Industrials/Basic Materials

Petrochemical-Fest – A Summary of the Texas Gathering

Written March 31st, 2014 by
  • General euphoria over the opportunity presented to the US by the abundance of shale gas – estimates of expected investments in the sector 30-40% higher than they were a year ago.
  • There have been plenty of basic chemical investments announced but it is clear that there are more in the feasibility phase. Forecasts of forward oil and natural gas prices in the US will do nothing to deter such moves.  IHS has oil rising from 2017, with natural gas flat, suggesting that ethylene margins will rise from current levels as new facilities start-up.
  • However, the IHS forecast assumes only 6 new ethylene facilities by 2018/19 (10 announced), and admit that ethane supply becomes an issue if more are built and that ethane pricing would increase above its extraction value with more demand.
  • Still plenty of capacity coming on line in China and the Middle East over the next 5 years – IHS tracking 53 coal to olefin plants in China which they believe will be built.  IHS also very cautious from a macro perspective about growth in China – citing debt/GDP and the quality of that debt as a major concern.
  • In our view the biggest mistake being made is forecast growth – ethylene demand growth ratio to GDP has broken down in the last three years, in our view because of the high prices, and is not an anomaly.  Growth shortfalls could make the 2017-2020 landscape much less friendly for all.
  • Near-term it is hard to see what will trip up the margins and cash flows.  This is priced in to WLK and LYB without consistent and “assured” return of cash to shareholders.  DOW supported by possible break-up value – otherwise expensive.  AXLL looks more interesting and Q1 earnings pullback presents an interesting entry point.

Overview

Unmatched optimism from the US companies and unmatched pessimism from the Europeans.  This is probably the best way to describe an industry gathering that I have been attending in Texas off and on for the last 26 years.  The Americans are more optimistic than they were in the late 1980s.  That was a period of misplaced confidence because the US did not have much of a cost advantage and the Middle East was emerging.  Today, even taking into account the lessons of the past, it is hard to poke holes in the optimism – which in our mind makes it far more dangerous.

We remain very concerned that the consensus view of forward demand is incorrect, with consensus choosing to use an historic ratio to GDP growth which has clearly been incorrect for the last three years.  As we have written now ad-nauseam, price elasticity explains the breakdown of the relationship and all forward estimates have pricing as high as it is today or higher for many years.  This will continue to encourage recycling and down-gauging and cut into organic growth.  Consensus views do not have high operating rates at any point in the future and if demand growth is out by 100-150 basis points a year, the operating environment will look increasingly poor as new US capacity is commissioned.  In such an outcome, you could see North America, the Middle East and possibly China trying to move incremental molecules to Europe and Latin America.  None of this will happen without real price pressure, everywhere, and it is unreasonable and naïve to assume that European higher cost producers will simply roll over to accept imports.  In the chart we show our base case for operating rates and how they would look in a 2.5% growth environment – versus the historic average of 4.15%.  Note that the global operating rate does not decline to the lows seen in the early 80s even in a lower growth environment.  As we indicated in research last week, if the US loses its competitive feedstock position, much of the surplus would be in the US and US operating rates could return to their lows of the early 1980s.   

Exhibit 1

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Source: IHS, Wood Mackenzie and SSR Analysis

Even with this fear, the bulls can justify building in the US because of the oil/natural gas differential.  If margins in the US fall by 40-50% (because ethane prices rise relative to natural gas) you may go from a 40% return on capital to 15%, which still beats the industry’s single digit historical average.

As we indicated in research last week, the wheels only com off if the US oil/natural gas ratio collapses back to fuel value.   The most likely cause, in our view, would be increased US LNG exports, enough to raise natural gas prices domestically.  If we had a scenario in which US natural gas increased to $8 per MMBTU and crude fell to $80, which is a long way from where we are today, but by no means a crazy idea, the US would no longer be a competitive exporter, and the oversupply in the US would result in increased local competition and much lower pricing.

Today there is not much to do as an investor – except to keep pressuring the existing US players to return cash to shareholders rather than participate in the capital spending frenzy.   We would like to see the following:

  • LYB should undertake – explicitly – to behave like an MLP and return a high fixed proportion of its cash to shareholders – dividends are better than buybacks because you are buying the stock at a peak, even if you are buying it at a great cash flow yield.
  • WLK should do the same as LYB. Both would have some upside on that basis, but not without in our view.
  • AXLL should look for ways to achieve as much of the ethylene “cost economics” that they want, while spending as little cash as possible.  AXLL’s share price looks interesting at these levels as most of the pull-back post Q1 guidance is in response to a one-time event.   The caveat here is that the winter has continued on the poorer than average trend since the guidance, so there could be further earnings slippage.
  • DOW should focus on whether, with the expected cost inflation around the US projects – skilled labor etc. – they still makes sense, particularly if other participants help bid up ethane prices after 2018.  Dow may be able to buy the ethylene capacity it needs cheaper in the future.  Investor focus will be on a possible restructure of the company in the short term and while we see the stock as more than fully valued in its current configuration, an Ag spin could generate some further upside.  We see no evidence that DOW is yet ready to tackle its higher costs.

After The Storm Clouds Clear – What to Buy On A Dip

Written March 14th, 2014 by
  • We expect many of the companies in our coverage universe to miss first quarter estimates – either choosing to guide down proactively over the next few weeks or simply coming up short when they announce.  This will provide some incremental buying opportunities for some companies and may undermine (over)confidence at others.
  • The misses will mostly be US weather related, reflecting either weaker demand or the cost pressure caused by higher energy prices.  While this should be largely expected, the market has for the most part ignored the risk and estimates really have not fallen that far.
  • Those that have offered guidance have taken a valuation hit, and where these are reasonably priced companies levered to the broader recovery in US manufacturing and general economic growth we see a buying opportunity.   We would focus on HUN, OLN, OI, BLL, SWK, DE and AGCO, but include a longer list of interesting names in the report, including several in the transport space.
  • Equally, companies that are discounting very lofty earnings expectations may have the marginal confidence knocked out of them if they miss Q1 materially, regardless of the excuse.  Here we would be most concerned about SHW, CYT, SEE, GNRC, HON, RPM and GWR.  These names are more likely to see a more permanent exit from non-traditional holders, and further downside.
  • The other downside risk sits at the commodity chemical group, where the higher costs in Q1 have been dismissed as a short term distraction.  If natural gas prices stay high – $4.50-5.00 (perhaps because of an expected hot summer and low inventories), this group has the most significant downside in our view; LYB, WLK and DOW.
  • For the medium term, we continue to see the Capital Goods space as the most attractive from a weighting perspective and would add ETN and CMI to CAT and SWK in the table below.  Outside Capital goods we are much more selective.

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European Chemicals – The Saber Rattling Starts – At Last

Written March 10th, 2014 by
  • INEOS CEO sees the European chemical industry at risk of failure within 10 years
  • The issue is relative energy costs – something we have written about and a conclusion that we share
  • Non-US companies are investing in the US to get access to cheap US feedstocks, but only INEOS itself in Europe
  • Risk for Europeans if they ignore the cost difference
  • Risk for US producers if too many people build in the US and there is not enough ethane/propane

Echoing our comments in research we published late last year, INOES chairman Jim Ratcliffe, in an open letter to the president of the European Commission has questioned whether much of the European chemical industry will be around in 10 years’ time.

As you would expect the central issue is energy and Ratcliffe is making the same point that we have made, which is that Europe cannot compete with the energy advantages in the US and the Middle East.  Moreover, many of the “green” policies in Europe are making matters worse by inflating electricity prices to justify solar and wind investment and restricting local E&P initiatives such as exploiting significant shale opportunities in Europe, both in the UK and on the continent.  In his letter, Ratcliffe suggests that electricity prices in Europe are 50% higher than they are in the US for industrial users – we actually think that in many locations the difference is higher.

Increasing European natural gas production through pursuit of shale base opportunities would not necessarily have an immediate impact on European natural gas prices as the region is very deficit, currently importing significant volumes from Russia and significant amounts of LNG from the international markets. However, it might make available some stranded ethane, which would help European production economics.

Our fear for Europe is that significant investment in lower cost chemicals in other parts of the world will ultimately lead to meaningful exports to Europe and a consequent fall in European pricing, squeezing the life out of many European producers.  The knock on effects for Europe would be more than just the direct jobs lost in the chemical industry as large consumers of derivatives of basic chemicals might be persuaded to relocate off-shore to get access to cheaper materials, cheaper power and possibly cheaper labor.

We have seen a couple of Asian chemical producers recently announce investments in basic chemicals in the US, Lotte and Shin-Etsu.  These companies are looking for lower cost ethylene based on cheap shale gas and these would be new business for each company – Shin-Etsu has existing PVC operations in the US, but also has assets in Europe – which could be supplied from the US – Lotte is building in joint venture with Axiall and will build ethylene glycol capacity to ship the product out of the US.   As yet the only European company looking to exploit the US cost advantage is INEOS itself.  The company has a large existing business in the US, but is investing to move US ethane to Europe, has just commissioned a new ethylene import terminal in Antwerp possibly to bring US ethylene to Europe and is looking at adding a new ethylene unit to its US complex at Chocolate Bayou.

The real risk for US ethylene producers is that everyone comes to the US for feedstock and that we get more ethylene units built than there is ethane feedstock for them – ethane prices rise because of scarcity and the US advantage is gone.

14 for 14 Portfolio Update – February and YTD Performance

Written March 6th, 2014 by

This year, for better or worse, we have decided to update our portfolio performance on a monthly basis.  As a reminder we began the year by recommending 14 larger cap long ideas and 14 names that we would be more cautious about.  We screened 7 and 7 in the mid cap space and also did a sector specific screen for Chemicals.  These are picks for the year – not for any given month and they are slightly more biased to valuation than they are to fundamentals/revisions.

  • Auto exposed stocks were among the best performers in February – good for CMI as a long, bad for PCAR as a short. Undervalued large cap performance was mixed, with pockets of relative strength (DD, SWK) and weakness (CAT and AA, after both gained strongly in January). For the large caps on average, the long and short screens had nearly identical performance, both above the market by about 1.5%.
  • Our mid caps were the most successful screen in January, but showed the poorest performance in February. KBR guided down significantly, weighing on the longs, and GNRC defied our short, bouncing back after a poor January to post the largest gain of any stock on any of our screens.
  • Long side Chemical picks beat the market handily, by 5%, but again, the short side was up as well. Only one stock on each side trailed the S&P (AXLL short, OLN long).
  • With Q4 2013 earnings all but wrapped up, we include a chart showing the 5 most positive surprises and 5 most negative surprises from our screened groups.  ROC blew out estimates, helped by a one off gain, but the stock has been a strong performer on the year nonetheless. Commodity Chemicals companies AXLL, DOW and LYB strongly beat consensus in Q4, but we remain cautious about their Q1 prospects.
  • We also show a review of revisions over the month (2014 full year) – again looking at the best and worst. Long and short picks are scattered on either end of this chart.
  • Short term we would focus on the companies that we think have high valuations and have real Q1 earnings risk because of the weather. This would include, GNRC, RPM, IP, LPX, SEE and POL, all of which are on one of our “concern” lists for 2014. IP cautioned about the weather related effects in its fourth quarter conference call, expecting a $40-50 million headwind in Q1.

For the full report and tables, please see our published research.

Commodity Chemicals – Setting Up For Disappointment

Written February 19th, 2014 by

26 of the 30 companies in our Chemicals index have announced Q4 earnings thus far, with only ROC, ECL, AXLL, and WLK left to report. On average, revenue growth has been positive, and all subsectors save Ag Chem show year on year gains.

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Commodity Chemical stocks have notably been the strongest, growing revenues by 8.8% over 2012 levels. The apparent momentum in the Commodity group is also reflected in 2014 EPS estimates, as this has been the only Chemicals subsector to see upward revisions year to date. Revisions have been largely driving performance in 2014, particularly so in recent weeks.

We repeat a chart from our recent monthly Chemicals report, plotting performance against revisions over the past month.

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To the extent that revisions have been driving performance and given the apparent disconnect between rising estimates and rising natural gas prices (a topic we have discussed in detail lately) we reiterate our concerns for Commodity Chemicals in Q1.  As natural gas prices are rising, the very poor weather is certain to put a meaningful dent in US Q1 demand and overall GDP.  Consequently we feel that commodity companies could get hit on the cost and demand front.  While there would likely be some demand rebound in Q2, if natural gas inventories continue to trend well below normal, prices could stay inflated to encourage enough production to rebuild inventories through Q2, keeping upward pressure on costs.

Late Q4 reporters AXLL and WLK should provide some data points on the operating environment thus far in Q1. Ahead of its upcoming earnings release on Thursday, WLK announced a two for one stock split and boosted its dividend, possible conciliatory gestures to offset a lackluster outlook. We remain most concerned with WLK and LYB as valuations are full and estimates are healthy – DOW is on the expensive side as well, but our current concerns here go beyond the company’s Commodity businesses.

News From Inside The Fridge – Beware Commodity Chemicals

Written February 11th, 2014 by

Following up from our research piece earlier in the week, we have some further data appoints to support our view that natural gas prices are likely to be stronger for longer – negatively impacting the US chemical industry, as well as other large industrial consumers.

  1. The first data point is that its FREEZING – those of us in the North East are getting really tired of waking up every morning to temperatures well below normal, snow and ice and on the ground, salt all over our cars and – in my case having to force the dog to go more than 6 inches from the front door to use the bathroom!
  2. More empirically; degree day data shows that the winter across the US has actually got worse since we last published the chart and the last two weeks have been 14% colder than a 14 year average versus the winter to date prior to the last two weeks being 9% colder – Chart 1.
  3. The last week of data in the chart is the week ending February 8th – if this data can be used as a proxy for natural gas inventories, we should expect a drawdown reported this coming Thursday greater than we saw last week, suggesting that inventories at the end of last week were as much as 35% lower than the same time last year.  Note that the week we are in now – data to be reported on Thursday of next week, appears to be no warmer than last week.
  4. Natural gas prices outside the US Gulf continue to strengthen – even though US Gulf prices have fallen from their high of last week.  Chart 2.
  5. US propane prices are at a 5 year high – this makes propane prohibitively expensive for ethylene producers who are pulling in even more ethane usual as a consequence – adding incremental upward pressure on both ethane and natural gas – Chart 3.

We believe there is real risk that natural gas prices move higher and directly impact chemical margins in Q1 2014 and possibly through the first half of the year and beyond if inventories fall even further and there is a need to replenish – keeping apparent demand high through the summer.

Even if gas prices simply sit in the $4.50-5.00 per MMBTU for much of the year while inventories are rebuilt, US ethylene margins could be 20% lower in 2013 than in 2014 – this is not reflected in estimates for the ethylene exposed names (DOW, LYB and WLK) – all of which are very expensive stocks today in our view.

Chart 1

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 Chart 2

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 Chart 3

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14 for 14 Portfolio Update: January Performance – A Better Start than Denver – Just!

Written February 3rd, 2014 by

This year, for better or worse, we have decided to update our portfolio performance on a monthly basis.  As a reminder we began the year by recommending 14 larger cap long ideas and 14 names that we would be more cautious about.  We screened 7 and 7 in the mid cap space and also did a sector specific screen for chemicals.  These are picks for the year – not for any given month and they are slightly more biased to valuation than they are to fundamentals/revisions.

  • We are losing in our first month on the large cap side as, while two of our real favorites – AA and CAT – have done well, the rest of the long group has not.  Absent DOW’s activist driven rally – helped further by better earnings, our cautious group have all had negative absolute performance, but on a simple average basis – not as much as the long group.
  • We have been more successful so far on the mid-cap side – which was where we had most success in 2013.  All but one of our mid-cap concerns underperformed the S&P500 in January, while we had a big win with UFS.
  • Our chemical picks did poorly in January as our long ideas all performed poorly and our more negative group generally did better – the exception being AXLL.
  • While not every company on our screen has reported Q1 earnings yet, we include a chart showing the 5 most positive surprises and 5 most negative surprises from our screened groups.  While LYB had the greatest positive surprise it was almost all because of a lower tax rate. The DOW gain was partly a tax rate benefit. The Alcoa miss is exaggerated because of the very small numbers involved, EBITDA estimates missed by less than 0.5%.
  • We also show a review of revisions for the month (2014 full year) – again looking at the best and worst. Stocks we like dominate the negative side of the chart.
  • Short term we would focus on the companies that we think have high valuations and have real Q1 earnings risk because of the weather – see our piece published yesterday.  This would include, GNRC, RPM, IP, LPX, SEE and POL, all of which are on one of our “concern” lists for 2014.

 

For the full report and tables, please see our published research.

Painting By Numbers – Still Too High

Written January 30th, 2014 by

SHW missed estimate and guided lower today, taking a stock which has already underperformed for the last 12 months down further.  The paint industry in general and SHW in particular was identified by us this time last year as a sub-sector that in our view had got caught up in its own euphoria.  Better housing demand and a better market structure had allowed earnings to grow quickly in 2012, and it was very easy to make a bull case, based on expected housing demand improvements and momentum.  SHW further impressed the market with its bold attempt to acquire Comex – a move that has so far been thwarted by the Mexican competition authorities.

A year ago we argued that the paint market was indeed strong and better structured but that the valuations in the sector for the most part already reflected the view.  We maintain the view that; not only with US home starts not return close to any prior peak, but that new home builds are not much of a needle mover for the group – existing home sales is the more important proxy and this number has improved and could improve further.

During the course of 2013 we talked about how analyst enthusiasm for the sector was growing, perhaps because of the relative underperformance, but that in order to maintain and increase enthusiasm, estimates had to rise to justify target prices that suggested further upside.  Here to an extent SHW is the victim as estimates have clearly become a bridge too far, based on today’s announcement.

The paint industry has average annual earnings growth in the 10-11% range looking at the three main purer plays in the US.  While the improving cycle and improving structure of the market has resulted in some very strong growth years recently, we should not be surprised to see a return to trend or perhaps something slightly better than trend, but not the 33% seen for SWH in 2012 and the 23% for VAL in 2012.   SHW’s mid-point for 2014 guidance is for recurring earnings growth of around 17%, which still seems high to us.    If we paid 20x earnings for this growth, we would be at around $175 per share today – 3% lower than today’s price and well below current consensus target price of around $200 per share.

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VAL is trading at 17x 2014 earnings estimates and RPM at 19x.  RPM in particular looks expensive if we are returning to more normalized earnings growth.

An added concern that we have for all three stocks is an emerging theme – that of the cold weather in the US and its possible impact on consumer spending and economic activity.  Our college Rob Campagnino wrote about heating spending yesterday, and today ARG guided lower for the current quarter in part due to demand slowing as a result of the weather.  ARG’s business is an accurate coincident indicator of US broad manufacturing activity.

Dow – Better Earnings – But Probably Only Adds Fuel To The Debate

Written January 29th, 2014 by

Dow reported better than expected earnings and in the accompanying conference call CEO Andrew Liveris went to great lengths to explain the stagey, implicit in which were the reasons why Dow sees benefit in keeping its portfolio together.

Not to take anything away from DOW, these were much better numbers – the cash flow was good and the increased dividend and share buy-back will be popular.  However, we do not think that this will do anything to stop or slow the debate, raised loudly by Third Point last week, and debated among Dow watchers for years.  The question is simple – “Is there a better way?”

The critics of the Dow strategy will raise the following arguments:

  • For a company supposedly going after costs in an aggressive way and selling assets, both SG&A and R&D costs increased quarter on quarter and year on year.
  • The real earnings gain came in the more commodity sectors – possibly inviting the argument that the portfolio remains cyclical.
    • The swing in equity earnings (almost all commodity) accounted for as much as 20 cents of the quarter on quarter gain – 60% of the gain (assuming that taxes on these income streams are minimal) and almost all of the annual gain.  As was pointed out in a question on the call – most of these ventures are commodity in nature and in Dow’s own words probable divestment targets if the right deal can be found.
    • Year on Year, EBITDA margins fell in the three businesses that Third Point wants to separate as a specialty company – Electronic and Functional Materials, Coatings and Infrastructure Solutions and Ag Science.  Q4 versus Q4 they generally increased.
      • Sales rose year on year but margins fell – this could be where the increased SG&A and R&D costs are going.
      • Too complex to understand and to manage.
      • Capital spending ramping up as cash flows improve – chart.
        • Dow has a habit of spending once it has capacity – either on acquisitions or on new plant and equipment.  While the buyback and higher dividend will be popular, capital spending and acquisitions have historically been less obvious value drivers.

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The supporters will say that the strategy is starting to deliver:

  • Higher cash flows – lower debt – increased dividend – increased buyback – nothing wrong there and this is a theme in the sector – DD, DOW and PX have highlighted buy-backs.
  • Improving return on capital.
  • More capital discipline.

The other risk is that the enthusiasm shown by Dow today influences estimates and creates expectation that are hard to meet in 2014.  We have identified Dow as a serial optimist – which means that the company (as reflected in analyst estimates) overestimates annual earnings growth more frequently than it underestimates – see chart.

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As we have indicated in prior research, we think the issue at Dow is primarily a cost issue and whether Dow is really achieving an adequate return on investment, whether that be new capital spending, acquisition or R&D.  It is likely that a less complex company (or less complex companies) could address these issues more easily, but unless these issues are addressed we see no real incremental value in breaking up the company.

CAT – By Some Measures Still a Long Way to Go

Written January 28th, 2014 by

Our position on CAT is unchanged from the company specific research we wrote in June of last year, we still have an out of favor stock at the bottom of an earnings cycle – but perhaps on the path to recovery.  Valuation has been hurt by the earnings and by grouping the company among the relatively unloved for the last 2 years.  CAT has the ability to outperform on two fronts – as earnings grow and as its relative multiple expands.  In the first chart we repeat and update a chart that we showed in our piece on CAT from last June.  CAT remains at a significant discount to our Capital Goods Index – an Index which includes CAT as a component. There is some slight movement away from the peak that we saw late last year, but there remains a significant distance to return to average levels of the past, or even a more conservative trend.

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This chart speaks to CAT’s relative position versus its peer group, but the Capital Goods space in aggregate is cheap relative to the Industrials and Materials sectors as well, suggesting that CAT has upside relative to the group and the group has upside relative to other groups in the same broad space – second chart.

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On an absolute basis CAT continues to earn 100 basis points below normal on a return on capital basis, but with this quarter the recent downward trend has become an upward recovering trend – see chart.  In our model, mid-cycle earnings are around $6.95 per share and while this may not be achievable in 2014, it looks more than achievable in 2015 in our view, supporting an end 2014 “normal value” close to $120 per share – more than 30% upside from current levels.

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