Written March 10th, 2014 by gcopley
- 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.
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.
Written February 19th, 2014 by gcopley
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.
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.
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.
Written February 11th, 2014 by gcopley
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.
- 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!
- 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.
- 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.
- 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.
- 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.
Written February 3rd, 2014 by gcopley
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.
Written January 30th, 2014 by gcopley
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.
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.
Written January 29th, 2014 by gcopley
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.
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.
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.
Written January 22nd, 2014 by gcopley
- Activism in the Chemical space has targeted the right companies – where returns on capital have been lackluster at best and declining at worst, and where there are examples of better business models at different companies.
- However the pillars driving this underperformance have been a function of sub-optimal strategic decisions over a long period of time and/or an unfavorable geographical footprint in terms of both manufacturing centers and head offices.
- Unlocking value will be a complex and time consuming process and the manner in which it occurs may be just as important – spin off versus sales for example, in any decision to separate businesses. In some cases high costs are also a problem and need to be corrected in addition to any business realignment.
- Intransigence of management practices and beliefs have been shown to be major impediments to rapid progress – often fresh thinking is the key but is not often sought out.
- Both APD and DD are struggling with how best to create the maximum shareholder value – we think Dow has a long road ahead to truly satisfy the activist investor. It can be done with the right steps but it will not be easy. At these price levels we would be cautious and would not recommend buying hoping for some big transformation. All three stocks have had a good 12 months partly as a result of the activism and only DD still looks cheap in our view.
It has been a busy six months for US Chemicals, with activists declaring stakes first in Air Products, then DuPont and now Dow Chemical. These are all big companies with complex global businesses, and in each case there is a strong consensus view that value is there to be unlocked; but what are the practical limits? All three companies have underperformed peers over the last decade and in that regard the activists have done a good job of identifying the right names.
Businesses can always be run better than they are today and Air Products watchers can point to Praxair, DuPont watchers can point to Monsanto and 3M, and Dow watchers can point to Lyondell and perhaps Monsanto. These are easy peers to name, but much more difficult peers to emulate. Praxair’s differences to Air Products exist in our view because of strategic decisions and operational practices that began more than a decade ago. Dow and DuPont have each changed strategic direction several times in the last three decades and these moves, right or wrong, have left both companies with product and geographic diversity which has moved well beyond optimal – both are addressing this, but it is either too little or too late in the eyes of the activists.
We look at the success that Monsanto has seen in its share price since 2005 but we forget that the core strategic decisions that created the Monsanto of today were taken in the mid-90s. We applaud the success of PPG and SHW in the coatings business and ARG and PX in US packaged gases, but these are consistent consolidation strategies that the companies have been working on for a decade or more and are only now really beginning to show their true value.
Different strategic decisions and different approaches to managing capital, R&D, overheads and sales and marketing can likely lead to value creation at all three targeted companies. In addition there are some break-up or separation options that could also help. Can these be achieved without major management shake ups? Unlikely in our view. These companies today are a function of decisions made and strategies followed over several years – unravelling decisions and changing strategies generally involves a cultural shift – such as those we have seen at Monsanto, Eastman and Praxair in the last 10-20 years. Nothing is quick and nothing is painless.
Complicating things further; these are not simple businesses – you cannot shutdown some stores or sell off easily carved out pieces:
- Integrated sites contain facilities that might naturally belong in different businesses, but their connectivity with other facilities results in a complex separation, where the value of one business versus another may be more a function of agreed supply and off-take agreements than the assets themselves.
- Shutdowns and business exits are not free. Site clean-up is in some cases prohibitively expensive and some facilities around the world run simply because the cost of shutdown is too high.
- Some businesses only make sense because of their integration – we have already commented that we struggle with the idea of Dow separating its ethylene business from its chlorine business – both, in our view, will be weaker long-term because of the separation.
- People become a major issue. Operations, and even headquarters, are located in towns where the company is the major employer. Where the opportunity to unlock value comes from cost reduction, these complications are not insignificant.
In our view the activists involved have all taken on some big challenges and it is not clear that they will win in a time frame that matters, even if they have a “long-term” view.
Written January 9th, 2014 by gcopley
As we think about how to invest in the Industrials and Materials sector in 2014 we are proponents of the idea that the laggards will play catch-up. We first wrote about this in November and have seen some success with the stock selections that we made at the time. We have seen almost two full years of momentum in the space with investors sticking with the stories that have worked and expensive stocks, in our view, getting more expensive, while the out of favor stocks languished. While there is generally a correlation between stock revisions and performance, that correlation was much weaker in 2013 than in 2012, suggesting that the benefit of the doubt was given to the “favorites” and not to the rest – see chart.
This is shown more illustratively if we look at a couple of the paper/packaging stocks – which screen as expensive today and also screened as expensive a year ago.
During the fourth quarter of 2013 we began to see a shift towards the underdogs, the stocks which have lagged, the stocks which in our view present the best valuation opportunities today. In recent research we have highlighted our preferred names for 2014, and we use the same valuation methodology that drove our preferences for 2013. Our 2013 selections did not work too well as the market essentially ignored value for the first 8 to 9 months of the year. Interestingly, our 2013 favored names outperformed our least preferred names by 170 basis points in December 2013, and if this signals the start of a more valuation driven market we are encouraged that our approach will be much more successful in 2014.