Description

Methanex (MX-T)

I believe the market generally misunderstands Methanex (MX) and treats it like a purely cyclical commodity business whereas it is a high quality business capable of compounding capital over a long period of time – borrowing from a Seeking Alpha article I read, maybe MX is more of a cyclical compounder. This misunderstanding is typically more pronounced in times of lower commodity prices and/or uncertainty where the market refuses to look forward enough to estimate reasonable normalized earnings power for MX. 

My investment thesis is:

1. Even assuming MX never operates close to full capacity, its current productive capacity (just under 7 mln tonnes) is trading at a healthy discount to replacement cost (US$1,000/mt+)

2. I estimate normalized FCF of C$8 per share, making MX unreasonably cheap at 6x normal FCF

3. Generally shareholder friendly management team with good history of capital allocation between growth, share buybacks and dividends.

4. Opportunity exists: a) Near-term methanol prices appear elevated and the conventional sell-side wisdom is equities can’t trade higher when its main commodity price driver goes lower, b) there is significant uncertainty around how MX will finance the completion of its Geismar 3 project, especially given its ~C$3 bln net debt on its balance sheet c) weak 2021 guidance, especially around limited gas availability at some plants (even though this is a feature of this industry)

5. A few free options that could keep methanol prices elevated including: a) higher oil prices, and b) new methanol uses including marine fuel.

Overview

Basically, MX produces methanol which is derived from natural gas using a process that involves adding steam (oversimplification). It is a just over 80 mln tonnes market that typically grows mid-single digits, with half of the demand from traditional chemical uses and half from energy related uses. As MX has been written up on VIC many times, I will defer to previous writeups for an overview and background on the business. However, having followed MX for over a decade, I will quickly spell out some of my nuanced views that may differ from the market and previous writeups:

1. Capital Light – Although a commodity business, MX is fairly capital light compared to other basic materials producers with maintenance capex likely in the low US$100 mln range or 3-5% of revenues depending on where methanol prices are. This is why MX is not like an E&P energy producer shoving all capital back into drilling with little FCF to show for it. Put another way, the heavy lifting is already done by natural gas E&Ps. In fact, MX has returned significant capital to shareholders via buybacks and dividends for a sustainably long period of time (except for right now).

2. Managed Prices – The industry appears disciplined with some good game theory cooperation going on. Afterall, MX posts what prices are every month and they buy methanol in the market too so they effectively influence 20%+ of the market at most times. This is probably part of the reason a “commodity” producer like MX averages EBITDA margins 15-20%+

3. Natural Gas Arbitrageur – I see MX’s business model as effectively a low cost and less capital intensive way (especially compared to LNG) to globally take advantage of wherever they can find low cost natural gas and finding the highest and best use of a reasonably easy to transport product: methanol. This is why MX has an edge compared to other producers focused in a certain country or region – augmented by MX’s logistic network and fleet of ships.

4. Technical Expertise – Although hard to quantify, I believe MX is competitively advantaged due to its know-how and operational expertise. For the last decade or two, there has always been the threat of new plants coming on, significantly incremental supply and methanol price risk associated with the market anticipated to be flooded with product. Time and time again, producers run into problems and delays. For instance, see my previous write up on OCIP-US or review the history of the Iranian Zagros facilities that were supposed to cause the market to be oversupplied. The latest conference call highlights the importance of technical know how when MX described maintenance delays as COVID protocol required ~40 experts to review procedures virtually when they were doing plant maintenance work.

Why This Opportunity Exists

Generally, I think this opportunity exists because management was a bit too aggressive in returning capital to shareholders and counting on pre-COVID run rate cash flow to complete its Geismar 3 project. When COVID hit and methanol prices dropped, the Geismar 3 project was put on hold and they drew their credit lines, just in case. The market proceeded to assume they were a bankruptcy risk, when realistically, MX could reasonably get debt covenant waivers and, if required, sell its fleet of ships and/or shipping company to stay afloat. 

Although methanol prices came roaring back from the low US$200/mt to US$450/mt+, MX share price corrected meaningfully recently for reasons I don’t think impair the value of the business longer-term:

1. US Spot Prices Trading Lower – With a seemingly elevated methanol prices (historically ranges from US$200-$500/mt), the sell-side appears very concerned with weaker methanol prices in the near-term going forward (apparent in an analyst asking about the suggested US$30/mt drop in spot prices in the latest conference call). Longer-term, what matters is a normalized price assumption (which I think is fair in the US$325/mt range), I get MX FCF in the US$500+ mln range which is too cheap relative to MX’s US$3 bln market cap

2. Gas Supply Issues – MX also spooked the market with some cautious guidance on production due to gas supply issues at its various facilities, including New Zealand, Chile, and Trinidad. This would essentially keep production broadly flat yr/yr in the 6.7 mln tonnes range. This is a feature of MX not a bug. In other words, I would suggest MX’s business model is to have facilities around the globe to take advantage of pricing differentials in natural gas and take advantage of it in a less capital intensive way than LNG. For instance, 15 years ago, MX’s medicine hat facility was uneconomic and there was little interest in North American production. At around the same time, the Egyptian facility held promise as it had access to sub $2 natural gas. Over a long period of time, MX has been nimble and took advantage of natural gas feedstock opportunities around the globe. 

3. Uncertainty Around Geismar 3 – The market also appears to dislike uncertainty on Geismar 3, a methanol facility that is/was under construction and subsequently delayed due to COVID (and low methanol prices) – especially when MX still does not seem to have a plan in place or approved the completion of the 1.8 mln tonnes project. While I don’t have any specific insight, the completion of the project appears to be a no brainer to complete for the remaining capital cost of ~US$1 bln. In other words, assuming a mid-cycle price in the low US$300/mt range, the return on the incremental investment is easily mid double digits. The problem is the market does not want to step in front of this uncertainty and hence the recent share price weakness. Some of the possible scenarios (none of which I think is fatal for MX): a) MX finds a partner to share capital costs (this is less likely given they have done such a search for one previously), b) MX uses cashflow and debt to fund the capital spend resulting in higher near-term volatility, c) MX (somewhat unlikely) issues equity to help fund the project. 

Valuation

There are many ways to approach valuation and my fair value range is quite wide: C$50 to C$125. Regardless, the current share price makes an investment in MX quite attractive.

$50 scenario: I assume production reaches 9 mln tonne range in 5+ years and use a normalized methanol price of US$325/mt (posted). In this ultra conservative scenario, I assume MX issues 30 mln shares to build Geismar 3 resulting in meaningful dilution and value destruction.

$70 scenario: I assume the same as above, without a massive equity offering and dilution.

$125 scenario: I assume ~C$8 FCF longer-term and apply a 15x multiple to this number. Admittedly, this is a more optimistic case and requires a longer time horizon to reach this share price.

Catalyst

Decision on Geismar 3

FCF Generation, Dividend Increase