LYB – Changing The Investment Thesis

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Graham Copley / Nick Lipinski



February 20th, 2018

LYB – Changing The Investment Thesis

  • With its planned acquisition of SHLM, LYB has changed its story, and appropriately raised investor concerns with respect to why they should own the stock.
    • LYB was down last week, in a week which saw better economic news, oil prices rise, natural gas prices fall, the stock market rally and other chemical peers appreciate.
    • There can be no doubt that this is not a popular move from LYB. The stock has not moved that dramatically because this is not a large acquisition, but the stock could continue to weaken if investors see this as an indication of a change in strategy and consistency.
  • SHLM may be a business that has been run poorly and it may offer significant cost opportunities for LYB – it will also be captive consumption for LYB polyethylene and polypropylene. These could be seen as positives and reasons to do the deal, but…
    • SHLM has a poor history of execution and very poor margins and this could be as much a function of end-market dynamics and customer mix as anything else.
    • SHLM competitors are likely to stop all purchases of polymer from LYB – this may or may not be significant.
    • Reporting will be important – are LYB margins higher because the company is transferring polypropylene to its business at cost? If it does the same for the SHLM business, “margins” will rise immediately, but then LYB falls into the “integrated” reporting trap that has been so unpopular and misleading with DOW for decades.
  • The deal is value destructive, as SHLM earnings will now trade at a lower multiple than they did previously. LYB has suggested that this is a platform to build on – so do we get more value destruction.
    • Investors own LYB for the almost pure play commodity chemical exposure, for capital and operational discipline and for returning cash to shareholders – not for M&A, where the current management team has almost zero experience.
    • We would rather own DWDP, WLK and Braskem but LYB will work if polyethylene works.
  • This deal is off-piste in two ways – it is an M&A move and it is not commodity chemicals.
    • SHLM has not been broadly covered – but the company and those covering it have been wildly optimistic for years – Exhibit 1.

Exhibit 1

Source: Capital IQ and SSR Analysis

How Out Of Control Is SHLM?

SHLM has had some major earnings misses over the last few years – surprising on the downside much more significantly than LYB – Exhibit 2. This comes on the back of meaningful negative revisions every year from 2015, as shown in Exhibit 1. In early August of 2016 SHLM issued a significant earnings warning for the quarter ending August 2016, having confirmed that the quarter was on track only 6 weeks earlier. In its most recent analyst conference – November 2017 – the company presented revenue split data from fiscal year 2015 – data that was 15 months out of date! SHLM has been doing very poorly for a business that should be levered to stronger economic growth.

When asked to elaborate on a number of the cost opportunities, synergies, cost miss-matches etc., on the analyst call following the deal announcement, LYB CEO Bob Patel continually talked about discovery that was yet to take place – prior to closing. This raises the question of how much due diligence LYB has been able to conduct at this point and how well they know the business they are acquiring.

Exhibit 2

Source: Capital IQ and SSR Analysis

SHLM has been looking for new leadership for a while – starting a search during 2017 and clearly deciding that putting itself up for sale was the better option, so is Lyondell buying an opportunity or a lemon!

SHLM has been struggling to keep up with earnings/synergy promises for years and has a history of optimism as shown in Exhibit 3.

Exhibit 3

Source: Capital IQ, SSR Analysis

In our view part of SHLM’s problems were caused by consolidation – an issue that LYB has now compounded (pun intended).

  • Consolidation in the sector by SHLM has caused customers in certain geographies to diversify suppliers at the expense of SHLM. When Dow bought Union Carbide it lost polyethylene business from customers who bought from both prior to the deal – this was not factored into planning assumptions adequately at the time the deal was valued. The HGGC acquisition looks like it created a similar problem for SHLM.
  • LYB has made small acquisitions to build its own compounding business but has done so for the most part in diverse geographies. The SHLM deal has geographic overlap with LYB and LYB could suffer from the same problem – companies like POL will likely benefit.
  • As indicated in the opening bullets, it is likely that LYB will now be competing with some of its current polyethylene customers – this will encourage them to look elsewhere for polymer as they will assume that LYB is giving its own business a special deal on transfer pricing and a competitive edge – other polyethylene (and polypropylene) producers will see this as an opportunity to win business.

If we look at some simple valuation metrics for SHLM we do not think that LYB got a particularly compelling deal here. Debt per share at SHLM rose so quickly that the company has negative tangible book value per share – Exhibit 4. Return on capital collapsed through the last decade and dipped again in 2016 but has improved subsequently – Exhibit 5.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Is LYB Out Of Control? – Probably The More Important Question

The LYB story WAS fairly straightforward – extreme leverage to polyethylene – operational excellence – return free cash flow to shareholders – invest in low cost high return expansions – easy!! Note that LYB saw peaks in its price to normal earnings both as oil peaked but also after oil had fallen (Exhibit 6) – suggesting confidence in the strategy. The low came in May of 2017 when the company decided that it might be time to start buying things and articulated the potential scale of a deal at an analyst meeting. The investor unhappiness with that idea caused the stock to drop and the company walked back the idea and resumed share buybacks. However, since that time a number of possible tie-ups have been suggested – Braskem, and HUN most significantly – all of which suggests that LYB has been actively looking for acquisitions – culminating in the SHLM announcement – and a reversal of the PE trend.

Exhibit 6

Source: Capital IQ, SSR Analysis

Investors should be concerned in our view, for a couple of reasons:

  • While the company can boast about the possibility of earnings accretion after synergies and debt refinancing, this is a value destructive deal because LYB is paying a much higher multiple for the business than its own multiple. Buying back LYB stock would have been a better and less risky use of the cash.
    • This is, in theory, a less cyclical business than commodity chemicals and all companies enjoy higher multiples – POL trades at an enterprise value of just under 12x EBITDA.
    • However well LYB runs this business and integrates it with its own, it will trade at a commodity chemical multiple There are too many stories of failed strategies of commodity chemical companies trying to improve their mix and getting no credit. The DowDuPont combination and split is an example of keeping the commodity stuff together and the specialty stuff together. Dow did not get value for the specialty additions to its portfolio.
  • LYB has suggested that this is a “platform” and that there might be more acquisitions. It is unlikely that these will be at lower multiples than SHLM unless they are part of a more commodity base – in which case the deals might make more sense.
    • If this is an ongoing strategy, LYB should (must) break-out this compounding business as a reportable segment and be clear how it is treating the transfer of LYB polyethylene, polypropylene and other products/services. We would like to see the polymers transferred at their most logical alternative value rather than cost, so that investors can put an appropriate value on the business and evaluate any further bolt-ons.
    • If LYB does not break-out the segment and provide transfer pricing clarity, that would be another strategic red flag.
  • The argument that this deal is ok because it is relatively small is naïve in our view. LYB has clearly been looking for an acquisition for a while, based on the rumors (there is always some basis for rumors). This could have been a much more dilutive and value destructive announcement had the target been HUN or CE or any one of a dozen other companies. These could still come.
    • In our view LYB should stick with what it knows – basic chemicals and polymers.

In 2002, Millennium Chemicals decided that it was going to re-brand itself as a specialty company (to try and command a higher multiple) based on the idea that less than 10% of its portfolio was in specialty TiO2 grades and co-products and specialty vinyl acetate derivatives that did not behave like the remaining commodity 90% of the business. The idea was that the company was going to acquire other specialty businesses to make this transition. The analyst community (this analyst in particular) took extreme issue with the strategy and the sitting CEO was out of his role within a few months. Millennium was eventually acquired by Lyondell

In July of 2008, The Dow Chemical Company agreed to pay $19 billion for Rohm and Haas in cash and debt assumption. The idea was to diversify away from commodities and try to get rewarded with a higher multiple. The timing was terrible and the borrowing almost pushed Dow into Chapter 11, but as show in Exhibit 7, the more specialty portfolio was unable to get back to prior DOW multiples – let alone see an improvement. The subsequent multiple rally was a function first of activism and then the DuPont deal – the idea that commodities would again be separate from specialties.

If LYB tries to use the SHLM acquisition as a stepping stone towards a “specialty” strategy we would avoid the stock completely. Today, any strength in polyethylene in 2018/19 will overwhelm the negatives of the SHLM deal, but perhaps not a “next deal”. We would rather take polyethylene exposure through DWDP, WLK and Braskem. Note the DOW cyclical commodity peaks in 1976 and 1987 in Exhibit 7 – DWDP today has more polyethylene capacity per share than DOW did in either of those industry peaks.

Exhibit 7

Source: Capital IQ, 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.

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