Chemicals Initiating Coverage 6 December 2018 Good value in a fundamentally sound Sector Chemicals sector Market cap in bn EUR 400 Germany’s chemical sector has traditionally a strong global standing. 350 Besides world market leaders like BASF and Linde plc, there are a 300 number of companies with strong positions in profitable market niches. After a muted year-to-date performance, we see good value 250 in a couple of shares. With this report, we are initiating coverage on 200 eight German chemicals. 150 Six clusters of chemical companies 100 In order to facilitate orientation in the sector, we introduce in this 50 overview a “typology” comprising six company clusters, which should 0 not only work well to categorize the German names but can also be Germany Western Europe applied to the European universe: Industrial gases (which includes the Industrial Gases Integrated / BASF SE Other Non-integrated Application-oriented Agrochemicals Logistics German Linde plc), agrochemicals (K+S and KWS Saat), application- driven companies (Symrise and Fuchs Petrolub), non-integrated chemicals (Covestro, Evonik, Lanxess and Wacker), which is the segment comprising most of the “traditional” business models, Target Last Up/ MC logistics (Brenntag) and of course BASF, which constitutes its own Name Rating Price Price Downside (EURm) investable segment, in our view. Brenntag Buy 53 41 30% 6.280 Evonik Buy 37 23 58% 10.886 In this report, we also discuss eight investment cases in detail. Fuchs Petrolub Buy 50 36 38% 5.043 KWS Saat Buy 353 290 22% 1.914 K+S AG Buy 24 17 45% 3.177 Performance and current valuation Lanxess Buy 68 49 38% 4.512 The sector faced a tough environment in 2018 and a number of shares Linde Hold 143 163 -13% 79.923 Symrise AG Hold 70 72 -2% 9.315 got hammered. Within our coverage, the shares of Lanxess, Evonik and Brenntag dropped by more than 20% year-to-date and Fuchs Petrolub, PE (adj) PE (adj) P/BV P/BV Div. Yield KWS Saat and K+S by 10-20%. Only Linde plc held up well due to Name 2018e 2019e 2018e 2019e 2018e positive news flow around the merger with US-based Praxair Inc. Brenntag 13,8 12,7 1,93 1,76 3,0% Evonik 9,3 8,6 1,37 1,27 5,1% Besides general concerns about the state of the economy and global Fuchs Petrolub 18,1 18,1 3,46 3,14 2,6% trade, the poor sector sentiment was in our view due to the exposure KWS Saat 20,2 18,7 2,28 1,99 1,1% of some chemicals to the German auto sector, which saw a number or K+S AG 37,3 12,9 0,76 0,73 1,9% Lanxess 10,1 9,5 1,72 1,52 2,0% profit warnings. On top of that, a couple of German chemicals suffered Linde 30,2 25,9 1,85 1,83 1,7% from increased logistic costs in 2018. These resulted from the low Symrise AG 34,2 28,8 4,98 4,50 1,3% water levels of the Rhine and other rivers due to the exceptionally dry weather in Germany. As we will outline in more detail in this report, we think these risks are manageable for the sector. Top Picks Our top picks in the sector are Evonik (Buy, TP EUR 37, not-integrated) and Fuchs Petrolub (Buy, TP EUR 50, application-driven). Evonik represents one of the most interesting transition stories in the sector at present and offers an attractive upside of more than 50% for investors who are willing to look through the cycle. Fuchs Petrolub is a high-quality play that enjoys high barriers to entry Analyst and reliably produces a three digit amount of free cash flow every year Dr. Knud Hinkel CFA +49 69 58997 419, [email protected] and RoCE after taxes close to 20%, with a low degree of cyclicality. Lately, the share price tanked due to a slight margin dip which we perceive as buying opportunity especially for mid to long term oriented investors. Please refer to importantThis report disclosures is generated on for the Christopher last 5 Seedorfpages of this document Chemicals Initiating Coverage German chemicals in the European sector context Germany traditionally has a strong standing in the Chemical sector: the eleven chemical companies included in our present target universe currently have a total market cap of EUR 194bn, which makes up for more than 50% of the Western European sector’s market capitalization of EUR 380bn (see Exhibit 4). Six clusters In order to facilitate orientation in the sector, we outline six clusters in the following sections, in each of which the German names have a strong presence: Industrial gases, agrochemicals, application / knowledge-driven companies, BASF, not-integrated chemicals (which is the segment comprising most of the “traditional” business models) and logistics. Please note that this segmentation is in no way an official / scientific one but rests entirely upon our subjective perception: Exhibit 1: Chemicals in Germany as part of the Western European sector Market cap in bn EUR 400 350 300 250 200 150 100 50 0 Germany Western Europe Industrial Gases Integrated / BASF SE Other Non-integrated Application-oriented Agrochemicals Logistics Source: Pareto Industrial Gases The Industrial Gases cluster is nowadays a real heavyweight sub segment in the sector despite comprising only two companies, one of them being the German/American combination Linde plc, which emerged from the merger of Linde and Praxair finalized in October 2018. Main products are atmospheric gases like oxygen, hydrogen and various specialities. The European players Linde and Air Liquide have also expanded into the healthcare space in the last decades, supplying gases to patients with respiratory diseases. Industrial Gases represent a highly consolidated industry with only three companies (Air Products (US), Linde and Air Liquide) controlling 70-80% of the global market but often facing strong small challengers in a local environment. In general, it is an industry with high capex needs and fixed costs but low variable costs. Capital intensity varies with the distribution mode, though (on-site and cylinder vs bulk). Thus this industry is scale-sensitive, which comes on top of other barriers to entry like network effects and high transportation costs vs low product value. Ultimately, these characteristics have shaped today’s industry structure. Energy costs are significant but are usually passed through to the customer. Technology does not play such a prominent role for the business, as it does not for the entire sector. 6 Dec 2018 Pareto Securities Research 2(44) This report is generated for Christopher Seedorf Chemicals Initiating Coverage Agrochemicals Agrochemicals represent a rather heterogeneous sector. In Europe, there are four specialized companies active in rather different areas. Vilmorin and the German KWS Saat are seed companies, in some crops competing against much larger chemical conglomerates like Bayer and BASF, which both have also a strong position in crop protection. In contrast, the Norwegian Yara produces nitrogen fertilizer while the German K+S is a basic commodity company, mining potash and salt in Germany, Canada and the USA. To some degree, it is fair to assume that crop prices are a common driver for all four companies. Crop prices are in general at low levels for already some time now but are assumed to rise in the long term. This results from secular trends like population growth and the diet change in the Emerging Markets which will result in rising demand that must be met with arable land that is more or less fixed. Two “hot” topics dominate discussions in the agrochemical space for some time now: First, gene- modified organism (GMO) play a huge role in the seed business outside Europe, and all large seed players have a respective franchise in that area (including KWS Saat). Second, there has been a wave of mega-mergers in the sector, as the German Bayer group has acquired Monsanto and ChemChina bought Swiss Syngenta. On top of that, there has been a merger between Dow Chemicals and Dupont in the USA. This consolidation wave will most likely not make life easier for the smaller seed companies like KWS Saat and Vilmorin which will struggle to keep pace with the technological progress due to relatively small R&D budgets. Application-driven Under application-driven companies, we understand companies that have a strong, knowledge-based position in niche businesses positioned downstream in the value chain. We would put Novozymes (enzymes), Croda (surfactants for cosmetics, among others), Ems Chemie (high performance polymers), Fuchs Petrolub (high performance lubricants), Givaudan and Symrise (flavours & fragrances) into that bucket. These companies usually set their prices based on value considerations rather than raw material price levels, with the flavours & fragrances sub segment being a (mild) exception to that rule. They regularly enjoy high barriers to entry which in combination with rather low capex requirements usually leads to capital returns clearly above costs of capital. These companies are only to a minor extend plagued by cyclical fluctuations and they usually grow above GDP. As this is an attractive bundle for investors, the respective shares are almost never cheap. BASF BASF represents a segment of its own right, in our view. It is one of the largest “traditional” chemical companies in the world. After an early move to Asia in 90ies, it now has a strong asset base in almost all important global markets. For its geographical expansion, BASF often relied upon joint ventures with strong local players like Sinopec (China), Gazprom (Russia) and Monsanto (USA, now part of the Bayer group).