Industrials/Basic Materials

The Most Important Question to Ask on Earnings Calls – Q4 Demand!

Written October 21st, 2014 by

We have touched on the subject of inventory drawdown in Q4 in a couple of recent reports, but the more we think about the subject and refer back to history, the more we believe that this could be the most significant year-end surprise across a number of industries, but most significantly those where crude oil is a major input.

Outside the US the economic news is worse, demand growth is slowing in Europe, and in large parts of Asia and Latin America.  Local sellers and distributors will likely look to lower inventories as a consequence of expected lower offtake.  Within our Industrials and Materials universe inventories are not low in absolute terms – see exhibit, but not particularly high as a percent of revenues.


More significantly, with the almost 25% decline in Brent Crude Oil pricing since its summer peak, any international consumer of products made from crude oil or its fractions, will be expecting much lower pricing going forward.  Consequently, if historical behavior is any guide, they will drop purchased volumes immediately (this will have already happened in October) – to the minimums that contracts allow, and wait for pricing to drop.  This behavior was very pronounced among Chinese plastics importers amid the crude oil volatility of the late 1980s and 1990s, and was last seen most obviously in the early months of the GFC, when demand vanished for a quarter or two.  The second chart is a repeat from recent work which shows short periods of negative demand surprises as crude oil prices fall.


As an example, Dow Chemical’s sales in Q3 2008 were 13% higher than the prior year – in Q4 they were 25% lower than the prior year and in Q1 2009 40% lower.  This was a combination of volume and pricing – with part of the volume swing driven by destocking as crude oil prices collapsed and part was the ensuing price response both to lower crude prices and lower demand.  We are not calling for a decline this significant this time, but we do expect a negative surprise for Q4 and possibly Q1 for all chemical producers and possibly for most industrial companies with significant international business.

The counter of course is that lower crude is likely very good for economic growth – longer term things should improve and our expected demand shortfall should be no more than a one or two quarter event.

Further, there are conflicting signals in the US as international chemical pricing specifically could fall much more quickly than US domestic pricing (because the US market is very short of some chemicals today) – it could take a couple of quarters for the US to catch up.  Additionally, given the constraints on rail and road traffic in the US today, consumers of chemicals and plastics will likely be reluctant to play the inventory game because of supply delay fears – at the margin we have seen inventories creep up in the US for supply security reasons in recent months.

Deere – The Floor Looks Robust

Written October 15th, 2014 by

In times when market momentum is very obviously directionally downward, certain stocks inevitably stick out as better insulated to the sell-off. With the S&P shedding more than 5% over the past week, DE has held firm around the $80 level and actually moved up as the market has moved steadily down – our prior work on the company and its historical valuation trends showed little room for further downside in the stock price.


Further downside to earnings remains likely, however, as certain tax incentives expire and farm incomes continue to be pressured by weak commodity pricing – but we retain our belief these effects are largely priced in, and DE’s recent performance offers some early support for this thesis. Notably, reports of bipartisan support for the reinstatement of a US farm equipment tax credit could be a source of marginal upside, though we note DE’s high non-US exposure, where agricultural industries will likely remain volatile but will also continue on the modernizing path that has driven growth for DE over the past decade.

In the more immediate term, history indicates we could see continued outperformance from DE in the fourth quarter – we modify an exhibit from our August report highlighting the company’s strong second half performances, noting that most of this outperformance tends to come in Q4. Additionally, valuation continues to be attractive, both relative to the broader Capital Goods sector and on an S&P relative P/E basis.


In short, farm economics remain a concern, but our belief that any weakness on this front is already priced into the stock has been confirmed by DE’s resilience in the face of the recent broad market sell-off. We believe considerable upside remains, with downside likely limited as demonstrated over the past few weeks, and our return on capital driven model shows a “normal value” of over $120 a share.

HB Fuller – Blaming SAP, But Where Is The Growth?

Written September 25th, 2014 by

HB Fuller is taking a beating this morning after a serious earnings miss.  This was a company we were not paying much attention to given relatively fair value and its only interesting screen was a high level of skepticism, suggesting that investors did not believe that recent high returns on investment were sustainable – seems they were right!

FUL is blaming an SAP integration and implementation delay for the miss and this brings back a sense of nostalgia for us.  In the 1990s we would see at least one company per quarter raise the specter of SAP as a reason why they had disappointed.  It was a more frequent excuse than overspending at times!  And SAP is the gift that keeps giving, as part of the very high expense of separating DD’s performance chemicals business from the rest of DD is unravelling the SAP system such that each company has its own, disconnected from each other.

But – ignoring SAP for a moment and looking at the numbers – there is little evidence in FUL’s numbers that the US is in much of a growth phase.  Adhesives have many industrial applications and consumer/retail end-uses, and for FUL to show only 2% organic growth in the US in this business is concerning.  We think that it is a function of a couple of things that we have talked about at length – the fact that growth IS slow in the US despite all the stimulus and the better employment rates, and specific to FUL, high energy costs drive high prices and high prices drive lower demand as buyers focus on minimizing use, minimizing waste and finding alternates.

Oil prices are falling, and this will likely cause pricing to decline, which ultimately could be good for FUL – however, and see recent research, as oil prices fall we often see coincident apparent demand fall for chemicals (chart), as buyers delay purchases in the hope that lower energy prices mean lower chemical prices in the near future.


More Ethylene from Lyondell – Unlikely to Discourage Others

Written September 24th, 2014 by

Today, Lyondell announced that it is studying yet another ethylene expansion in the US and that once complete by the end of 2017 the company will have added as much as 2.4 billion pounds of capacity through plant expansions over a 4 year period.  This is as much as, and in some cases more than, many of the companies planning new capacity will be adding.  Recent capacity expansion are summarized in the chart provided by Wood Mackenzie below.

The LYB expansions make good economic sense in that they are a fraction of the cost, on an installed pound or ton basis, than the new facilities and they can be brought on line quite quickly – we would be surprised to see any of the new-build running before the end of 2017, maybe CP Chemicals and Exxon.  LYB is adding some new derivative capacity to consume ethylene in the US, but has yet to announce enough to consume all of its expected new supply.  LYB needs to do this otherwise it will be adding to what we think will be a destructive ethylene surplus in the US by 2018.

Unless LYB acquires one of the major US ethylene consumers, or does some sort of cost based supply deal with one of them, we do not think that LYB’s actions will slowdown plans to build by others.  The second wave of expected ethylene additions in the US is dominated by current ethylene buyers looking to back-integrate and they will keep going unless someone offers them an incentive to stop.  While LYB’s expansion probably makes great economic sense for LYB, unless it helps to displace other plans it will only add to an ethylene/ethylene derivative surplus in the US.  The US becomes increasingly reliant on exports – see recent research – and this only makes sense if the oil/US natural gas differential remains high.   In our view, companies like LYB should be making pro-active moves to ensure that some of the planned new capacity in the US does not get built.

Ethylene Capacity Additions

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.


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