Description

I am recommending the purchase of  Methanex (MEOH), the global market share leader in methanol production.  MEOH is no stranger to VIC members, having been written up three times previously: twice by fw51, in December 2004 at $18.31 and in July 2001 at $5.75; and by Robert 511 in June 2003 at $11.17.  Each of these recommendations were timely calls that offered the opportunity for handsome profits over the subsequent 18-24 months.   At current trading levels, I believe MEOH offers an outstanding risk/reward proposition for investors with an intermediate term investment horizon who can look past the current cyclical trough in the methanol pricing environment.  The Company has the wherewithal to withstand this cyclical downturn given its strong balance sheet, with modest leverage, no near-term debt maturities, and substantial available liquidity.  Finally, MEOH has a shareholder friendly management team that has returned almost $1 billion to shareholders (compare the current market cap of approximately $650 million) in the past five years through dividends and share repurchases.

Methanol is a clear biodegradable liquid petrochemical usually made from natural gas (higher cost Chinese capacity uses coal). Methanol is a chemical intermediate used in: formaldehyde, which in turn goes into auto, construction and pharma applications; acetic acid, which is used in the production of paints and adhesives; and other products used to make numerous industrial and consumer products such as synthetic textiles, recyclable plastics, and foam cushions and pillows.  These are relatively mature end-use applications for methanol that currently represent approximately 75% of global methanol consumption, which approximated 40 million tons in 2008.  The remaining 25% is consumed in fuel/energy-related uses, including the manufacture of MTBE, a mature fuel component that when added to gasoline makes the gas burn more cleanly and produce fewer emissions; and emerging applications in biodiesel and dimethyl-ether (DME), which represent potential catalysts for acceleration of future methanol demand.

MEOH operates globally with facilities in Chile, Trinidad, New Zealand and, upon completion of a new 60%-owned facility in early 2010, in Egypt.  The Company's facilities in Trinidad represent over 2 million tons of low-cost annual capacity that operate roughly at capacity.  MEOH's Chilean facilities have 3.8 million tons of annual capacity but operated at less than 30% of capacity in 2008 due to an inability to procure adequate supplies of natural gas.  Until mid-2007, MEOH had natural gas supply agreements with Argentinian suppliers, but the Argentinian government abrogated these agreements.  Since then, MEOH has been working with Chilean energy companies to develop additional gas supplies in Chile.  The Company's principal facilities in Trinidad and Chile are believed to be in the lowest cost quartile globally and are cash flow positive at current trough pricing.  MEOH's New Zealand facilities comprise 1.4 million tons of capacity that operate well below capacity as these are relatively higher cost facilities that are used for flex or swing capacity.  The Egyptian facility will have 1.3 million tons of annual capacity and is expected to be among the lowest cost in the industry as it is supported by long-term, low-cost gas supply arrangements. MEOH's gas supply contracts typically include a low base price and a large variable cost component tied to methanol pricing, which substantially mitigates gas pricing risk assuming facilities that are strategically located near low-cost gas supplies as most of MEOH's are (by contrast, most U.S. facilities have been priced out of the global methanol market because of the high cost of natural gas).

Methanol demand historically has grown at rates consistent with to slightly higher than global GDP (4.8% volume CAGR from 1995-2007).  Although management expects continued market growth to be supported going forward based on the emerging energy uses for methanol, my thesis for MEOH doesn't depend on an acceleration of market growth, which I have no basis to predict, but instead constitutes additional upside should it materialize. Like most chemical intermediates, methanol pricing is quite cyclical and can be especially volatile, as production capacity (supply) is fixed in the short term, with relatively small changes in demand driving significant changes in market pricing.  Global methanol consumption approximates 40 million tons, but will be lower this year given the ongoing global recession.  Methanol demand dropped an estimated 15% in the fourth quarter, which caused spot methanol pricing to collapse from a high of over $800/ton a year ago to a recent low of approximately $150. MEOH's average realized pricing in Q4 was $312/ton, down 22% sequentially and 38% yoy.  Given the speed with which the global economy contracted in late 2008, inventories swelled so some of the reduction in demand represents destocking.  The Company's current posted prices vary by region but approximate $220/ton, and management expected realized prices in Q1 to approximate $200/ton.  Importantly, the market appears to have stabilized at this level as MEOH has rolled January pricing into February and currently expects March pricing to be at least equal to February.  Over the past decade, methanol pricing has generally tracked oil prices, which is also supportive of methanol pricing being at or very near a bottom.  For further detail on the Company, the methanol market and historical pricing, see the MEOH's excellent website (www.methanex.com) and the prior VIC writeups referenced above.  In addition, the Company will be presenting at a CIBC investor conference on February 19, which will be webcast on MEOH's website.

MEOH's revenues, cash flows and stock price historically have tracked methanol prices quite closely.  Thus, results in the fourth quarter were horrendous and were exacerbated by the rapidity of the decline in pricing as MEOH was selling high-priced FIFO inventory at ever-lower prices.  This dynamic likely will drive a net loss in the current quarter in addition to the fourth quarter net loss.  Despite the reported loss, MEOH generated $50 million of operating cash flow in Q4 based on a reduction in working capital, a modest silver lining or shock absorber provided by lower pricing.  Moreover, the Company is cash flow positive and profitable on a run-rate basis at current realized methanol prices of $200/ton.

Given all this bad news and my generally worse-than-consensus outlook for the global economy, the logical question is why bother with MEOH now?  The answer is that Mr. Market has sold off MEOH viciously, pricing in all the bad news and then some.  From a 52-week high of over $33, the stock has fallen over 75% to a recent $7, including a drop of approximately one-third year-to-date.  Today, MEOH sports a market cap of approximately $650 million and total enterprise value of $1.1 billion.  MEOH has made substantial investments in recent years to increase capacity and lower its operating costs, which should drive higher earnings power in the future.  However, to illustrate how cheap MEOH is, one can evaluate its current valuation relative to average earnings over the past 11 years, which includes two years of operating losses.  TEV of $1.1 billion represents 3.2x average EBITDA of $294 million and 4.5x average EBIT of $246 million, respectively, over this 11-year period, during which MEOH also generated aggregate operating cash flow exceeding $3 billion.  Finally, over this period, MEOH has more than doubled tangible book value per share to nearly $14, approximately $3.50 of which is cash.  MEOH also sports a nearly 9% dividend yield, though I view the dividend, which totals $57 million annually, as offering a liquidity safety valve that can cover maintenance capex in a downside scenario, with the cash on the balance sheet and operating cash more than sufficient to fund MEOH's two key growth initiatives:  (i) the completion in early 2010 of the low-cost Egypt facility, and (ii) its minority investment in a Chilean natural gas consortium, the objective of which is to secure low-cost, long-term supplies of natural gas to facilitate production growth at MEOH's substantially underutilized Chilean facilities.

Given the cyclicality and volatility of MEOH's financial performance, I believe a short-term forecast is really guesswork, and I expect the first quarter to be every bit as difficult as the fourth quarter was.  I take comfort from the fact that the industry has already shuttered as much as 25% of the highest cost capacity (e.g., six million tons of annual capacity in China has been shut down because current prices are below cash costs), which provides support for what appears to be a bottom in methanol pricing.  The timing and extent of future price recovery will depend upon the global economy, but MEOH will generate cash (before the Egypt and Chile investments, which total $200-250 million through 2010) at current pricing levels.  The Egypt facility is over 70% complete, on time and on budget; given management's experience and the status of the project, I believe remaining timing and budget risks are immaterial.  As for the Chilean gas development projects, MEOH's contributions could be delayed/deferred to some extent if circumstances required, though these are believed to be high return and strategic investments.  Maintenance capex will approximate $50-60 million in aggregate over the next two years.  Current cash balances of $328 million cover these expenditures with some margin even before internally generated cash, which is why MEOH has maintained its dividend to date.  Nevertheless, given the generally prudent approach of management, MEOH has suspended share repurchases and has reserved the right to reevaluate the dividend rate given the ongoing credit crunch and the 2010 maturity of MEOH's unfunded $250 million revolver.  The dividend is a nice bonus should it be maintained, but MEOH is primarily a capital appreciation play.

At current levels, MEOH has 3-5x potential upside over the next three to five years with very modest downside given tangible book value of $14/share, expected production increases in 2010 and beyond (Egypt, Chile) and proven cash flow generating capabilities of the business.  Moreover, there are several potential catalysts for MEOH, including a global economic recovery, a substantial increase in production in Chile as new gas supplies come onstream (which has an additional benefit of facilitating reduced purchases of methanol from third parties, a source of losses in 2008), acceleration of methanol demand driven by DME alternative energy applications (e.g., fuel blending and cooking/heating applications in China), and an increase in energy prices.  In the next cyclical peak, MEOH could possibly generate more annual EBITDA than its current TEV.

The key risks to MEOH are disruptions in natural gas supplies and a much longer, deeper downturn in demand and pricing than even the most bearish forecasts.

Catalyst

See above