Profitability peak

28 March 2005 00:01  [Source: ICB]

The coming petrochemicals peak is likely to exceed the 1994-95 peak and could rival the super-peak of 1988-89. Joseph Chang reports

Firing on all cylinders, the North American petrochemical industry is gearing up for peak profitability ahead, on the back of a robust upcycle. With supply-demand fundamentals tightening after years of under-investment in the industry, Wall Street is predicting peak profitability in 2006, extending into 2007 in perhaps the longest, strongest cycle peak ever.

Many on Wall Street are forecasting that the coming peak will exceed the previous peak of 1994-95 both in intensity and duration because of an unprecedented four years of under-investment in North American petrochemical capacity and few new projects in the works.

‘We believe that the current recovery in the ethylene cycle is likely to be of longer duration and higher amplitude than the 1994-95 peak,’ says Merrill Lynch analyst Donald Carson. ‘Ethylene cash margins ended 2004 approaching levels achieved during 1994-95, and we expect margins to improve further in 2005, peak in 2006 and remain relatively healthy in 2007.’

‘We remain very bullish on the cycle,’ says Fulcrum Global Partners analyst Frank Mitsch. ‘We think that 2005, 2006 and 2007 will be very good times, barring an economic recession due to high energy costs. Operating rates are clearly moving in the right direction. The absence of new capacity gives us confidence that we are going to see a materially better chemicals environment than we saw in 1994-95.’

The last cycle peak in 1994-95 was driven by customer inventory restocking following several unplanned outages, notes Carson. This coming peak will be driven by demand catching up to the lack of capacity additions, resulting in tighter supply-demand fundamentals.

The 1994-95 peak lasted just nine months while the 1988-89 peak extended for about a year and a half, points out Greenwich Consultants analyst Michael Judd. ‘During the mid-to-late 1980s, commodity chemical companies were trying to reinvent themselves as higher margin speciality companies,’ he says. ‘At that time, the companies were buying and investing in the speciality chemical business and were selling commodity chemical assets and generally under-investing in commodity chemical plant and equipment.’

Lack of new capacity

Both upcycles ended with the surge of new capacity. However, so far there is little new capacity on the horizon. Capital expenditures (capex) have severely trailed depreciation for the past four years as companies sought to preserve cash in the worst downturn in chemical industry history. While expenditures will rise in 2005 from 2004 levels, they will still largely remain flat to below depreciation for most companies.

For example, while Dow Chemical plans to boost capex from $1.33bn in 2004 to $1.5bn in 2005, spending will remain below depreciation of $1.9bn. Lyondell will increase capex from $229m in 2004 to $332m in 2005, remaining well below depreciation of $660m. However, Nova Chemicals aims to spend $300m in 2005 – about even with depreciation – versus $242m in 2004.

‘Capital expenditures will clearly be picking up in 2005, but the fact that they have been so muted in the past several years bodes well for the years ahead,’ says Mitsch.

‘What is unusual about the current peak period is that it could last for four years,’ says Judd. ‘In the last couple of cycles, it was the big investments made by companies that added to supply and killed the upturn. What could be different this time is that companies are adding less capacity.’

The only major new commodity chemical project on the slate in North America is Shintech’s $1bn integrated vinyls complex to be built in Louisiana by the end of 2006. However, a number of analysts doubt the facility will start up as scheduled. Shintech is also evaluating the possibility of building an ethylene plant in the US.

Pemex and Nova plan to build a $1.9bn ethylene and derivatives complex in Mexico, but that project is not scheduled to come on line until 2009 or 2010.

Wall Street hikes estimates

Wall Street is becoming increasingly bullish on the profit outlook for commodity chemical companies. Analysts are starting another wave of upward earnings estimate revisions after a rash of upgrades late last year.

JPMorgan analyst Jeffrey Zekauskas has boosted 2005 earnings per share (EPS) estimates for Dow, Lyondell, Nova and Westlake. He maintains ‘overweight’ ratings on each.

‘Activity in North American ethylene markets in recent months provides further evidence that a strong cyclical upturn is now well under way,’ says Zekauskas. ‘Continued economic expansion, stable capacity and unplanned outages have led to gains in cash margins beyond our previous forecasts. We expect these trends to be sustained and we now project full-year 2005 ethylene cash margin improvement of 7 cent versus 5 cent previously.’

The analyst has hiked his 2005 EPS estimates across the board for Dow (from $4.25 to $4.65), Lyondell (from $2.60 to $2.90), Nova (from $3.75 to $4.50) and Westlake (from $3.35 to $3.85). Zekauskas was an early bull on commodity chemicals, having upgraded Dow in early 2003, Lyondell in mid-2003 and Nova in mid-2004.

Merrill Lynch’s Carson has raised his profit forecasts for Dow and Lyondell – both of which carry ‘buy’ ratings. For Dow, the analyst boosted his 2005 EPS share estimate from $4.50 to $5.00, and his 2006 peak forecast from $6.50 to $7.50 to reflect increased confidence in the amplitude and duration of the coming peak. For Lyondell, Carson has raised his peak 2006 estimate from $5.50 to $6.00, and his price target from $36 to $40.

‘Our $7.50 peak estimate for Dow assumes recovery of about 85% of the absolute dollar margin lost company-wide since the 1995 peak,’ says Carson. ‘Full margin recovery would result in peak EPS greater than $8.’ The analyst sees cash margins in ethylene/polyethylene, ethylene glycol and chlor-alkali fully recovering to 1988-89 levels – higher than 1994-95 – but styrenics margins not fully recovering to 1994-95 levels because of high benzene prices and new capacity coming online in Asia in 2006.

Upside in stock prices?

Despite the huge run-up in commodity chemical stock prices over the past year and a half, Wall Street sees a further upside as the industry marches to the peak.

‘It is rockin’ and rollin’ here, but Georgia Gulf, Nova, Olin and Dow still offer value, even after the price appreciation we have seen,’ says Fulcrum Global’s Mitsch. The analyst is particularly bullish on Nova and Dow.

Mitsch has Nova earning $4.50/share in 2005, followed by $8.00 in 2006, and Dow making $4.25/share in 2005 and $5.50 in 2006. ‘However, we think Nova could get north of $10/share and Dow above $6 at the peak.’

Greenwich Consultants’ Judd still sees an upside in stock prices, although the easy money has likely been made. ‘We are reaching a point now where it is not exactly a big secret that companies are doing really well,’ he says. ‘At this point in the cycle, I like companies with quite a bit of leverage that are generating lots of cash and paying down debt. That includes Lyondell and Huntsman.’ The analyst estimates Lyondell will earn $2.85/share in 2005 and $5.85 in 2006. He has Huntsman earning $2.83 in 2005 and $4.27 in 2006.

Cycle peak duration

Wall Street is more focused on the duration of the coming peak rather than its height since a longer peak will allow companies to generate more cash flow and significantly pay down debt.

‘I think the peak will approach 1988-89 in terms of duration, which is extremely important because it means that the amount of cash these companies generate will be at high levels for an extended period of time, says Fulcrum Global’s Mitsch. ‘Whether or not the peak hits the amplitude of 1988-89 is secondary in our opinion.’

‘What is interesting about a cycle that lasts longer is that, over an extended period of time, companies can generate a lot of cash to pay down debt,’ says Judd. ‘A lot of people are focused on how high the peak will be: that is important, but duration is perhaps more important.’

Chemical stocks should be valued on an EV/Ebitda (enterprise value/cash flow) basis, notes Judd. Enterprise value is equity market capitalisation plus net debt.

‘As companies potentially use the cash flow generated during this peak earnings period to reduce debt, we expect their stock prices to continue to increase,’ Judd says. ‘From an enterprise value perspective, if debt is reduced, the value of the equity should increase.’

Merrill Lynch’s Carson estimates that from 2005 to 2006, Lyondell will be able to slash debt by $3.2bn. ‘A $3.2bn reduction in debt equates to a nearly $12.50/share increase in equity value, holding the enterprise value constant,’ he points out.

Risk factors

While the industry marches to the peak, the road may not be without potholes. Risk factors that could dampen or derail the rosy forecasts include a slowdown in the global economy driven by spiking oil prices, a slowdown in China, and the eventual build-up of excess capacity.

‘We view weaker-than-expected global economic growth, which could be brought about by a hard landing for the Chinese economy, surging energy prices or numerous other factors, as the primary risk to our forecast,’ says Carson.

‘The key risk to our positive outlook is a sharp, extended decline in global economic activity, which we do not expect,’ says JPMorgan’s Zekauskas. ‘Shorter-term concerns include an inventory build during the first quarter in anticipation of accelerating Chinese demand following its Lunar New Year respite.’

‘High energy costs leading to a global recession is the biggest risk out there,’ says Mitsch. ‘We do not believe the expansions in China are enough to derail the coming peak. China is still going to be a large merchant purchaser of a lot of these materials.’

Threat of overcapacity

While times are improving, industry executives are ever watchful of overcapacity, which would squash the upturn as it has in every cycle.

‘The biggest threat to this industry is overcapacity,’ says Peter Huntsman, president and ceo of Huntsman Corp. ‘It is like there is a rule in the petrochemical industry that if you operate at over 90% capacity, you have to shoot yourself in the foot. However, I am hopeful that after years of tough times, boards and ceos will be responsible with how they spend their money.’-

Joseph Chang is executive editor, financial, of Chemical Market Reporter, also published by ICIS Publications.

 

Wall Street's earnings per share estimates*, $

	2004	E2005	E2006
Dow Chemical	2.71	4.44	5.95
Lyondell	0.61	2.97	4.95
Huntsman	N/A	1.21	2.27
Nova	1.39	4.40	7.15
Westlake	N/A	3.95	4.50
Georgia Gulf	3.18	5.18	6.33
Methanex	1.93	2.43	1.67
*as of 10 March 2005
Source: CMR

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