Caution To Trinseo Shorts - Closing The Barn Door After The Horses Are Already Gone

Summary

• Trinseo short interest is up over 60% in the last two months to 5% of shares outstanding and ~8% of the actual float.
• In simple math, we walk through how EBITDA will quadruple to $510 million in EBITDA from consensus in the current year trough of $125 million.
• Morgan Stanley's downgrade May 28th, from Neutral to SELL after 6 years at "Neutral" appears years late, as it is based on a contraction in styrene spreads to marginal cost, which has already happened.
• While having bounced slightly off the bottom, the stock is still down over 71% from the 2018 high and has underperformed the group significantly.
• Our model and assumptions are already appropriately-conservative given the environment. We remain perplexed that short interest and negativity are increasing and how someone can sleep at night being short a stock with so much upside.

March to May 2020 - The COVID Impact, and a big "V"

What a year 2020 has been so far, and we are not even at the halfway mark. We have witnessed volatility in the markets and economy that certainly makes trading stocks exciting. We have heard many superlatives applied to everything ranging from "greatest economic shock," "shortest bear market" and debate and discussion over when and what the recovery would look like. In retrospect, people are now concluding this was a one-time event that had an overwhelming shock, but that things will return to normal. The only question is when. But the market is discounting a "V" recovery, and just as investors were lamenting that 2020 might be a global disaster of unknown proportions, the indexes are largely almost back to flat and the NASDAQ hitting all-time highs. “The greatest 50 days of the stock market history” has come and gone, and the ubiquitous consensus call for us to “retest the lows” as we entered April, and even into May, has now converted to a fear of missing out (FOMO) with investors chasing cheap, beaten and unloved stocks including (and perhaps especially) airlines, cruise lines, travel and energy stocks. While eradicating nearly the entirety of the losses into March from COVID fears (and in the case of technology – being up on the year), most pundits and analysts are now saying we need some consolidation, time to digest our rapid gains, and even encouraging some profit-taking and trimming positions. Large-cap names such as Dow Chemical (DOW), which we recommended in March has more than doubled off of its March low. And retail names such as Capri (CPRI), PHV (PVH) and Guess (GES) have seen triples and quadruples. We agree some of the large-cap and especially growth names likely need to see less investor chasing and more consolidation, the small-cap value remain ridiculously cheap and continue to lag, particularly with our highest conviction BUY recommendation, Trinseo (NYSE:TSE). However, we believe this is about to change.

What are the Bears Missing?

The bears are singularly focused on excess supply in styrene monomer pressuring spreads from the high levels over the last few years. This has already happened, and the expected supply response is already stabilizing spreads at marginal cost. Just as importantly, the company’s other divisions are likely to see a sharp recovery, likely magnified by the restocking driven by the recovery in oil prices. As the economy recovers and people realize oil prices are not headed back down, we are very likely to see accelerated re-stocking. Part of the headwind on the way down was falling oil prices, so customers extrapolated waiting to replenish inventories at lower prices. On the way up, not only will you have restocking from customers, but the inventory timing that the company recognizes though the PNL will go from a big negative number ($65 million in 2020) to a positive number. Even if it reverses half of the drop, this is a $100 million EBITDA tailwind (absence of $65 million negative hit plus $35 million revaluation). For a company with an EBITDA consensus of $126 million for 2020, this is a huge earnings uplift, even before the underlying earnings start to recover, or we include the impact of customer re-stocking.

While all the focus from the sell-side and shorts is on the negative styrene call (which by the way has already played out as price has troughed at marginal cost) the other segments of the company are set up very favorably for the economic recovery.

1. Tires: We can already see in the Chinese market that miles driven are accelerating more than expected as people want to drive more instead of using public transports for everyday purposes, while they also want to drive for their vacations as opposed to using planes, trains or cruise lines. This behavior is already evident in Europe and the US as well even though they are lagging the Chinese recovery due to the timing of the virus. In addition, inventories in tires are quite low as both tire companies as well as distributors/dealers raised cash with the onset of the virus.
2. Specialty plastics for Automotive: Not only is China automotive recovering sharply and has for the last two months been running above pre-COVID levels, but we are seeing a significant acceleration in the US and Europe as well. In addition, when looking at the stimulus in both Europe and China, it is clear that the governments are accelerating incentives for EV cars. We know the content per car for EV cars is a lot higher than it is in regular cars, so the acceleration of EV adoption will be a big tailwind for TSE. (Covestro stated that they have 6x the content on an EV car vs. a regular internal combustion engine vehicle.)
3. Polystyrene. Demand outlook has improved on the back of more packaging demand and more e-commerce, while supply has tightened up significantly, with TSE’s main polystyrene end market seeing 7% of industry capacity coming out in 2020.

Trinseo’s Excess Liquidity

Now that we are passed the shock of the COVID shutdowns, TSE will have excess liquidity as it generates ample cash, and we expect buybacks to accelerate in the second half of the year. Given the limited liquidity and the increasing short base in the stock, we suspect a buyback will cause a significant squeeze in the stock. Last time they did this, the stock went up 72% in 2 months.

The Short Case – All About Styrene – A Dangerous Game

We believe a small consortium of hedge funds working in sync with Morgan Stanley, are increasingly bold with their negative stance on TSE. I have detailed this and in my analysis of the recent Morgan Stanley downgrade of Trinseo from Neutral to SELL. The entire thesis revolves around how oversupply in styrene monomer will hurt the company’s profitability. With low stock liquidity in an uncertain environment, they press the stock lower as short interest continues to build. As a reminder, there are no BUY ratings on the stock, with 2 analysts covering the stock rating it SELL and the other 7 rating it NEUTRAL.

As often happens on Wall Street, the neutral ratings, really means that the analyst is negative but does not want to hurt the relationship with the company, so they call it “neutral.” Putting a "Sell" on a stock can cause management to be defensive and to have apprehension in communicating with the sell-side firm that publishes a SELL rating. If done purely objectively and with a reasonable thesis, most managements adopt a professional stance and do not have a problem with an analyst being unfavorable on the company. Needless to say, with regard to Trinseo, there is not a single analyst suggesting investors should buy the stock. As billionaire investor Howard Marks from Oaktree Capital says, “the most important thing to know about the direction of stock is the expectations or setup.” This is no different from playing the odds at the racetrack. If a horse has lost 100 consecutive races, a bet on that horse winning the next race will be very cheap. While the setup alone is clearly not enough if detailed work and analysis demonstrate that the bear case is highly improbable or flawed, the payoff will be very big if the setup is skewed. There is no doubt the setup here is extreme:

1. Trinseo’s stock has been a terrible performer and is still down more than 70% from its 2018 high (it has gone from $85 to $24),
2. It is a smaller cap (below $1 billion market cap) so a lot of the big funds are not even able to own it.
3. TSE has exposure to Europe (which most investors are negative on), and,
4. There is oversupply in one of the company’s key divisions (styrene monomer).

Often, a long bet on a stock is trying to prove the core tenet of the short thesis is wrong. However, there are sometimes, when investors can make a lot of money going long the stock, even if the bear thesis is correct. TSE is one of those stocks. Here is why:

Trinseo is a company with 6 divisions and they have all had significant negative impacts during the past two years.

Some of the factors which affected TSE negatively causing the steep decline of the stock include:

1. The trade war with China,
2. The disruption of European auto manufacturers due to the transition to new emission standards and now,
3. The economic slowdown from COVID-19.

In addition to the macro and industry dynamics just mentioned, Trinseo has also been hurt significantly by industry capacity (supply growth) in styrene monomer exceeding demand. The trade war and the uncertainty surrounding it caused an industrial recession in TSE’s main markets (China and Europe). The trade war started in 2018, so let’s look at the average of the three years prior to that. During this period, the average EBITDA of the company was $584 million. Of that $584 million, $79 million was styrene monomer (feedstock segment). Another $65 million was from the part of Amsty JV EBITDA coming from styrene monomer (the rest is polystyrene where utilization is improving). So in total, styrene monomer contributed $144 million to the $584 million. This means that excluding styrene monomer, TSE generated $440 million in EBITDA. In addition, the company has disclosed that they will see savings of $50 million starting this year with another $20 million (my estimate, the company has commentary suggesting “tens of millions” from supply chain savings). The supply chain savings come in large part, from better raw material pricing terms now that the Dow contract just expired. So, in very simplistic terms, Trinseo has done $440 million WITH ZERO contribution from styrene, and now they have $70 million in lower costs. At face value that is $510 million, again without any improvement from styrene.

Given that large parts of the cost curve in Europe were underwater in Q1 and 13% of the supply base has come off-line because they are losing money, we are pretty confident that European styrene profitability will not go down from here. To be conservative, we also assume that it won’t improve at all. This means that we assume the $79 million from the feedstock segment will be ZERO for the next three years. The styrene business that is part of Amsty, will likely be slightly positive as the US is at the lower end of the cost curve. However, our model and numbers assume a conservative stance and assume they also earn ZERO for the next three years. Again, if one takes the cost savings at face value (and the CEO, Frank Bozich, has quite a good reputation from his prior roles), we are looking at $510 million of EBITDA as the economy returns to something we would characterize as “closer to normal.”

Following the Morgan Stanley downgrade, I was bombarded with messages and emails from readers, investors, friends, etc., asking how could I have such high conviction, and how could Morgan Stanley be wrong. I replied in detail and posted a general overview of the downgrade in the comments section of other articles I have written. In a nutshell, I replied that factually and objectively, Morgan Stanley has been wrong for six years. Having a "Neutral" on a stock going from low teens to $85 after the IPO is a huge miss, and simply wrong. And missing the stock as a covering analyst from $85 back to $15 is equally wrong. It should have been a SELL. And they are compounding their error by downgrading to a SELL at the trough. The most intriguing aspect for me is, even if Morgan Stanley proves to be accurate on their styrene projections (we view as highly unlikely), they will still be wrong on the stock.

COVID, China and Europe

While we are all concerned about COVID, note that China is past COVID, while the situation in Europe is much further along than the US and looks increasingly like China. These are TSE’s main markets. Let’s assume that despite running styrene at ZERO, we cut our $510 million by $50 million (some of the cost savings are passed on to customers and the recovery to the 2016-2018 average takes longer). This puts us at $460 million in EBITDA. Given that the big IT project will be completed by the end of this year and growth CAPEX is pulled back, we expect CAPEX to go to $75 million (could be lower, maintenance CAPEX is $40 to $45 million, so it still assumes $20 million of productivity and $10 million of growth CAPEX). This translates into $275 million of free cash flow (calculated $460 million in EBITDA - $40 million in interest - $75 million in CAPEX - $70 million in taxes), which is a 30% free cash flow yield. Of that we get just under 7% as a dividend, so the other 23% as a buyback. If one looks historically, this company has a great track record of using any excess cash to buy back stock. At this rate of buybacks, the company will buy back all of its shares in just over 4 years. And this is with ZERO contribution from styrene monomer. I think it is likely styrene may end up being a little better so the buyback would be even faster, but we are being conservative in our assumptions.

If funds shorting Trinseo (and sell-side analysts) believe TSE stock is likely to move lower as EBITDA increases from the current consensus of $125 million to ~$500 million over the next 2 years, we think they will be wrong. Again, even assuming styrene is ZERO, the earnings revisions for this company will be quite dramatic as we come out of this COVID shutdown. In addition, the European governments have finally stepped up and unveiled a stimulus plan as large as the US plan, which combined with China recovering, will most likely generate above-average growth for Europe coming out of this. (Europe is much more leveraged to export and industrial recovery than the US, where consumption is over 70% of GDP). As demand recovers and revisions start to turn sharply positive, the sell-side is likely to move from uniformly negative to more positive. Given a growing short base in an illiquid stock during this slowdown period, the setup is quite exceptional in our view, to be long. For those who are emboldened to short TSE, potential investors on the sidelines, and analysts, God forbid the styrene bear downturn is not as strong as they believe (think project delays as usually happens, higher-cost capacity coming out, higher demand from unprecedented stimulus), then the 30% free cash flow yield likely goes to mid-40%. After paying the dividend, this takes the company private in 3 years. That is not our base case, and investors certainly do not need this upside case to happen for TSE to be a home run, but if it happens, it will be even more painful for the shorts than the prior upcycle when TSE soared from low teens to $85. Finally, investors should be reminded that there are very high activity levels in chemical M&A, both from strategic players as well as private equity. As Trinseo’s valuation is currently lower than where Bain Capital took the company private last time, I would not sleep well at night if I were short.

A Few Final Thoughts on More Fuel for TSE

Also, recall that most of TSE assets and business are in Europe even though they report in USD. This means that the massive rally in the EUR over the last two weeks will help the translation. Not only are the earnings recovering but they are being translated into USD at a higher EUR rate, which means your EUR earnings are now worth more to a company that reports in USD.

Total shares outstanding are about ~38mm. Activist investor M&G Investment Management owns 7.8mm. And Blackrock owns another 6mm+. (38.2 - 7.8 - 6.0) = 24.4mm shares that could possibly float. Based on conversations with several other large holders, we would argue the real float is likely closer to 20mm shares. With short interest up 60% in the past two months to 1.8mm at the end of May, the short ratio is likely higher than 8%. Also, keep in mind that the Morgan Stanley downgrade was on May 28th with heavy volume specifically calling to short the stock. We would wager the short interest is now likely more than 2mm shares, but we shall see. Regardless, with a relatively thin-trading stock, a reduced float of shares since M&G owns 20% and Blackrock owns 16%, with numbers soon to move up, along with all of the other variables pointed out that provide a tailwind to Trinseo, we believe the shorts’ luck is on borrowed time.

UBS Chemical Team Investor Call Data Points

Primary Points from the call:

1.) UBS hosted a conference call for their institutional investors presenting real-time data for chemical companies is better than expected.

2.) The main theme in chemicals that UBS recommends investors to play is the fact that due to COVID-19, more people want to avoid public transportation/ Uber, etc. and drive more in individual cars.

3.) What is the best play on higher miles driven? Trinseo. Since Lanxess sold its rubber business to Saudi Aramco, Trinseo is best-levered rubber play for exposure to increasing individual miles driven. There was another rubber company, “Synthos” but it was taken private. This makes Trinseo the only game in town for investors looking to play this trend. Their synthetic rubber business did $137mm when the market was healthy. Expectations are for $25mm. One can see there is a disconnect here.

Remember, investors move into large-cap stocks first. For example, quality large-cap such as DOW move first despite there being less overall upside. For investors seeking liquidity, it is the quickest way for exposure to the sector. As the market has now bounced a lot and most people have missed it, they need high beta to catch up. TSE is still down around 40% YTD while the market is back close to flat. TSE is still down nearly 80% from in 2018 high. Trinseo's end markets are already looking better than what analysts and investors were expecting. TSE will provide the high-octane for investor portfolios from this point.

My Assessment Of The Morgan Stanley Downgrade Of TSE from May 28, 2020

As I have received many questions on TSE, and how a mega-bank such as Morgan Stanley could downgrade to a SELL and possibly be incorrect. I reiterate that TSE is my TOP PICK and very high conviction. Bottom line – I think the Morgan Stanley research report is sub-par, poorly researched and utilizes specious reasoning, flawed logic, and simply...analyzes the math incorrectly generating unrealistic estimates. I think it is an unfortunate example of inadequate research to a firm of Morgan Stanley's reputation and caliber.

I went through the 65-page MS report, written by Angel Castillo, for the second time. The underlying argument is centered on the styrene market being oversupplied, everything else is backfill. The Morgan Stanley call on styrene is that massive capacity is coming on via China (which we knew about, acknowledged and discussed), but that this time the high-cost producers won’t shut down to offset it. The report cites no data nor argues for why (they cite 13% import tariffs from the US, but this is irrelevant as the US doesn’t export much styrene to China anyway, and even if they did, all these tariffs do is change trade flows (US export to Europe and Europe exports to China without a tariff)). So basically they are asserting that despite the evidence we have to the contrary, (high-cost plants shutting now) this will be different in the future.

Economically, this makes little sense...be that as it may. The report actually shows how utilization for polystyrene is going up (which is true) but they assume the polystyrene earnings are flat (so styrene profits down because of lower utilization but polystyrene profits don’t get the benefits of higher utilization). For all the other divisions, they basically assume very little recovery in earnings to justify the sell case (even though we have plenty of data to support the opposite). To me what is most interesting is that the entire case is based on something that has already happened – styrene profitability is already at marginal cost. (Sell-side analyst jobs can be very stressful, and there are plenty of analysts who like to see a scenario playout prior to putting out their view. However, seasoned investors recognize that when something has already played out, it is likely already reflected in the stock price.) Relative to styrene profitability already being at marginal cost - we believe it makes complete sense. This is because a lot of the supply has already come online while demand has been weak due to COVID. The lengthy report emphasizes why oversupply is such a problem but then shows that in fact, styrene earnings are ALREADY negative and has Trinseo very slowly recovering from losses to break even. The analysis assumes ZERO shutdowns of capacity outside of the TSE plant in Europe. The analysis ignores the boost to profitability for TSE from closing the plant (even though we know it lost a lot of money last year and more in Q1 2020).

Morgan Stanley also ignores the fact that the negative impact to EBITDA in 2020 from the oil crash will not happen again in 2021. In 2020 there is a $65 million hit to EBITDA from revaluation of raw materials because of the oil crash. Unless one assumes oil is returning to the lows and then will have a similar crash next year, (which would basically take it to zero) in 2021 Trinseo will have a tailwind from the absence of the $65 million negative impact even if crude prices had stayed where they were at the end of Q1 (Brent crude was $22 per barrel on March 31). Since crude has actually already recovered to $35 as of last week, not only will Trinseo not experience this numerical hit but will in fact have the opposite effect on the income statement. This is very high level but if crude going from $60 to $22 caused a $65 million headwind, crude just going from $22 to $35 should give TSE a $22 million tailwind (65/38 * 13). This means that if oil stays where it is, 2021 EBITDA will be helped by the absence of the $65 million impact plus the $22 million positive, for a total tailwind of $87 million. The Morgan Stanley analysis ignores this.

In addition, the Morgan Stanley analysis ignores the fact that as styrene profitability stays at break-even, CAPEX will go down, boosting free cash flow. We believe the likely scenario is that the rest of the Trinseo businesses will recover, and the styrene business will recover somewhat as there are some shutdowns as we are currently seeing. As oil pricing continues to recover, not only will Trinseo not get the hit to EBITDA from raw materials timing but will actually see a boost to EBITDA (double-positive as the negative impact goes away and then you get a positive impact on top). This means that EBITDA will recover to about $460 million over the next 18 months and then gradually recover the lost $100 million from styrenics over the following 2 years. While many investors were spooked by this MS report, we believe the company will start exceeding numbers significantly starting this quarter, and people will forget about the Morgan Stanley SELL report, and TSE will head much higher, and inflict a great deal of pain on those who are short the stock.

Analyst’s Disclosure: I am/we are long TSE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.