringing Seifi Ghasemi into the lead role.

  • Seifi has direct experience running an industrial gas business as he lead BOC’s US business in the 90s
  • He has been a director of APD for more than 6 months and by now should have a good handle on what needs to be done and what can and cannot be done quickly.

o   We should see strategy implementation fairly fast.

  • He is very popular with analysts on both sides as he has done a good job with Rockwood.
  • He is capable of making the hard decisions that are needed at APD

On the negative side:

  • At 69, we doubt whether he plans to say for as long as it will take to fix the bigger problems

o   So we quickly get back into the debate around succession

  • In our view he is more of a deal maker than an operator – APD needs both, but needs a strong operator more desperately.

The deals will help – if the company can pull of a few asset swap or straight divestments quickly this will likely give investors confidence that the story is moving in the right direction.  But again there are some constraints:

  • The stock valuation is very high – sales will be dilutive for the most part.
  • The company may be in a stronger position to buy, but given past performance with acquisitions we do not think it would sit well with investors.
  • A broader company break-up is again impeded by valuation as APD’s multiple is so much higher than the sum of its parts today even with the most aggressive assumption

To justify the price today APD has to grow earnings and grow them quickly and this is why we cannot recommend chasing the stock here.  Near-term growth will be very dictated by investment decisions made over the last 2 to 3 years and we are not confident that these are going to generate the returns needed to improve earnings.  The company is doing very well in its Chemicals and Engineering business, but very poorly in its core gases business.

A cost cutting initiative would perhaps help, but tensions must already be high within the ranks at APD and a major lay-off today will do little to focus attention on the internal changes that need to be made.

A divestment program – while likely to be small will benefit the asset buyers at least as much, if not more than it benefits APD.  We still think that PX and ARG are the better bargains in the US, and the valuation gap between APD and PX has moved back close to an extreme today as shown in the chart.

We see today’s move as a possible reason to support current valuation at APD not a reason for it to move higher.  We would still prefer PX.


Westlake – Another Interesting Move – Vinnolit

Written May 28th, 2014 by

We have written about some of the opportunities to move the US shale advantage to Europe.   While they are limited, they revolve around cost effective ways of moving low cost molecules from the US to Europe – or other parts of the world.  The optimal solution is to move something with as much US cost advantage as possible in the manufacturing process in a form that is also cost effective to ship.

Whether or not Westlake has plans to move US based PVC feedstocks to Europe to support its Vinnolit acquisition, it is this product chain which in our view provides the greatest economic opportunity.  Both ethylene and chlorine in the US have significant cost advantages versus Europe and EDC (ethylene di-chloride), as a liquid, is relatively inexpensive to transport – see associated research, from which the chart below was created.   Simply put, you can add more value to a European producer (on a ton of ethylene basis) by moving EDC from the US to Europe than by moving anything else.


Like everything, it is not quite that simple, as to move from EDC to PVC you either need more ethylene or you need to be able to dispose of hydrochloric acid (depending on your process), but these are issues that can be overcome if the economics are good enough.  As we have indicated in the past, it will be far easier and more stable for the European market to move 200,000 tons of PVC raw materials to Europe – to one consumer than to try and sell 200,000 tons of PVC into an oversupplied market – in transactions for a few thousand tons each, at best.

Alternatively, Westlake may be able to achieve better economics without shipping anything, given that at least one of Vinnolit’s current ethylene suppliers in Europe has a large US presence and there may be the ability to swap product in the US for products in Europe.

Whether or not this is what Westlake plans – in large or small volumes – it is only one of several reasons why this transaction looks interesting:

  • Timing – we have written recently that across all industrial and material sectors Europe appears to have turned. While the growth rate might not be high, it is positive rather than negative.
  • Valuation – Westlake is picking up the business for a good price – a fraction of what the replacement value would be.  This is a function of European profitability over the last few years.
  • Consolidation: the European PVC market has been horribly fragmented and we are beginning to see signs of change with Ineos and Solvay combining forces.  There are other assets that Westlake should look at in Europe, but even without them Westlake is likely buying into a better market structure than existed previously.
  • Technology: Vinnolit has some interesting specialty PVC products in Germany and in the UK and there will be opportunities for Westlake to expand sales of this product line in the US and possibly Asia.

This move, in addition to the recently announced MLP split, shows that WLK is very focused on creating value.  The stock has had an extraordinary few years, but the company has always been a great steward of its capital and cash, and continues to think outside the box.

While we might bet against the ethylene cycle and a long term high price differential between US natural gas prices and global crude oil prices (we are comfortable with the medium term), we would not bet against WLK within those confines. The likely MLP yield supports owning the stock even at current levels, though it does not support a lot more upside.

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