LyondellBasell and Westlake – Not Yet!

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Graham Copley / Nick Lipinski
203.901.1629 / 203.989.0412
gcopley@ /nlipinski@ssrllc.com

December 4th, 2014

LyondellBasell and Westlake – Not Yet!

  • Westlake could still be expensive, though LyondellBasell looks more fairly valued. Given the uncertainty in the energy and chemicals markets, we go back to our roots and wait for the stocks to fall to “normal” value before we get more constructive. If energy stabilizes where it is or recovers we may not get to normal value for WLK, but we see the risk as high and want a level of protection.
    • This would require 22% more downside for WLK – LYB is there
  • We have reworked “normal” for LYB and WLK, ignoring the recent margin highs and looking at longer term proxies, choosing to settle on WLK’s average return on capital (ROC) since its IPO (12.2%). This is above the chemical industry average and trend and recognizes the more written down nature of the two portfolios – it compares with current “normal” ROC for DOW of 7%.
  • While we can construct lots or arguments as to why oil prices should not go back to the historic relationship with natural gas that resulted in “normal” margins for the US industry, we can also construct some arguments that suggest they can. Therefore, it makes sense to look at the implications.
  • Despite the recent run-up, US ethylene margins have averaged 9.4 cents per pound since January of 1981 – Exhibit 1 – and have generated an average return on capital that has not come close to covering the cost of capital. Over the last 10 years, they have averaged 17 cents per pound. Suggesting that WLK and LYB can earn a long-term 12+% return on capital on what are predominantly ethylene assets is a leap of faith and assumes that the last ten years are the new norm.
  • Current normal values on this basis are: LYB $79; WLK $53; DOW $45. LYB is hovering around this level today and while we would not chase the stock, we might be tempted by further weakness.

Exhibit 1

Source: IHS, Wood Mackenzie and SSR Analysis

Overview

Temptation can be very powerful and it can lead people into all sorts of trouble. As analysts covering “value” sectors, the most common temptation is the “it’s different this time” lure of an industry or company that appears to be on a new path – enough so for you to change or “tweak” a model.

So, it’s time for confession – we have been guilty when it comes to valuing both Westlake and LyondellBasell; attracted by the lure of the shale economy and hindered by a lack of historical data, a factor which we have used to cover up otherwise flawed analysis. Our “normal” models rely on reversion to mean or reversion to trend, but for these to work you have to have enough history to establish a credible trend or a mean. This data does not exist for LYB and there is really not enough for WLK either. We have been for the most part bearish on stocks that have run away from us through 2013 and most of 2014, and tried to play catch up by allowing our valuations models to be driven by short term data. Consequently, the falls in both LYB and WLK stock prices over the last two months were sufficient to make them look attractive in our models; inconsistent with our views of leverage to ethylene margins and possible earnings declines in 2015.

Our models are likely flawed, as they suggest “normal” returns on capital that are too high unless you assume a prolonged significant cost difference between making base chemicals in the US and in the rest of the world. It is an appropriate time to look at what valuation should be absent that assumption.

Exhibit 2 shows return on capital for DOW, WLK and LYB since LYB went public in June 2010. LYBs return on capital has averaged 18.7% since the company went public. Over the same period WLK has averaged around 15.5% and Dow a little over 7%. WLK has averaged 12.2% since it became a public stock (August 2004) and DOW has averaged 7.8% over the same roughly 10 year period. We should not be overly influenced by the DOW data as the company has historically been a very poor steward of capital and it would be unreasonable to paint WLK and LYB with the same brush. It is interesting however to note that the “shale” opportunity in the US has allowed DOW to move its current ROC back to its 10 year average, while WLK is almost 1000 basis points better than its 10 year average – Exhibit 3.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

If we use Dow as a proxy (Exhibit 4), we can perhaps conclude that the 2008 trough was representative and that the period from August 2004 to today is representative of a full cycle – suggesting that the 12.2% return on capital average for WLK is a good normal and given that we have little else to help we should probably use the same average for LYB.

Exhibit 4

Source: Capital IQ, SSR Analysis

Assuming a 12.2% “normal” return on capital for WLK and LYB yields a current normal value of $52 for WLK and $79 per share for LYB. The calculation is summarized in Exhibit 5 and the numbers make intuitive sense given WLK’s greater leverage to US ethylene margins. What the data shows is that if US basic chemicals profitability normalizes to the average of the last 10 years, WLK is still quite expensive, while both DOW and LYB are moving closer to normal value.

Exhibit 5

Source: Capital IQ, SSR Analysis

A Reasonable Assumption For Earnings Power

Today, we do not know how far oil prices will fall, if any further, how long they will stay down, and what this will mean for the competitive dynamics of the global base chemicals industry. Conventional economics leads us to the cost curve shapes in Exhibit 6, but if oil falls further and natural gas does not move, the lower curve will flatten. Even if oil does not move materially, if ethylene co-products retain a higher value than in the past then the curve will flatten. If oil rises, etc.

Exhibit 6

Source: SSR Analysis

The power of a “normalized” approach is that it takes away all of the cyclical what-ifs and provides a base line. The issue with both LYB and WLK is that there is not much history and no obvious proxies – DOW is far too complex to compare to WLK, but is closer to LYB from a business perspective. DOW also has a capital structure that is very different.

Today the cost of capital for all Industrial companies is very low – Praxair was recently able to raise 10 year 500mm Euro denominated debt with a coupon of less than 1.7%! Industrials and Materials have very mixed return on capital trajectories, depending on the sub-industry, as shown in Exhibit 7, and chemicals has cycled around a slowly improving trend in the 10-11% range. Note however, that no sub industry except for conglomerates is currently trending above the average return that we are proposing for both LYB and WLK. Within the chemicals group, there are winners and losers – we have already shown DOW as a loser; recent winners would include EMN, PX, and even DD. The winners are generally not in the commodity group; in fact most are winning because they have essentially exited commodities.

Exhibit 7

Source: Capital IQ, SSR Analysis

The temptation is that current investments look for lower returns (based on fixed hurdle rates over lower costs of debt), miss the target (as they have done in the past), and result in lower industry average returns going forward. It is going to be very hard to resist the current cost of capital given the under-levered balance sheet the industry has today – Exhibit 8.

Exhibit 8
Source: Capital IQ, SSR Analysis

If all of the new ethylene investments in the US managed a return on capital above 10%, it might be appropriate to propose a higher “normal” ROC for LYB and WLK given a largely depreciated ethylene asset base. History has told us that investment cycles in commodity chemicals do not hit hurdle rates so it would be adventurous to assume that they will this time – the last few weeks have shown just how quickly assumptions can be challenged.

In the overview we suggested using WLK’s 10 year average ROC as a proxy for normal, both for WLB and for LYB – 12.2%. This is higher than the commodity sector has managed in the past and higher than the current point on the trend for the chemical group as a whole. We could argue for a lower number and for a higher a number, but we cannot argue for a higher number without making some long-term energy assumptions that look quite speculative today.

Valuation – In a Normal World, Things Could get Cheaper

The downside for both LYB and WLK comes from any expectation that we could be heading back to a more normal world. If we use the 12.2% for return on capital for both companies, the normal valuation charts “look” right – Exhibits 9 and 10, especially when compared to Dow – Exhibit 11.

Exhibit 9


Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

©2014, 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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