Lyondell – Over-Optimistic on Ethylene Means Over-Aggressive on Cash Return

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 29th, 2016

Lyondell – Over-Optimistic on Ethylene Means Over-Aggressive on Cash Return

  • Lyondell’s recent investor presentation on the ethylene market suggests a rosy view on ethylene conditions in the face of pending global capacity increases
    • Assumes demand growth keeps pace with capacity additions in the period from 2016-2020, implying 4% + ethylene demand growth and possibly ignoring the phasing of additions within that period
  • The company continues to pursue a strategy of aggressively returning cash to shareholders
    • On the margin, this strategy will rely on utilizing the balance sheet as dividends and share repurchases should outstrip free cash flow from operations – debt levels are rising
  • The prospect for declines in integrated polyethylene margins make earnings estimates for Lyondell vulnerable for downward revisions (see related note)
    • Ethylene/polyethylene production per share is the highest in the industry at LYB and we still believe that the market could see a 10-15 cent per share decline in ethylene/polyethylene margins over the next 12 months
    • A margin decline of 10-15 cents per pound would take $0.40 to $0.60 cents off EPS in each quarter of 2H ’16 – consensus currently has a $0.30 EPS decline in 2H ’16 vs. 2H ’15
    • A margin decline of 10-15 cents per share would amount to an annual 15-25% hit to 2017-2018 EPS – consensus currently sees year over year growth in each of those years
  • The combination of rising debt levels and negative revisions could be a recipe for increased stock volatility over the next few years
  • Both DOW and WLK have better structured balance sheets today and net debt that has been moving in the right direction – both are better positioned to ride out any possible ethylene/polyethylene weakness – even if WLK is successful in acquiring AXLL its balance sheet will remain in good shape

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

As detailed in research published in tandem with this piece, we are about to see a wave of ethylene capacity increases over the next few years. The fact that the ethylene capacity will be coming on is not up for debate but what is more uncertain is demand growth and, consequently, global ethylene operating rates over the next few years. At a recent conference, Lyondell presented an outlook that showed incremental demand matching incremental capacity through 2020 but this implies demand growth of 4.5% per year. It is our viewpoint that demand growth will be more like 3% at the high end. Exhibit 2 summarizes the situation. Based on our demand outlook, the resulting overcapacity is expected to weigh on operating rates over the next five years – Exhibit 3. While LYB may be optimistic in its forecast of demand – Exhibit 4 – the company is also smoothing over the near-term impact of additions in 2016 and 2017 (Exhibit 2) by aggregating the period from 2016 to 2020.

Lower operating rates have serious implications for profit margins, more so than the most recent downturn in in the latter half of the last decade when the industry cost curve was steep enough for the lowest cost operators to capture small profits. With lower oil/gas price ratios, we are now back in a position that resembles previous periods of depressed operating rates in terms of the flatness of the cost curve, which will have a major impact on North American producers despite the shale-related feedstock availability.

Exhibit 2

Source: Wood Mackenzie, SSR Analysis

Exhibit 3

Source: IHS, Wood Mackenzie, SSR Analysis

Exhibit 4

Source: IHS, Company Reports, SSR Analysis

Why This is So Important for Lyondell

Lyondell already has the largest operating leverage to polyethylene among major US producers, with over 25 pounds of capacity per share as shown in Exhibit 5.

Exhibit 5

Source: Wood Mackenzie, Company Reports, SSR Analysis

Because of this inherent leverage, if 2H ’16 sees a meaningful decline in ethylene/polyethylene pricing, LYB estimates are particularly vulnerable given a flatter cost curve. Given our view of pending oversupply, we believe that the market could see a 10-15 cent per share decline in ethylene/polyethylene margins over the next 12 months.

Estimates for the second half of 2016 are only $0.30 below actual results from 2H ’15 ($4.68 estimate vs. $5.00 actual).

A 10 cent decline in margins applied to LYB’s exposure of ~25 pounds per share, tax adjusted and put on a quarterly basis amounts to a $0.40 earnings decline in each quarter of 2H – a more aggressive assumption of a 15 cent margin decline amounts to a $0.60 quarterly EPS hit.

The potential impact of $0.80-$1.20 cents dwarfs the current expectation for a $0.30 year over year decline in earnings – Exhibit 6.

Exhibit 6

Source: Capital IQ, SSR Analysis

The same analysis applied to 2017 and 2018 earnings estimates shows consensus may be 15-25% too high.

LYB Leveraging Up at the Top

There are implications for Lyondell above and beyond the normal earnings-related ones due to the company’s capital allocation policies. Lyondell has pointed out its aggressive capital allocation policy which includes the funding of $5.6 billion of capital investments and $18.7 billion of dividends paid and shares repurchased over the past four years. What becomes apparent, however, is that over the past two years the company has needed to increase its net debt by $4.3 billion dollars (almost $10 per share) to fund its capital spending and shareholder return policies.

Prospectively, 2016 is looking like another year of rising leverage. Consensus EBITDA is expected to decline year-over-year by around $1.2 billion and capital spending is expected to rise by around $400 million. All else equal, free cash flow could fall to around $3.2 billion in 2016. After $1.4 billion of dividend payments, there would be $1.8 billion left over for share repurchases before tapping the balance sheet. The company has a stated target of acquiring 10% of its stock which would equate to roughly $3.8 billion at the current stock price. This would require incremental borrowings of $2 billion and would raise debt/share by around $4.50 per share.

Exhibit 7

Source: Bloomberg, Capital IQ, SSR Analysis

©2016, 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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