Industrials/Basic Materials

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.

DuPont/Tronox – The Math Says Yes – The Rest Says No

Written May 26th, 2014 by

There is recent speculation that DuPont may explore a reverse Morris Trust (RMT) option as a means of divesting its performance chemicals, with Tronox as the “acquirer”/partner.  It is understandable why there would be such speculation – Tronox is the right size from a corporate perspective and has significant NOLs which the combined entity could utilize.

Financially, the deal looks very interesting.  The RMT would allow DuPont to exit a business with almost no tax basis in a very tax efficient way, effectively buying back stock or receiving cash or both as a consequence of the exit.  Separately, Tronox has around $1.5bn of potential NOL’s in the US.  Alone Tronox will not generate enough US EBIT to make use of these NOLs and they have been viewed as of more limited value (though not zero) to the company since its restructuring in 2011.  A combination with DuPont’s performance chemicals business would create a large enough stream of US EBIT to make full use of the NOLs, as DuPont’s business is profitable even at the bottom of the TiO2 cycle.  The business had global operating income of $2.1 billion at the peak of the TiO2 cycle in 2011 and almost $1.0bn in 2013 at what will likely be the trough (though it may be repeated in 2014).  This EBIT is biased towards the US where DuPont has the greatest cost advantage in TiO2.

So financially this is certainly worth looking at.  If you gave a $1b of the NOL’s to DD shareholders through the valuation of the deal it would add around 1.6% to DD value.

This assumes that DD is neutral to the RMT versus a spin or split (the current path).  Financially there are likely other benefits from the combination in terms of head office costs, SGA and R&D.  If we assume that all $200m of Tronox costs could be avoided this would likely sway DD in the direction of the RMT.  This does not include the intangibles of a consolidation move within TiO2, but this is where we start getting into the problems

Would the deal be allowed? 

Huntsman announced its proposed acquisition of Rockwood’s business in September of 2013, with an expected early 2014 close.  The deal is still being reviewed by the European Commission and clearly the argument that the real competition is now coming from Asia is not having much success.

If the HUN/ROC deal is approved in Europe this would make things more complicated for DD/TROX, as both have European assets and the European Commission would review the deal in the light of a now more consolidated market – i.e. HUN/ROC have first mover advantage.  If the only way this deal could get done would be through European divestments, and only after a long review period, DD would likely take the easier and more certain route of the spin/split.

DD’s CFO has been very clear that an alternative to the spin/split needs to generate a lot more value to make it worth the extra work and the extra risk.

Who would run the business?

In our view a DD/TROX deal would only work if TROX were willing to concede control and management of the combined entity to the legacy DD management.   DD is the 800 pound Gorilla in these businesses, with the best assets, the best technology and the best product line.  While TROX also operates chlorine based technology for TiO2, the economics of the process do not match those of DD and the opportunity would come from what DD know-how could do for the TROX assets.  In addition the rest of DD’s performance chemicals portfolio is substantial and unknown to TROX.

The PPG/Georgia Gulf deal worked because Georgia Gulf (now Axiall) management was always going to remain in control.    That is not the case here, and potentially a major impediment.


We expect DD to look at this opportunity, assuming that Tronox management is willing to entertain the discussion.  But DD are fast developing all the data needed to put a base case fair value of the business as a stand-alone, and it is unclear to us that a deal with Tronox would trump the base case when adjusted for the risk associated with getting the deal done.

Tronox may well find a partner/acquirer who would place more value on the NOLs without the complication of trying to combine two businesses in the same, already consolidated, markets.

Dow – Lots of Talk – But Good Topics

Written May 23rd, 2014 by

In our recent research comparing the opportunity at DOW versus LYB we talked about the number of levers that DOW has available – other than the US ethylene margin – to add to earnings and value.  Yesterday we saw another example of DOW talking the talk, with a statement suggesting that the company is exploring an MLP structure for some of its US Gulf ethylene assets – more on the specifics and our view in a moment.

Chemical companies and many other Materials and Industrials companies tend to focus on big stuff – investments, M&A, inventions, etc. that either cost a lot of money or cause a lot of distraction.   Over the last 10 years it has become very clear that the better performers are those that also focus equally on the small stuff – the singles rather than the home runs.  This has been a large part of the success at PX, is increasingly important at PPG and to an extent has helped at LYB.  This is very much the way forward for DD and will be the only logical way forward for APD once a new leader and a new plan is in place.

DOW is still thinking about the big stuff – SADARA, US Gulf investments, divesting the chlorine business, divesting AG etc. – but is talking about some more interesting smaller stuff as well, such as further cost initiatives and select divestments of businesses or JV’s that show little value in DOW’s portfolio but could be worth much more to someone else.

The MLP idea is both a big and small idea.  It could involve a lot of assets and it could have significant cash flows – but it will not materially impact the overall cash flows at DOW.  It is more tactical and more about getting additional value for the cash flow rather than changing the cash flow itself.  We are sure that there will be nay sayers in DOW, who see this as “financial engineering” and not “core”, but this is all about creating value, and it could create a lot.

One of the challenges for DOW in this MLP idea will be the need to price ethylene, propylene and co-products at market value, as product is transferred from the MLP to DOW.  This is something investors have wanted DOW to do for a very long time, as the view has been that the cost based transfer that the company practices today is opaque and does not allow us to see the true profitability of the derivative businesses.  The challenge that DOW faces here is that the derivative businesses, particularly Performance Polymers in our view, will look poor if base chemicals are transferred at market prices.

The other question we would raise is around the statement that only the new facilities are being considered for the MLP.  We think that DOW should spin off all of its qualified North American ethylene, propylene and pipeline assets into an MLP and then have the MLP invest to build the new units:

  • The MLP will need to rise equity to build – DOW should contribute its share of that equity – by raising debt and buying the new shares, but the independent investors will be asked to contribute proportionally.   This may force DOW to be more open about the economics of the investments, which may not be a bad thing, but it will also reduce DOW’s direct exposure to what is a major capital plan, which is probably a good thing.
  • By including all of the assets (where allowed), the MLP would be very large, more liquid and more interesting to investors.
  • By including all assets – especially those that are fully depreciated – the earnings will be higher and the yield based value will increase.
  • DOW’s 80% (our guess) ownership of a very valuable MLP could have a meaningful impact of DOW valuation.

The best thing about this MLP discussion in our view is that it shows that DOW is thinking and thinking down non-traditional paths for the company.

Today we have a lot of interesting talk – lots of topics – all of which could be pursued to ends that create value.  But…some of this is already priced into the stock and so if all we have is talk and there is no action the stock will stumble.

However, we already see a more intense focus on costs, including a rethink about where to best allocate R&D dollars, and this has so far impacted the bottom line in Q4 2013 and Q1 2014.

In research that we published on February 24th, we suggested that DOW could restructure its portfolio and cut costs to such a degree that we could see the stock above $80 per share.  We did not include an MLP structure in that thinking – in part because we do not have the data to model an MLP by virtue of the way that DOW reports earnings – however, in our view an MLP would increase this target.

Natural Gas – Chance of a Price Spike?

Written May 16th, 2014 by

Natural gas pricing has come off a bit as we have moved through May, but has been volatile around the weekly inventory figures, moving up again yesterday.  While inventories have begun to be replenished, they remain well below the seasonal norm. In the most common depiction (first chart) we see the start of a recovery in inventories from the low at the end of March.  The question is whether inventories are rising quickly enough – enough to allow all of the gas fired power plants to run flat out through the summer, while at the same time build enough inventory to see us through the winter.

In the second exhibit we take a more analytical view of inventory and look at the statistical significance of the current level.  We do this by looking at the historical mean and range for each week and calculating a standard deviation for each week – when the band in the first exhibit is narrower, the standard deviation is smaller, when the band is wider the standard deviation is higher.

While inventories are recovering they are today more statistically deviant from average than they were at the absolute low in March – in other words, they are perhaps not rising fast enough.

The critical question surrounds summer demand, and relief may come from the expectation that natural gas demand will be the highest in regions with the most likely increase in production.  The NGL rich fields in the North East are profitable at gas prices of $4.00-4.50, though we are not seeing a meaningful increase in the rig count in this region as yet.  This is the region where the demand swing will be greatest from here as the summer cooling demand picks up – it is already high in the South.

Our statistical analysis of deviations from mean has always served us well in the past and so the shape of the second chart is very concerning to us – and suggests that there might still be short term upside to natural gas prices, particularly if it warms up in the North East.


Westlake – Showing/Giving Us the Money

Written April 29th, 2014 by

WLK has indicated that it will place its US ethylene and pipeline assets into an MLP and has filed a registration statement for an initial public offering of the MLP.  Not surprisingly the stock has reacted very favorably to the news – up almost 15% at its peak today and up 9% at the time of writing.

Our view on both WLK and LYB has been consistent; that while the stocks look expensive on any “normalized framework” they do not look expensive based on current earnings and cash flows.  The risk is that the cash gets spent on an acquisition or series of acquisitions at the top of the market valuations, something the industry has been guilty of in past cycles.

By forming the MLP, Westlake is effectively committing the bulk of the free cash generated by the ethylene and pipeline assets to the shareholder.  Any further investments in ethylene and infrastructure will need to be done through a capital raise from shareholders.

WLK is expected to earn $5.21 this year; if 90% of this is paid out as a dividend, even with today’s appreciation in the stock, you get a 6.7% yield.  This is a little simplistic as not all of Westlake’s assets and earnings will reside in the MLP, but it serves as an illustration of why the stock has done so well on the announcement.

On its quarterly conference call this morning LYB management responded to questions by suggesting that the tax base at LYB – post bankruptcy – makes a similar decision more complicated for LYB.

We would be more interested to see what the possibilities would be at DOW.  Not only because it is likely that DOW has substantial assets that would be appropriate for an MLP, but also because a DOW MLP could then build the ethylene and propylene plants in the US by raising equity rather than by the DOW parent raising debt or reducing share buyback/dividend increases.

US Natural Gas – Not Out of the Woods Yet!

Written April 28th, 2014 by

US natural gas pricing remains fairly close to its 52 week high (Exhibit 1), as the very low inventories created by the cold winter are showing limited signs of rebuild (Exhibit 2).  This is happening at a time in the year when we would expect the rate of inventory rebuild to accelerate – ahead of the summer, when demand rises again (electrical power – cooling).

Despite many weeks of natural gas pricing above or close to $4.50 per MMBTU, we are not seeing a supply response in terms of increased on-shore rig counts.  The Baker Hughes rig count increased meaningfully last week – by 30 rigs – but 28 of these were oil and only 2 gas (Exhibit 3).

In other words, producers either do not see the economics working at $4.50, or they have little confidence that prices will stay at these levels for long.  Most of the shale based oil plays have significant associated NGLs and natural gas, and in Texas (for the most part) there is infrastructure to bring these products to sources of demand.  Most of the increased rig count was in Texas.

Ethane pricing has weakened relative to natural gas, and extraction margins, which jumped close to break-even in late February and early March and negative once again (Exhibit 4).  Ethane pricing however remains well above this time last year (Exhibit 5 – last 16 months Mt Belview and Conway).

Ethylene spot and contract pricing is falling in the US, suggesting lower margins for the major sellers of ethylene in Q2 than at the same time last year given higher ethane prices.   It is not clear that there is much strength in pricing in any of the major ethylene derivatives in the second quarter and consequently Q2 2014 profitability in the US is unlikely to be better than Q2 2013 on a per pound of product basis.

The risk is that natural gas prices react to the lack of inventory build by rising further – and far enough to convince E&P companies that more natural gas drilling activity is needed.  If natural gas were to rise into the $5.00-6.00 range all of the major basic chemical companies in the US would see negative revisions for Q2 and possibly Q3 2014.

In Exhibit 6 we show expectation for each of the natural gas levered names for Q2 and Q3 2014 and put these into context with Q2 and Q3 2013 numbers and anticipated growth.

See our published research for the full report and exhibits. 

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