Macroeconomic upswing, US tax reform to provide 2018 tailwind

04 January 2018 17:49 Source:ICIS Chemical Business

It’s already become a well-worn phrase, but the “synchronised global economic upswing” indeed bodes well for the overall chemical markets in 2018. As in any year, there is the risk of major external shocks to the system. Yet on a fundamental basis, the positives shine through the clouds, for now.

Robust manufacturing activity is being led by the US and Europe with exceptionally strong PMIs (purchasing managers’ indexes) which are key leading indicators for the manufacturing economy.

Global Mfg PMI

On 3 January, the US ISM Manufacturing PMI reading came in at 59.7 for December, up from 58.2 in November. Within the PMI, the New Orders Index surged to 69.4, up 5.4 points from the prior month.

For PMI figures, anything over 50 indicates expansion in the manufacturing economy, while under 50 indicates contraction.

Meanwhile, the Eurozone Manufacturing PMI compiled by IHS Markit reached a record high of 60.6 for December, up from 60.1 in November.

For the once sleepy Eurozone, this marks the highest reading since the survey began in mid-1997. Business optimism also rose to the highest level since July 2012 when this first was gauged.

It’s not just the strong PMI numbers but the sustained high level of these readings that are impressive. The US PMI has been above 55 for seven straight months, and spent all of 2017 at 54.8 or above. The Eurozone PMI has been higher than 55 for 12 consecutive months, spending all of last year at 55.2 or above.

The latest strength in this key leading indicator is hardly a flash in the pan, and points to further strength in the manufacturing economy ahead.

In China, the key Caixin manufacturing PMI came in at 51.5 for December, higher than expected and up from 50.8 in November, even as the government crackdown on pollution hits certain sectors hard.

China’s PMI, while staying above the 50 line for seven straight months, has badly trailed those of the US and Europe and warrants close watching.

Looking at the broader global economy, all major countries and regions are expected to see GDP growth in 2018, according to the IMF. This was also the case in 2017, but not in 2016 as Brazil and Russia were mired in recession.

Surging commodity prices are also underpinning the recovery in certain emerging markets, including Brazil and Russia. Crude oil, iron ore and copper are all on the rise, with the strength surprising many analysts.

A slow, steady rise in crude oil prices tends to be a net positive for the chemical sector, as the pricing power that producers gain often outweighs the rise in feedstock costs.

US TAX REFORM IMPACT

In the US, where petrochemical producers are already riding the shale gas cost advantage, the historic tax reform signed into law in December 2017 is expected to provide another earnings boost starting in 2018.

The new US tax law brings the corporate tax rate down from a top rate of 35%, to 21% across the board, and also allows for full expensing of certain capital investments such as machinery and equipment for the first five years.

US sales percentage

International companies doing business in the US are also expected to benefit. UK-based energy and chemical giants, Shell and BP, have already announced they anticipate favourable future impacts from the US tax law.

Most 2018 earnings estimates for US-based chemical companies likely do not fully reflect the impact of US tax reform.

Expect more clarity from companies during Q4 earnings season in late January to early February, and a resulting bump up in estimates. Analysts are starting to take a crack at the potential impact.

Wells Fargo chemicals analyst Frank Mitsch sees a modest bump to 2018 earnings per share of around 4% on average for US-based stocks under his coverage, but with wide variations among the individual names.

Prime beneficiaries include Westlake Chemical, Olin and RPM International, the analyst points out. Companies with a higher percentage of sales in the US stand to benefit the most.

EPS accretion

Westlake would be the biggest beneficiary of US tax reform, with around 11% earnings per share accretion, followed by Olin and RPM with accretion of 7% and 6%, respectively, according to Mitsch.

Westlake’s US sales will be around 75% of total sales in 2018 while US pre-tax income will represent about 85% of the total, notes the analyst.

CASH FLOW IMPACT

The new tax law’s impact on free cash flow could be more profound than on net income, especially for those that pay high cash taxes.

Companies would benefit not only from a lower tax rate, but the full expensing of certain capital expenditures.

At an early December dinner with the Wells Fargo analyst, Westlake’s management suggested that its cash tax rate could fall to the mid-teens.

“Using our estimates for Westlake EBITDA (earnings before interest, tax, depreciation and amortisation) and cash flow items and assuming a mid-teens cash tax rate, we estimate that FCF (free cash flow) could improve by over $275m, or around 30% versus our current estimates, on an eight-10 percentage point reduction in their cash tax rate,” said Mitsch in a 1 January research note.

“RPM and LyondellBasell would also be among the key beneficiaries under our analysis,” he added.

M&A MAY GET A LIFT

Most companies should be flusher with cash starting in 2018, and managements are likely already planning on how to spend the government’s largesse.

This could add fuel to the mergers and acquisitions (M&A) fire, but US assets are also likely to become costlier, as the lower tax base increases cash flows and brings up the overall value of the targets. It’s not inconceivable that US-based companies could use more of their newfound cash flows to acquire overseas businesses.

“We expect tax savings proceeds to be allocated to a combination of internal investments, accretive bolt-on M&A, debt paydown, and/or share repurchases and dividends,” said Wells Fargo’s Mitsch.

“While we expect some companies may decide to fund incremental buybacks, at these valuation levels, we believe the more accretive option would be to fund organic growth projects or M&A,” he added.

US CORPORATE DEBT IMPACT

Yet companies must think twice before levering up with acquisitions or massive share buybacks, as an important provision in the new US tax law caps the deduction of interest expense at 30% of EBITDA for the first five years.

Thereafter, interest expense deduction will be capped at 30% of EBIT – a huge difference, especially for the capital intensive chemical sector where D&A (depreciation and amortisation) tends to be significant.

Previously, 100% of interest expense was deductible.

Companies with high debt levels will be heavily penalised by this important change, and the impact magnifies as EBITDA (and EBIT) shrinks during a downturn. Those struggling with high debt levels will be even more disadvantaged as earnings decline in the next cyclical downturn.

Given that the chemical industry is largely beholden to such cycles, companies must take even more caution regarding debt levels. On the flip side, if players start to eschew debt, a less leveraged industry could prove to be more competitive in the long run.

DON’T GET COMPLACENT

While everything’s been coming up roses on the economic outlook, there is tremendous risk, and 2018’s favourable outlook must be caveated as such.

Paul Hodges, chairman of International eChem, notes in his 2018 outlook, that “as in 2007-2008, financial news continues to be euphoric, yet the general news is increasingly gloomy”.

The US standoff with North Korea on nuclear weapons looms large. Inherent in any military action against a nuclear nation is the potential for widespread disaster. In such a scenario, you can throw all the positive PMI and GDP data out the window.

The US is also threatening to withdraw from the multi-nation deal lifting sanctions on Iran, amid the growing political unrest there. An unstable and re-nuclearised Iran may not directly impact earnings, but it won’t be a good thing.

Trade tensions are also arising worldwide, with the Trump administration in the US renegotiating existing free trade agreements, and threatening tariffs to protect local US business interests. The global chemical markets are highly dependent on trade, and barriers would prove harmful to commerce.

Then there are interest rates. Where once you had synchronised monetary easing among the major central banks, a tightening phase is now under way, led by the US Federal Reserve. The European Central Bank continues its easy money stance, but is looking towards tapering its massive purchases of debt securities (quantitative easing). China has been raising interest rates.

China, as the world’s second largest economy, is undergoing a major transition away from a cost-based, export-led, manufacturing powerhouse, to one based on higher value, safer and environmentally friendly manufacturing, high tech services, and domestic consumption.

This won’t happen without a degree of pain – a reining in of excessive credit and the bubbles they’ve created, and higher environmental and regulatory standards that will disrupt certain industries and increase costs.

By Joseph Chang