Chemicals – Analyst Positive on Chlor-Alkali Exposure; OLN Prefered

Chemicals 
Chlor-Alkali Flash: Prices Percolate Post Production Pinch
• We remain constructive on chlor-alkali exposure. Two recent data points suggest to us that the cyclical ascent in the US chlor-alkali market is alive and well: (1) news of a substantial contract price increase proposal after the close yesterday; (2) US chlorine production data for the month of January (out on Tuesday); and (3) a rebound in caustic soda spot prices. These signs point to upward tension in US caustic soda contract prices, even entering the spring, which is typically a period of seasonal increase in supply. Looking ahead, we judge that the CAV cycle is likely to exhibit durable strength, perhaps through 2020+, supported by a relative dearth of capacity increases. In this context, we affirm our Buy rating on Olin Corporation (Buy, PT = $40) as our preferred means to gain exposure to chlor-alkali and vinyls (57% of Olin sales and 84% of EBIT in 2018E).
• Olin has proposed a substantial contract price increase as spot prices percolate higher. Our sources suggest that Olin has proposed a contract price hike of $85 per dry short ton (DST) of diaphragm- and membrane-grade caustic soda in the US market. For context, the magnitude of this proposed increase is 13-15% of existing contract price levels, depending on grade, and more than double the proposed increase of $40/DST put forth by Westlake Chemical (Hold PT $115) earlier this week. As a result, we would expect Westlake and other US chlor-alkali producers to…
• Cold weather constrained chlor-alkali production in January. The Chlorine Institute released monthly US production data for January after the close on Tuesday. The industry operating rate declined to 84%, which is slightly above the four-year average operating rate of 83%, but well below the 89% level witnessed in January 2017. We attribute the drop not to weakness in demand, but rather to extremely cold weather in the southern Unites States, which caused a decline in chlorine production of 5.6% y-y. In other words…
• US producer outages could keep supply tight this spring despite a re-start in Brazil. Looking ahead, we anticipate that US chlor-alkali supply will remain tight in light of planned outages among four producers in chlor-alkali and vinyls (CAV): Shintech (PVC at Freeport in March); Olin (chlor-alkali at Freeport, TX in March; Formosa Plastics (chlor-alkali at Point Comfort, TX to operate at a reduced rate in April); and Westlake Chemical… 
• We prefer OLN as way to play chlor-alkali strength. For chlor-alkali exposure we prefer Buy-rated Olin Corporation (OLN) where our price target of $40 suggests upside potential of 25%. With OLN shares having pulled back in early 2018, we consider valuation to be more appealing, especially in light of where Olin’s businesses are in the cycle. As we survey Olin’s portfolio, we note that ethylene dichloride (EDC), epoxy resins, and Winchester are all at or near cyclical trough conditions presently. These businesses generate 43% of Olin’s sales in the aggregate. Meanwhile, chlorine likewise remains below mid-cycle profitability. We reckon that only caustic soda (28% of sales) is trending above par in 2018. In this context, we consider OLN shares to be priced attractively at 6.9x our estimate of 2018 EBITDA vs. 8.0x for Hold-rated WLK, which has similar leverage to caustic soda price increases. As a reminder, our OLN price target is based on an average of two valuation frameworks; a relative EV/EBITDA multiple and a relative normalized P/E multiple. Our relative EV/EBITDA multiple uses a 1.5x discount to the group average and suggests a warranted stock price of $40. Our normalized P/E methodology also suggests a warranted value of $40, based on our normalized EPS estimate of $2.60 and a 12.5% discount to the group average multiple applied thereto.
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