28 March 2005 00:01 [Source: ICB Americas]
Coming peak could rival super-peak of 1988–1989. 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 up after years of underinvestment 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 1994–1995 both in intensity and in duration because of an unprecedented four years of underinvestment 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 1994–1995 peak,” says Merrill Lynch analyst Donald Carson. “Ethylene cash margins ended 2004 approaching levels achieved during 1994–1995, 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’re going to see a materially better chemicals environment than we saw in the 1994–1995 timeframe.”
The last cycle peak in 1994-95 was driven by customer inventory restocking following several unplanned outages, notes Merrill Lynch’s Carson. This coming peak will be driven by demand catching up to the lack of capacity additions, resulting in tighter supply-demand fundamentals.
The 1994–1995 peak lasted just nine months while the 1988–1989 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 specialty companies,” he says. “At that time, the companies were buying and investing in the specialty chemical business and were selling commodity chemical assets and generally underinvesting 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 (CAPX) have severely trailed depreciation for the last four years as companies sought to preserve cash in the worst downturn in chemical industry history (see chart). 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 CAPX from $1.33 billion in 2004 to $1.5 billion in 2005, spending will remain below depreciation of $1.9 billion. Lyondell will increase CAPX from $229 million in 2004 to $332 million in 2005, remaining well below depreciation of $660 million. However, Nova aims to spend $300 million in 2005, about even with depreciation, versus $242 million in 2004.
“Capital expenditures clearly will be picking up in 2005, but the fact that they’ve been so muted in the past several years bodes well for the years ahead,” says Fulcrum Global’s Mitsch.
“What’s unusual about the current peak period is that it potentially could last for four years,” says Greenwich Consultants’ 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 $1 billion 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 $1.9 billion ethylene and derivatives complex in Mexico, but that project is not scheduled to come on until 2009 or 2010.
Wall Street 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 estimates on Dow Chemical, Lyondell, Nova and Westlake. He maintains “overweight” ratings on each.
“Activity in North Americanethylene markets in recent months provides further evidence that a strong cyclical upturn is now well underway,” says Zekauskas. “Continued economic expansion, stable capacity and unplanned outages together 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 cents versus 5 cents previously.”
The analyst has hiked his 2005 EPS estimates across the board for Dow Chemical (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). Mr. Zekauskas was an early bull on commodity chemicals, having upgraded Dow in early 2003, Lyondell in mid-2003, and Nova in mid-2004.
In early March, Merrill Lynch’s Carson raised his profit forecasts for Dow Chemical and Lyondell—both of which carry “buy” ratings. For Dow, the analyst boosted his 2005 EPS share estimate from $4.50 to $5, 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, and his price target from $36 to $40.
“Our $7.50 peak estimate for Dow assumes recovery of about 85 percent of the absolute-dollar margin lost companywide 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 chloralkali fully recovering to 1988–1989 levels—higher than 1994–1995, but styrenics margins not fully recovering to 1994–1995 levels because of high benzene prices and new capacity coming on line in Asia in 2006.
However, in mid-March Carson trimmed 2005 forecasts for Lyondell and Nova based on short-term weakness.
Upside in Stock Prices?
Despite the huge run-up in commodity chemical stock prices over the past year and a half, Wall Street sees further upside as the industry marches to the peak.
“It’s rockin’ and rollin’ here, but Georgia Gulf, Nova, Olin and Dow still offer value, even after the price appreciation we’ve seen,” says Fulcrum Global’s Mitsch. The analyst is particularly bullish on Nova and Dow.
Mitsch has Nova earning $4.50 per share in 2005, followed by $8 in 2006, and Dow making $4.25 per share in 2005 and $5.50 in 2006. “However, we think Nova could get north of $10 per share and Dow above $6 at the peak.”
Greenwich Consultants’ Judd still sees upside in stock prices, although the easy money has likely been made. “We’re reaching a point now where it’s 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 per 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 1988–1989 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 1988–1989 is secondary in our opinion.”
“What’s 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 Greenwich Consultants’ Judd. “A lot of people are focused on how high the peak will be—that’s important, but duration is perhaps more important.”
Chemical stocks should be valued on an EV/EBITDA basis (enterprise value/cash flow) basis, notes Judd. Enterprise value is equity market capitalization 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.
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