LONDON (ICIS)--Covestro’s banner financial run is expected to continue with the release of its fourth-quarter (Q4) results this week, but questions still remain about how long the current pace of demand will continue for some product lines, as well as what the company will do with its growing war chest of cash.
Since it went public in late 2015, Covestro has been defying the odds. Casting out as an independent after former owner Bayer decided to eliminate the three-pillar structure that the company has historically held in favour of a stronger focus on pharma and agrochemicals, there was speculation from the start about how Covestro would fare on its own.
In spite of the examples of successful, well-managed commodity players in the US such as LyondellBasell and Westlake, analysts questioned whether a company focused on heavily-cyclical basic chemicals markets could thrive in Europe in the face of competition from lower-cost areas.
But the majority of Covestro’s divisions, which have been focused on the higher and specialty end of the commodities space, have benefited from extremely strong demand and pricing throughout much of 2018.
Third-quarter polyurethanes (PU) earnings before interest and taxes (EBIT) nearly tripled year on year in 2017 to €466m as prices soared amid prevailing tight demand for toluene di-isocyanate (TDI) foam.
Third-quarter polycarbonates (PC) division EBIT rose over 15% to €167m as a higher-value product mix buoyed a 9.4% increase in selling prices.
The pace of growth in those segments eclipsed a drop in earnings for adhesives, coatings and segments, which has been a laggard for much of 2018 and saw third-quarter EBIT fall 14.9% to €97m.
Overall net income nearly doubled for the quarter to €491m.
Investment bank UBS guided in January 2016 that the company’s share price would peak at €42 apiece later that year then drop, but the rally continued to rise on the back of strong pricing and demand.
Covestro stock currently trades near €90/share in the wake of the selloff seen in public markets earlier in February.
TDI RIDING HIGH
Nevertheless, there remains an expectation that a reckoning for the company may have been delayed long past expectations rather than avoided, with speculation at present focused around TDI, where the company is enjoying a bonanza on the back of a spate of outages across the globe.
“I think they have benefited massively from a tight supply/demand environment for all three of their main commodities,” said an industry source.
“I think that therefore they are almost at… the reverse of perfect storm.”
With BASF’s 300,000 tonne/year TDI plant expected online later this year, following substantial delays, and significant new capacities either ramping up or in the pipeline in the Middle East from Saudi Aramco’s Sadara plant in Al-Jubail and from Wanhua Chemical in Yantai, China.
These three plants are likely to increase global supply by double-digits, and Covestro has guided for substantial reduction in polyurethanes revenues as a result of that new balance to the market, according to another source.
But with new supply likely to be slightly staggered, and production curtailments ongoing, it remains to be seen exactly when the crunch will hit, or even whether it will be this year, according to the first source.
“What you can say about Covestro is that they will continue to have at least another two good quarters this year,” it said.
“I think the big debate will be is if the decline in TDI margins going to happen in Q2 [second quarter] or Q3-Q4, or will it be pushed back a little further because of the some of the curtailments in supply currently.”
Margins for methyl di-p-phenylene isocyanate (MDI) are not as inflated as TDI, but demand remains relatively strong, despite a slight downward trend in pricing in February due to longer supply.
Annual demand growth for MDI is almost double that of TDI, standing at 5-6%.
Aside from the flagship 400,000 tonne/year MDI unit at Sadara, which came onstream in the summer of 2017, no new greenfield capacity is currently expected before 2020 other than Covestro's own debottleneckign at its Brunsbuttel, Germany, site, set to double MDI capacity to 400,000 tonnes/year and to be complete by the end of 2018.
Due to the absence of expected new rival capacity in the next two years, and the long lead times for construction and commissioning of new units, MDI pricing may remain relatively stable in the mid-term.
Dynamics in the market have also shifted in recent years, with a deepening production pool making the advent of new units less transformational than it once was, according to Barclays analyst Sebastian Saltz.
“Historically one of the issues was that every individual world-scale plant was a significant chunk of the global capacity, but with the total market having become larger, the increments are becoming relatively smaller,” Saltz said.
“Therefore one plant doesn't change the supply/demand balance as dramatically as before,” he added.
PC prices, another key market for Covestro, have also proven resilient on market tightness.
“Covestro has obviously benefited from tight supply in TDI during 2017, and that could obviously start to dissipate as new capacities come onstream,” said the analyst.
Having said that, demand continues relatively strong for their products, so growth in demand should help contain a reversal of the price rises that we have witnessed over the past couple of years.
BUYBACKS AND ACQUISITIONS
The level of margin growth in key product lines has swelled Covestro’s coffers far beyond market expectations, leaving the firm with a substantial war chest of ready capital.
“In June last year they were guiding for €5bn over a five-year period, I think that by the time we got to Q3 you were probably closer to €6bn, but depending on your views [on company cash flow] you might be closer to €6-7bn,” said a source.
“They are spending somewhere between €700m-1bn a year on capex [capital expenditure] at some point, so they have an embarrassment of riches,” it added.
The company cast about for potential acquisition targets last year but, with a dearth of viable prospects and a premium on chemical company valuations, management opted to funnel that cash into a share buyback as the best way to add value.
This approach met with market approval and swelling shares.
“Most people I speak to would prefer to have the cash than them going out and spending money on a bunch of businesses which they may or may not know how to run,” said a source.
The extent of the company’s windfall last year is such that it may not need to choose between the buyback programme, diversifying through M&A, according to Barclays' Saltz.
“Those options aren't mutually exclusive. At the moment they generate so much cash that even after the significant buy-back that they're undergoing, their balance sheet remains very strong and they have headroom to do acquisitions,” he said.
Irrespective of portfolio expansions, expectations are growing that the company is likely to invest in substantial new capacity in the future, a new greenfield site rather than simply debottlenecking existing assets, with MDI pegged as the likely product and US as the likely market.
“They will need to build some new capacity at some point to facilitate further growth. Given the long lead times to build any of those plants, and it's probably not going to be a long time before they need to announce something, most likely an MDI plant,” Saltz said.
The company’s Baytown site, on Texas’ Gulf Coast, has space for such a development, and the existing infrastructure there would reduce the headroom of the investment.
“Most people in the industry expect that to be North American MDI. If it is that, then they do have spare capacity at Baytown to add a greenfield but not have to put all the infra down, so it saves them couple of hundred million to $300m of capex,” a source said.
Covestro also faces a transition this year in the departure of CEO Patrick Thomas, who has run the company since 2007 and shepherded it through its first years as a listed independent.
Handover is already well underway, but Thomas officially steps down on 30 September this year.
His replacement, by former Covestro CCO Markus Steilemann, is not expected to bring any substantial shifts in policy. A member of Covestro’s management board since 2015, Steilemann is said to have a good understanding of the company’s production assets, and an eye on the bottom line.
“I have heard that from other people outside the company or people who have left that [Steilemann] knows how to run PU assets and he knows how to run them at low cost,” a source said.
“I don't expect any radical change to strategy,” it added.
While a moderation of Covestro’s current banner margins is still expected, with the right conditions the company could make it most of the way through the year before a correction.
Pictured above: Covestro's site in Tarragona, Spain
Focus article by Tom Brown