LYB – Adding Strategic Risk to Fundamental Risk

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

August 28th 2018

LYB – Adding Strategic Risk to Fundamental Risk

  • While LYB is not an expensive stock on a current or forecast earnings basis, the company strategy has changed meaningfully over the last 18 months and creates a story that is now much less interesting than it was.
    • Free cash flow had been directed to smaller opportunistic capex with rapid payback, mainly in ethylene, or directed to share buybacks – which has been the majority.
    • From 2011 to 2017 LYB spent $28 billion on dividends and share repurchases versus $10 billion on capex. As shown in Exhibit 1, in 2017, capex was only slightly lower than dividends plus buybacks. In 2018, with the SHLM acquisition and the raised capex, the spending on dividends and buybacks will fall below capex and acquisitions for the first time.
  • We don’t like the SHLM acquisition and we don’t like the spend on the new PO facility, but in times of peak profitability companies can get away with some marginal strategic decision. LYB has a large cash cushion assuming that the average cash from operations for the last six years can continue. Note that the trend in cash from operations has been negative since 2013
    • But, as we have been discussing in recent research, the US ethylene and polyethylene market is much weaker in Q3 2018 than expected, and while we are not calling for a global market collapse in ethylene, 2H 2018 could be much worse than 1H 2018.
  • LYB is very levered to the ethylene and polyethylene markets – the only company potentially more levered is Braskem – a company that LYB is contemplating acquiring.
    • LYB has only been public in the “good times”. Times when the US shale advantage has been in place and while we have seen 8 years of global economic expansion.
    • A continuation of higher NGL prices in the US, combined with an erosion of polymer prices around the world could take billions of dollars out of EBITDA for LYB in 2019 if what we are witnessing today is sustained.
    • We do not believe that this is likely, but if it appears to be a possibility as we move through 2H 2018, LYB could easily revisit valuation lows of 2017 – downside of 20%.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

In our opinion LYB is starting to make some considerable strategic errors, and while a recovery in the ethylene/polyethylene market would expose the relative attractiveness of the stock from a valuation perspective, without this there are risks.

Polyethylene has drifted further in the US in August, while ethane prices have moved slightly higher. Integrated polyethylene margins could be as much as 7 cents per pound lower in the US in Q3 2018 versus Q2 if there is no recovery in September – Exhibit 2.

LYB has around 12 billion pounds of ethylene capacity in the US and if the company saw this full decline across the entire US ethylene portfolio, it could knock 50 cents per share from earnings sequentially.

  • On the plus side, styrene has not seen the same decline as polyethylene as most is sold on a formula.
  • On the negative side – Europe will also most likely be weaker in Q2.
  • Currently Q3 estimates are 60 cents lower than Q2 – possibly conservative enough but it is unclear as refining margins look like they will be lower in Q3 versus Q2 without a recovery in September.

Exhibit 2

Source: Bloomberg, Capital IQ, and SSR Analysis

LYB has only been a public company in the “good times”, going public in the second quarter of 2010 as the US shale advantage was materializing and accelerating – Exhibit 3. Almost immediately prior to Q2 2010 and in all of the prior history, crude oil and ethane were much closer together on a barrel of oil equivalent basis, and the US economics for ethylene relied on the marginal valuation differences between international naphtha prices and US NGL prices. An advantage that the US had during the oil price hikes of the 70’s – not shown in the chart – resulted in the US building surplus chemical capacity for export – much as it has done in recent years. That advantage was gone by the mid-1980s and from 1986 to 2009 US basic chemicals exports declined on a trend basis and were only profitable when the world was short of product – these tended to be short periods.

The shale advantage in the US may return to the highs of 2013 and 1H 2014, but we think this is unlikely unless oil prices can move meaningfully higher. At the same time, we need to see the current NGL logistical challenges fixed so that the US Gulf moves back to a surplus ethane position.

Today it is interesting to hear traders in Asia talk about no issue with Chinese import tariffs on US ethylene because spot prices in the US are so low it does not matter, but this only works because Chinese ethylene prices are well above local manufacturing costs. If the US surplus becomes a global surplus all bets are off.

Exhibit 3

Source: Bloomberg, Capital IQ, and SSR Analysis

We do not see the poor US ethylene and weakening US polyethylene market extending through 2019 without a shock to demand – which could either come from an economic deceleration, or, perversely, a sharp drop in oil prices, as this would cause some de-stocking. Continued strong economic growth should see global ethylene and polyethylene catch up with supply in 2019 and should drive better US margin.

SHLM: Q3 numbers will be confused by 6 weeks of ownership of SHLM, given that the deal closed last week. The company will likely take a charge for integration costs and one time deal related charges and consequently the LYB Q3 headline number will be much lower than consensus.

  • We think this is bad deal for LYB, and while LYB talks about earnings accretion, the deal was very dilutive on a multiple basis, especially given the significant earnings miss in Q2 2018. This is not the first time that SHLM has surprised the market with very negative results – Exhibit 4 – and we wrote a piece in 2016 where we debated whether SHLM was poorly run or just in some bad businesses – we concluded that it was a combination of both. LYB has overpaid for a portfolio that is poorly managed – presenting room for improvement, but at the same time in some bad markets – not easily fixed.
  • One of the concerns that we have is the packaging exposure in the SHLM portfolio – given as 39% of sales in SHLM’s 2016 presentations and reduced to 25% in the LYB deal presentation – Exhibit 6.
    • With the mounting pressure on packing waste and the expectation that consumer products and food companies will want to be seen to do the right thing, we see a scenario where compounded packaging demand trends to zero as a compounded polymer cannot be easily recycled. We are especially interested in why LYB thought this was a good idea given its move in polyethylene and polypropylene recycling in Europe.
    • We understand the automotive appeal, given LYB’s existing polypropylene compounding business, but this and other segments are going to have to grow quickly to offset losses in packaging in our view.
  • As long as LYB retains this business it will trade an appropriate commodity chemical multiple and if LYB manages to turn the business around and improve the profitability it will not impact the overall company multiple because it is too small.
    • In 2001, Millennium Chemicals decided to focus on the “specialty” piece of its portfolio in an attempt to persuade investors that the company was undervalued. LYB is not making this claim (yet) and would be wise not to as the Millennium move cost the then CEO his job!
    • The opportunity for LYB is to fix this business, integrate it with its own compounding business and then sell or spin it out – capturing the multiple arbitrage which exists today between LYB and POL – 5x on an EV/EBITDA basis.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Company Reports and SSR Analysis

Spending at the peak – LYB broke ground this month on the long-debated PO/TBA facility in Texas. This is a $2.4 billion-dollar investment to add significant capacity to the slow growing, but currently profitable raw material market for polyurethanes.

  • My now 35 years of association with the chemical industry tells me that it is generally not a good thing when a company announces something as the “single largest investment in the company’s history”. The value creators in this industry buy well and build cheap. Note that as DOW, CPChem and Exxon have brought on stream their new integrated ethylene complexes in the US, they are seeing margins that are as much as 75% lower than they were when the decision to invest was made.
  • LYB is not the only chemical company investing today, as costs rise and margins for some products fall, but it is the first of the new group to break ground. As we have written previously, we would expect others – mostly looking to invest in ethylene – to be reviewing plans based on current margins and re-working forecasts to reassure that planning assumptions have not changed.

If we make some estimate around the replacement cost of LYB’s intermediates business, we can show that the returns have not been adequate to justify new capacity in recent years and appear to be deteriorating rather than improving – Exhibit 7. Maybe LYB has the timing right on this investment, but if so they will be in the 1% of chemical companies that gets an investment right in a cyclical business.

Exhibit 7

Source: Capital IQ and SSR Analysis

Valuation

But, Lyondell is not expensive, and through valuation work that we did in early 2017, to support a buy recommendation at the time, derived a value of $106 per share – lower than today’s price but a 20% premium at the time. On this basis the downside is not that great, but in the work in 2017 we had assumed that European profitability fell to zero and the US “shale advantage” remained in place. The US shale advantage is looking less robust today, but Europe has not seen a collapse in ethylene margins. At less than 7x EV/EBITDA, LYB is not expensive, but if EBITDA falls by 25%, as it could in a weak ethylene market, the stock would likely test its 2017 lows again.

LYB’s valuation is not out of sync with the other commodity exposed names in the group – Exhibits 8, but with the exception of IFF, we would rather buy everyone to the right of LYB in the exhibit.

Exhibit 8

Source: Capital IQ and SSR Analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

Print Friendly