European chemicals: at the start of an earnings upgrade cycle?
Chemical production can be seen as a proxy for global industrial production (IP), which is strongly correlated with economic growth. Therefore, chemical stocks react vehemently to changes in growth expectations. The biggest sector risk remains a global economic downturn, while China stands out as the key catalyst. Up till now signals point in the opposite direction.
Since 3Q16, the sector outlook has indeed brightened. Improving earnings prospects are based on higher volumes, particularly in the automobile sector, and on improving market conditions in China. Cefic, the European chemical industry council, expects a small uptick in chemical production in the European Union in 2017 of around +0.5%, after a year in which output stagnated (+0.0%).
Apart from volume growth, the key profitability drivers are innovation and cost leadership. Pricing is a function of external factors (economic growth), input costs (mainly oil prices for petrochemicals), and most importantly, the balance between supply and demand. Therefore, capital expenditure discipline is of utmost importance to avoid overcapacities. This was historically lacking in China, which constitutes 40% of the global chemicals market. However, policy changes in the country have now begun dictating more rational capacity additions and tighter environmental standards. This is a key positive for the sector, especially for BASF, which operates a huge site in Nanjing. Production is exclusively oriented towards the Chinese market.
Overall, the sector is in good shape with earnings improving thanks to cost cutting, a better supply/demand balance and M&A. Arkema exemplifies the successful transformation that many companies are going through: a trend towards more added value, higher efficiency, lower capital intensity and better returns on invested capital.
M&A has been driven by portfolio transformation. Most companies avoid large-scale acquisitions, and instead focus on add-ons offering complementary technology or market access. Megamergers occur only in two subsectors—agrochemicals and industrial gases—and the lack of growth in both has necessitated larger scale. The outcome of three-mega acquisitions in agrochemicals (Syngenta, Dupont and Monsanto) depends on the decision of antitrust authorities.
BASF hasn’t participated in this consolidation: it is comfortable with its standalone crop science and claims to be ahead in innovation and its ability to provide more choice to farmers. It also stands to profit from forced divestments. Bayer is progressing well with its Monsanto acquisition. The intended rights issue (~EUR 14 bn) will offer a great opportunity to add to positions.
Air Liquide got its timing right when acquiring Airgas. It was criticised for overpaying, but the deal could turn out to be more beneficial than believed initially given >USD 300 mn in synergies, a stronger US economy and lower taxes. Investors did well to participate in its preferential rights issue at EUR 76 per share. Linde resumed its merger talks with Praxair, this time with unanimous support from its board after appointing a new CEO.
We expect BASF and Solvay to profit significantly from these market dynamics. As the world’s largest chemical company, BASF’s trump cards are its cost leadership through its highly integrated operations, its focus on innovation and its broad and strong market positioning (technologies, vertical market segments and regions).
Solvay has structurally improved its portfolio through the acquisition of Cytec, a leader in composites for aeronautics. It has divested non-core assets quickly (only polyamides is left for sale). Solvay is also a self-help story: huge cost savings should drive its earnings. Investors have taken a dim view of the commodity activities at Basf and Solvay. They underestimate their cash contribution. Profit is nice, but cash is king: it provides the means to explore new avenues.
Danny Van Quaethem
Data & recommendations as of December 19th, 2016 close
This document is an objective and independent explanation of the content of the recommendation and cannot be considered as adapted to a person or based on the analysis of the situation of a person.