Trimming 2018E as Univar Shrinks To Prosperity
• Ex disasters 3Q EBITDA would have been in line with our pre-Harvey forecast, but 4Q outlook dims. Excluding the net impact of hurricanes, we estimate that Univar’s adjusted EBITDA would have grown by approximately 8%, a solid result in a challenging operating environment to be sure. However, that would put earnings just in line with our pre-Harvey forecast. Looking ahead, management signaled 4Q EBITDA below Street expectations. We attribute part of this to residual storm-related impacts ($6mn), but underlying margins also appear to be improving at a less exciting pace. In an effort to improve profitability, Univar has been shrinking volumetrically for three years now: -7% in 2015, -4% in 2016 and -5% YTD in 2017. In this context, we can’t help but wonder whether the discipline required to turn away low margin business is restraining upside, at least temporarily while the company hires new salespeople aggressively to chase higher margin opportunities. To be clear, we are not ready to give up on CEO Newlin’s strategy as we believe it is “penny wise, pound foolish” to chase lower-margin, higher-risk opportunities just for the sake of shoring up volume. For example, would you have wanted to “win” business in 1H17 by locking in caustic soda prices to customers for a year? We think not. Still, we feel no sense of urgency to be exposed to UNVR, notwithstanding share price performance of +4.8% YTD, which makes the stock the second worst performer among the 18 names in our coverage universe.
• Our top 10 takeaways: (1) adjusted 3Q17 EPS of $0.36 exceeded our $0.23E and consensus of $0.25; (2) adjusted EBITDA $152mn likewise beat consensus of $145mn and our estimate of $142mn; (3) we attribute upside to a hurricane-related earnings impact that came in less than expected at $6mn vs. Univar’s prior range of $10-25mn; management anticipates a similar impact in 4Q17; (4) on a segment basis, USA, EMEA and ROW propelled upside vs. our expectations, while Canada was in line; (5) gross margin continued to expand rising 30bps y-y, which supported modest growth in adjusted EBITDA margin of...
• We reduce our EBITDA forecast for 2018. Our model revisions are a mixed bag. Our 2017 EPS estimate rises by $0.05 to $1.12E from $1.07E thanks to 3Q earnings upside, partially offset by a weaker than expected outlook for 4Q due to lower projected margins and residual pressure from natural disasters. For 2018 we reduce our estimate by $0.10 to $1.40 from $1.50 on lower projected EBITDA margins in the USA, Canada and EMEA segments, partially offset by higher sales and margins in ROW, aided by Univar’s recent acquisition of Tagma (Brazil).
• We rate UNVR shares Sell. Our price target of $30 suggests that UNVR shares offer limited potential for upside in terms of total return (UNVR shares do not currently pay a dividend). We base our valuation of UNVR on an average of 3 methodologies: DCF, relative P/E multiple, and a relative EV/EBITDA multiple. Our DCF analysis supports a fair value of $36 per share. We apply a 0% premium to the S&P500 market P/E multiple (2018 basis) to generate a relative P/E value of $25, and finally we apply a premium of 1.0x to the average EBITDA multiple for our coverage average, which gives us warranted value of $32 per share. We remind investors that, unlike Univar, we do not add back stock-based compensation expense ($10mn in 2016 and an estimated $20mn in 2017E) to calculate adjusted EBITDA used for valuation purposes. We are pleased to see however that Univar has begun to report an adjusted EPS figure that includes the effect of stock-based compensation.
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Air Products and Chemicals (APD: Hold, $157 PT)
Praxair, Inc. (PX: Hold, $142 PT)
Industrial Gas Outlook Improving; Raising Numbers for APD and PX
• We are encouraged by industrial gas producers’ results. Our analysis of third quarter earnings reports from APD and PX suggest that underlying growth in demand for industrial gases is picking up after having languished for several years (see Figure 1). Price contributions have likewise been lackluster in recent years at ~1%, but the outlook appears brighter here too based on prospects for higher rates of capacity utilization and industry consolidation (we expect the Praxair-Linde MOE to close in 4Q18). While our 2018 forecast suggests that FCF yields among industrial gas producers are likely to remain 200-250bps below the chemicals sector average, we view sub-par FCF yields as somewhat less problematic today vs. years past. In other words, re-deployment of excess CF had been just about the only path to premium EPS growth in an anemic macroeconomic growth environment, so sub-par FCF has hamstrung gas producers to a degree. Now, with industrial production growth inflecting higher, gas producers are better positioned for earnings growth based on a combination of (A) higher baseline volumes; (B) better pricing, supported by higher capacity utilization; and (C) a rising backlog of new projects. We consider (B) and (C) to be “on the come” and we still prefer exposure to commodity chemical names at this juncture, but we exit 3Q feeling more cautiously optimistic that industrial gas stocks can keep pace with chemical sector peers moving forward.
• We raise our F2018 estimates for APD. We increase our F2018 EPS estimate from $6.90 to $7.20, including $1.69E for F1Q18. Drivers include an improved volume and earnings outlook in all major regions of the world, supported by a new project in India and continued smooth execution at Jazan (Saudi). Whereas Air Products F2018 EPS range of $6.85-7.05 excludes the company’s JV with Lu’An (China), we note that our $7.20E includes an estimated run-rate EPS contribution of $0.26 per annum from Lu’An on a gross basis, or $0.15 net of the four air separation units (ASU) that were in our model previously but are now folded into the JV. Based on our projected start-up of 1 February 2018 this translates to an expected EPS contribution of $0.17 (gross) and $0.10 (net) in F2018.
• Our PX estimates likewise move higher. We maintain our 2017 EPS estimate of $5.80, now including $1.48E in 4Q, depressed by an estimated $0.02 due to hurricane Maria. For 2018 we increase our EPS estimate by $0.15 to $6.25, although we remain $0.10 below the FactSet consensus of $6.35 for next year. Drivers of our higher earnings forecast include a higher 3Q17 earnings base in North America and Asia relative to our prior model as well as prospects for moderate improvement in the Brazilian industrial economy, partially offset by a slight increase in share count as Praxair paused share repurchases while its proposed merger of equals (MOE) with Linde AG is pending.
• Our top 10 APD takeaways from F4Q17: (1) adjusted F4Q17 EPS of $1.76A vs. our $1.69E, consensus of $1.68, and management’s implied 4Q range of $1.65-1.70; (2) sales increased 13.1% to $2.2bn, which represents ~2% higher growth than our forecast of $2.16bn; (3) adjusted EBIT of $493mn contributed $0.07 of positive EPS variance vs. our $473mn with earnings upside in Industrial Gases - Americas, EMEA and Asia, partially offset by weaker than expected earnings in...
• Our top 10 PX takeaways from 3Q17: (1) adjusted 3Q EPS of $1.50A exceeded our $1.46E; (2) sales of $2.92bn exceeded our forecast of $2.78bn as volume growth accelerated to 5% from 3% in 2Q17; (3) EBITDA margin of 32.7% dipped 10bps y-y and came in 30bps below the level of 33.0% that we had penciled in; (4) hurricane Harvey clipped 3Q EPS by $0.02, while hurricane Maria is expected to have a similar impact in 4Q17; (5) the MOE with Linde appears to be on track; management expressed confidence that required divestitures will not exceed the “trigger” threshold of…
• Overall, we remain market weight on US Chemicals exposure, albeit with a healthy appetite for risk. Within the chemicals sector we continue to prefer value vs. growth, preferably with a catalyst. Notwithstanding the strong performance of most commodity-linked chemical stocks YTD, our bottom-up work on cash flow and valuation leads us to believe that exposure here remains attractive, whether through pure-plays or diversified chemical names. Our Buys of this ilk are DOW, EMN, HUN, LYB and WLK, plus now TROX and VNTR on which Matt DeYoe on our team launched coverage with Buy ratings on 23 October. Among growth-oriented specialty chemical producers, the pickings are slimmer in our opinion, although we see value in PPG and maintain a Buy on WR Grace since having launched coverage in May 2017. Elsewhere among specialties we've shifted to a less bearish, although still not constructive posture on industrial gases having upgraded Air Products to Hold from Sell in early August 2017 and having previously upgraded Praxair to Hold from Sell in December 2016. Since mid-2017 we've considered coatings and industrial gas stocks to be on equal footing in terms of risk-reward for the first time in nearly six years, as the former group has struggled to defend margins in an environment of rising raw material costs and ongoing supply-chain consolidation.
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