Lyondell – Growth or Income, Both Have Risk

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 7th, 2013

Lyondell – Growth or Income, Both Have Risk

  • We would argue that LYB is fairly valued today, despite forward estimates that could persuade one otherwise. The new LYB only has trading history in a period of huge US feedstock advantage, which we see as cyclical rather than permanent, consequently “normal” value is well below current value in our view.
  • LYB management was dealt a very good hand post bankruptcy, and has played that hand exceptionally well; the stock is up 250% in roughly three and half years – Exhibit 1. However, with success, there is often a “halo” effect and consensus expectations for LYB today reflect everything going right over the next 2-3 years and nothing going wrong.
  • Presentations appear to telegraph more focus on capital projects to achieve growth than they have in the past – which in our view adds risk. Additional risks include the closing of the gap between crude oil and US natural gas prices, further deterioration in profitability in Europe, and a more permanent squeeze on refining margins. These are more adequately reflected in valuation today than they are forward estimates in our view.
  • These are not only LYB risks, they exist also for both DOW and WLK, though WLK does not have the European risk and neither have the refining risk. We do not think that the recent history of excessive shareholder returns at LYB can continue and at the margin we think there is risk that forward estimates are too high. That said, we would not favor another US ethylene stock over LYB.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Lyondell is one of the most loved chemical companies according to recommendation analysis by Capital IQ. Monsanto is in the lead, but Lyondell is a very close second (Exhibit 2).

Exhibit 2

Source: Capital IQ

We would argue that it is time to revisit that conclusion as we are not sure that the much talked about growth story is enough to offset the inherent risks that accompany any commodity platform. While we could certainly make the bull case today, we think that LYB is now much more of an income story rather than a growth story and as such is at least fully valued. The dividend and buyback programs are likely to provide the shareholders with reasonable returns, but the stock will only be bid higher if the expected growth initiatives can be realized in full without offsets and with further (likely more risky) growth initiatives yet to be announced. In our view offsets would include:

  • Further margin pressure in Europe – LYB is doing a great job of controlling costs, but lower cost exports from the Middle East and possibly North America should maintain downward price and margin pressure in Europe.
  • Declining US polypropylene margins if rising propane prices impact marginal economics for propylene and squeeze propylene derivative margins as a consequence. There might be an offset here in polyethylene and styrene demand/pricing.
  • Closing the gap between natural gas and oil pricing and thus reducing the margin umbrella enjoyed by NGL based producers in the US.
  • Any further deterioration in refining margins.

Consensus estimates for 2015 and beyond call for the benefit of all current capital projects falling to the bottom line as advertised by the company and by default reflect none of the risks outlined above taking place. We think that it would be more prudent to haircut the estimates and consequently see negative revision risk outweighing positive revision risk. Lyondell traded down ahead of Q3 earnings, the company missed the consensus estimate and the stock is again lower since, despite weaker natural gas prices which have often been a trigger for stock appreciation.

Lyondell is generating plenty of free cash and has the ability to continue buying back shares and continue with special dividends and in our view could generate as much as 6% shareholder returns without any stock appreciation going forward. This is not a bad story, but we would not bid the stock higher at this point.

The Bull Case

Lyondell has performed very well since its emergence from bankruptcy, outperforming the sector and all of its direct peers except Westlake, as was shown in Exhibit 1. As indicated earlier it is a much loved story and while the analyst community has moved to a more cautious stance on Westlake as prices have risen, it has not really done so on Lyondell.

The bull case is represented in current consensus estimates, which show EBIT growing in line with the project start-ups that Lyondell is pursuing, in fact slightly ahead of that guidance. If correct, you have a compelling story at some level because earnings per share grow to $8.20 in 2015, so the stock is at 9.5x 2015 earnings today, versus Dow Chemical at 11.4x and Westlake at 11.9x. Moreover, if we use our own valuation analysis (and take some liberties with LYB assumptions) we also get a similar pattern – LYB fairly valued, Dow expensive and Westlake very expensive – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis

We would probably argue that you should buy LYB over both DOW and WLK, but the more important question is whether you should buy any of them. Saying that LYB is undervalued because if you give it a DOW multiple of 2015 earnings it should be at $92 per share, assumes that DOW is either attractive or at a minimum fairly valued.

The Real Valuation Story Is Different

There is a flaw in the analysis above because we are basing LYB’s return on capital on its average since emerging from bankruptcy – 18%. This is flawed because LYB has only been a public company in the good times and not yet through a cycle. To adjust for that we have the analysis summarized in Exhibit 4. Here we have looked at the peer group to see how average returns from 2000 compare with the period from June 2010 (post LYB start of trading). Ignoring DOW for the moment and just looking at the group and WLK, we see somewhere between a 40% and 45% improvement in the recent period versus the longer but inclusive period. The longer period – in fact a much longer period is driving the valuation models for many of the companies in our coverage, capture several cycles in many cases.

Exhibit 4

Source: Capital IQ and SSR Analysis

If we simply reduce LYB’s “normal” return on capital by the 45% – so down from 18% to around 12.5% we get a much different view of valuation relative to DOW and WLK – Exhibit 5. Our view is that this approach is probably a more valid approach to determining fair value for LYB and it creates a fair value of $51 per share.

Exhibit 5

Source: Capital IQ and SSR Analysis

Like others, Lyondell is riding a wave of very favorable feedstock dynamics in the US, and while “normal” value is an interesting concept, it clearly does not represent what is going on today – it is however a useful reminder of what could happen in the future and this is where we need to talk about risk.

US Ethylene Margins – Unlikely To Get Much Better

US ethylene margins are at extreme highs and we have written previously that it would be improbable for them to improve further. The margins are a function of the spread between US natural gas pricing and global crude oil pricing, which peaked in 2012 – Exhibit 6. The reason why profits in the US continued to rise post that peak was that NGL prices then collapsed relative to natural gas. Exhibit 7 shows a 12 month rolling average of an ethane to Brent ratio, but hides the fact that the last 12 months have been effectively flat.

Exhibit 6

Source: IHS and SSR Analysis

Exhibit 7


Source: IHS and SSR Analysis

So how can this get better for US producers?

  • Crude could rise relative to gas. The forward curves are negative, but these have been bad predictors in the past. We are more focused on rising supply and very stagnant demand, which absent the ever present “political risk” should maintain downward pressure on crude.
  • Natural gas could fall relative to Crude. This is possible as natural gas fell well below $3.00 per MMBTU in 2012 – causing the peak in Exhibit 6. However, it is widely accepted that most shale based production is unprofitable below $3.50 per MMBTU and the trough in 2012 lasted around 6 months, while production corrected.
  • Ethane could fall relative to natural gas. US fractionators are running at a cash loss today based on fuel equivalent value, so there is not much room for further declines as at some point ethane or ethane mix gets preferentially burnt as a fuel.

In our view, for two of the three of the possible changes outlined above, the more likely movement is in the opposite direction to the one needed to help US chemical producers.

A more prudent approach to modeling LYB and others might be to take a haircut to current US margins both for the existing capacity and the expected new capacity and that haircut should increase the further out you get.

European Margins Likely to Get Worse

We have made no secret about our view that demand growth is slow in a high price environment
. If you then couple that to a less than stellar global economy you have the very limited chemical and plastic demand growth globally that we have seen in 2012 and 2013. This slow growth increases the risk that when we get a wave of new capacity in North America, China and the Middle East from 2016, the World does not really need it. As this realization hits we would expect the gloves to come off in some of the regions where costs are viewed as being high, as lower cost importers seek to gain a foothold to enable increased trade as supply rises. This is bad news for Latin American producers, but it is also bad news for Europe.

We would expect to see constant downward pressure on European prices and margins through the next three years, and while we are impressed with the cost cutting measures we have seen from LYB and DOW so far, we do not expect profits from Europe to improve. In our view this justifies the forward multiple premium that exists today for WLK versus LYB and calls into question the multiple for DOW.

Refining Margins

This is not an area of real expertise for us, but we do believe that it is going to be hard to improve the economics of complex refineries on the Gulf Coast as we start to see more and more light crude coming down from the shale plays. This will be compounded if we start to see declines in gasoline consumption in the US as a result of the new CAFE standards, increased use of diesel and increased use of electric/hybrid. Both the GTL plans for the Gulf Coast and the increased use of electric vehicles are a substitution of crude as a transport fuel starting point with natural gas (as the marginal generator of electricity and as the feed for GTL).

What Cycle?

LYB (and others) are at best fairly valued today and otherwise expensive. What might keep us interested would be a cycle – an old fashioned run up in prices based on an expected shortage of supply, and margin expansion above and beyond break-even for the incremental producer. This would be a situation where everyone makes money, even the high cost guys and where current US NGL based producers would make even more than they are making today.

Given the short history for LYB, we will use DOW as an example. Exhibit 8 shows Dow’s discount from normal value using the methodology that we have discussed at length in prior research and which provided the data points in exhibits 3 and 5. The prior valuation peaks (1988 and 2005) show that there is still significant upside to DOW should either a commodity cyclical peak occur or should the market chose to discount one, as was the case in 2005/2006. Note that a cyclical peak guarantees nothing, as there was a small positive cycle in mid-1990s which failed to impress on a relative basis as the tech bubble was starting and there was reduced investor focus on Materials in general. We would expect Lyondell’s value to spike also in the event of a peak or in anticipation of one and this could carry the stock to a 2+ standard deviation premium to normal – which would get us close to $90 per share. (The same analysis would get us to a target of $50 per share for DOW).

Exhibit 8

Source: Capital IQ and SSR Analysis

But is a cycle or belief in a cycle likely?

We would caution against too much optimism here, for the following reasons:

  • Demand growth has disappointed in 2012 and 2013, causing many to reset expectations around basic chemical consumption over the near-term. The optimists suggest pent-up demand and have above trend expectations for 2014 and 2015, but they had this view of 2013 a year ago and they were wrong. The pent up demand thesis is largely flawed as consumables are such a large market for basic
  • plastics, and there is limited if any pent up demand in consumables – here we have seen a reduction in use, or substitution or increased recycling and these explain the disappointments. Consequently, we do not expect a return to trend demand growth without a return to trend economic growth.
  • Even then, there is the risk that higher prices constrain demand – in Exhibit 9 we show a chart that we have published several times – a plot of global ethylene demand growth and crude oil prices. There is not a tight empirical relationship, but there is a clear pattern and as long as oil prices stay high we think that global demand growth will remain below trend, regardless of whether economic growth shrugs off the drag of higher oil prices and manages to get back to normal.
  • Even if we do see improved demand and higher pricing for basic chemicals and polymers, there is the risk that the market looks right through it and focuses on the wave of new capacity coming on line in 2016, 2017 and beyond, and does not give the stocks credit for the higher margins, similar to what happened in the second half of the 1990s.

Exhibit 9

Source: IHS and SSR Analysis

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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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