|Shares Out. (in M):||94||P/E||8.7||6.6|
|Market Cap (in $M):||4,233||P/FCF||NA||6.2|
|Net Debt (in $M):||682||EBIT||701||865|
Methanex Corporation (“Methanex” or “MEOH”) is the world’s largest producer of methanol to markets in North America, Asia Pacific, Europe, and South America. Methanol is a clear liquid commodity chemical that is predominantly produced from natural gas and, particularly in China, from coal. Approximately 60% of all methanol demand is used to produce traditional chemical derivatives, including formaldehyde, acetic acid, and other chemicals that form the basis of a large number of chemical derivatives for which demand is influenced by levels of global economic activity. The remaining 40% of demand comes from a range of energy-related applications, many of which have experienced significant growth and for which, contrary to consensus opinion, demand will remain durable even following recent Brent oil price declines. Methanex’s production is at the bottom two thirds of the global cost curve (MEOH’s highest cost production in New Zealand is at $173/ton vs. East China—the marginal producer—at $328/ton), which is very steep at the high end, resulting in robust margins and full operating rates for MEOH in a variety of demand scenarios.
Methanex shares provide a highly compelling investment opportunity at today’s price with a number of potential idiosyncratic corporate events driving value in the next 6-12 months independent of commodity prices. Methanex is in the process of relocating two 1 million ton per year (tpy) plants from Chile to Geismar, Louisiana. The completion of this project will completely transform Methanex’s free cash flow generation profile. At ~$350/ton realized pricing from 2015E-2017E (a conservative mid-cycle estimate given the increased demand and limited supply coming online in the next few years), Methanex can generate annualized FCF of ~$9/share by mid-2016, easily supporting share prices well in excess of $80.
My probability-weighted price target of $73 represents a 67% one-year IRR (including dividends) and is based on a number of realized methanol price and production scenarios (explained in further detail below). My $73 target includes roughly $3/share in NPV from a 30% probability weighting of Methanex pursuing an MLP of its 2 million tons of U.S. production in mid-2016. Risk/reward is very favorable with upside to $103/share in a robust pricing environment in the MLP scenario and with downside in the low-$50s in a weak pricing environment.
MEOH has been written up five times previously by dionis589 (April 2011), paddy788 (February 2009), fw51 (December 2004 and July 2001), and robert511 (June 2003). These write-ups have provided an excellent overview of methanol industry dynamics, so in this write-up I will focus on changes to the supply/demand picture since 2011.
Methanex is mispriced for a number of reasons:
1. Sell-side price targets based on 2015E EBITDA, ignoring substantial increases in near-term production. Most sell-side analyst price targets are based on 2015E EBITDA. Street 2015E EBITDA estimates likely include only 900k tons from Geismar 1, ignoring 1 million tons of production coming online in Q1 2016. 1mm tons of production = roughly $125mm in EBITDA, or ~$10 per share in value at 7.5x EBITDA.
2. Demand destruction fears related to oil price sell-off overdone. MEOH has sold off in concert with recent declines in Brent oil prices as it is incorrectly believed that sustained low oil prices will negatively impact demand for methanol’s higher-growth energy-related applications. As shown below, only one small and slow-growing energy-related demand vertical is threatened at $60-$65 Brent; methanol is still highly attractive in the larger, higher-growth applications.
3. New Methanex U.S. production offsets low-margin purchased methanol sales. In addition to its 5mm tpy of production in 2014E, MEOH will sell ~2.5mm tons of purchased methanol at low margin (zero margin in my model). As the market leader, Methanex meets customer requirements in excess of its production capacity by selling methanol purchased from third parties in cost-effective regions. Even in a slower than expected demand environment, MEOH’s 2mm tons of additional production in Geismar will replace 2mm tons of low-margin methanol sales.
4. Supply glut fears unsubstantiated. Ex-Methanex, 7.5mm tons of capacity have been announced in North America. The bulk of these projects are slated to be in construction in 2016-17, resulting in a crunch that will drive up the cost of construction and dramatically weaken labor productivity. Methanex’s own Geismar relocation project is expected to come in 25-30% over original budget due to construction cost inflation even during a period of relatively benign competition for labor – the company’s Geismar relocations will be completed well ahead of 58 announced Gulf Coast petrochemical projects representing $100 billion of capital investment slated for construction before 2018. If realized methanol pricing is low, competing project ROICs will not justify new construction and projects will be delayed or cancelled outright (Competitors’ likely budgeted ROICs have been ~13%, or a 8.0x build multiple, assuming $125/ton in EBITDA at $350/ton realized pricing and $1,000/ton build costs. ROICs and build multiples are 8.6% and 12.0x at $1,500/ton construction costs).
Only in a scenario in which 30+ million tons of incremental demand come online will realized methanol pricing be high enough to provide competitor ROICs high enough to justify completing the 7.5mm of announced capacity additions. In such a case MEOH’s realized pricing and mid-cycle FCF would be substantially higher than my most bullish case.
5. Exodus of event-driven money / Inordinate focus on MLP of Geismar assets. In conversations with sell-side analysts, I have heard that 60% of calls as recently as a year ago were from hedge funds presumably focused on a near-term MLP announcement – one analyst said today roughly 80% of his calls are from long-term long-only funds. While I estimate an MLP is worth ~$10 per share in NPV, MEOH is grossly undervalued even in the event that the company elects not to pursue an MLP. In the non-MLP scenario, I believe MEOH will effect a substantial issuer bid and could buy back 25% of the company’s outstanding shares by the end of 2017.
Sell-side price targets based on 2015E EBITDA ignore substantial near-term increases in production
In July 2012, Methanex announced it planned to relocate a 1mm tpy plant from Chile to Geismar, Louisiana. Methanex’s 4 million tons of Chilean production had for years relied on gas imports from Argentina. In 2007, Argentina limited gas exports as the country found it untenable to pay high prices for imported LNG in northern Argentina while exporting gas in southern Argentina for $1/mmbtu. Methanex’s Chilean plants have run at very low operating rates since then, producing <500k tpy in 2012 and 2013. In April 2013 Methanex announced it intended to relocate a second Chilean plant to Geismar, for a total of 2mm tpy of production capacity by early 2016.
The completion of the Geismar relocation truly transforms Methanex’s free cash flow generation profile – below are summary P&L items from my base case model, which assumes ~$350/ton realized pricing from 2015E-2017E and share buybacks with excess free cash flow. Note that even in a low demand growth environment, MEOH’s incremental 2.5mm tons of production from 2014-2017 will replace the low-margin sales of methanol purchased from third parties (2.7mm tons in 2013).
|Production by plant (000s tons)||2012A||2013A||2014E||2015E||2016E||2017E|
|Trinidad (Atlas 63% interest)||826||971||899||899||899||899|
|Egypt (50% interest)||557||623||414||465||497||497|
|Chile II / Geismar I||0||0||0||871||950||950|
|Chile III / Geismar II||0||0||0||0||818||950|
Methanex confirmed on its Q3 earnings call that the two plant relocations would exceed original construction cost estimates of $1.1bn by 25-30%. Analysts were quick to punish the company in notes following the call, but continue to ignore much of the incremental 2mm tons soon to come online as most analysts value the company on either calendar year 2015E EBITDA, or, in one case, LTM September 2015E EBITDA. 2015E estimates ignore at least 1.1mm tons of high-margin production set to come online with a full year of production from Geismar 1 (expected to be online in January 2015) and the completion of the second Geismar relocation (expected Q1 2016).
Demand destruction fears related to oil price sell-off are overdone
Global methanol demand is expected to grow by 20-25mm tons by 2017 from 2013 demand of ~60mm tons. Much of this growth is expected to come from three key energy-related verticals: Di-methyl ether, or DME, fuel blending, and as an alternate feedstock for ethylene production in China (methanol-to-olefins or “MTO”).
DI-METHYL ETHER (DME)
While MEOH shares have largely traded in line with Brent in the last two months, $60-$65 Brent really only threatens affordability levels of DME, which at ~4mm tons of annual global demand (7% of demand) is the smallest and slowest growing energy-related vertical. DME has potential for use as an automotive fuel and is used in domestic applications such as heating and cooking. On an energy equivalence basis, DME production from methanol is not competitive with Brent below $95 (I calculate production costs of $331/ton from methanol vs. current Chinese spot methanol prices of $335/ton). However, in the past, 2mm of the 4mm tons of methanol-based DME production has run irrespective of oil prices, while 2mm tons of production has been fairly quick to be shut down. Consistent with historical experience, Methanex has commented recently that the company continues to see robust operating rates in DME and that at current methanol and propane prices (for which methanol is substituted into DME), DME continues to enjoy substantial use. Furthermore, Methanex specifically targets chemical company customers who value Methanex’s security of supply and global availability. Still, even if we assume demand for methanol in DME goes away entirely, the demand story for methanol’s larger, higher-growth energy applications remains extremely compelling.
Methanol has seen substantial adoption as a fuel in China because of its high octane levels and clean burning characteristics. In Europe, methanol blending into gasoline is allowed at up to 3% of the fuel pool, but in China, Methanex sees blends from 5% (“M5”) up to 85%, and in some cases, 100% (“M85” and “M100”). Methanol blending into the fuel supply represents 7mm tons of demand in China today, and is expected to grow at 700-800k tpy as China adds 1mm cars/month to its roads. On an energy equivalence basis, methanol affordability would be ~$600/ton equivalent based on $3.60/gallon gasoline in China, substantially above current Chinese spot methanol prices of ~$330/ton.
METHANOL TO OLEFINS (“MTO”)
Finally, methanol can be used in lieu of traditional petroleum-based feedstocks to produce ethylene and propylene. Today methanol demand for methanol-to-olefins (“MTO”) processes is roughly 5mm tons per year in China, with another 12mm tons coming online through the first half of 2016 according to a December 2 Methanex investor presentation. Importantly, MTO plants are NOT feedstock flexible and cannot accept naphtha; thus, 17mm tons of MTO demand (12mm of which is incremental to year-end 2014) MUST use methanol to produce olefins.
At 2.6 tons of methanol per ton of olefins, $275/ton of utilities and admin costs, and $250/ton of co-product credits, non-integrated MTO producers can make $117/ton in margin on olefins at $330 methanol even if ethylene prices drop to $1,000/ton. At $1,000/ton ethylene, MTO producers would break even on olefin production at methanol prices of up to $375/ton.
How worried should investors be about Methanex’s leverage to China? While China is responsible for much of the robust demand growth story over the next 3-4 years, demand is split between a number of high-growth silos, and demand in new geographies is likely to develop. Outside of China, demand for methanol in maritime fuel could account for 25-40% of current global methanol demand in the intermediate term. Maritime fuel consumption today is ~150mm tons per year. With 10-15% fuel blending, demand for from maritime applications alone could account for an additional 15-22mm tons per year.
Further, at least half a dozen other countries (Australia, Israel, Iran, Trinidad, Iceland, and Indonesia) have all tested low-to-mid-level methanol gasoline blends, which could eventually transition into commercial adoption.
Capital Allocation – Share Repurchases & MLP Potential
While I estimate an MLP of Geismar 1 and Geismar 2 is worth an additional $10/share in NPV, the opportunity for capital return through share buybacks is still very substantial. Based on my methanol price slate outlined above, Methanex could buy back 25% of outstanding shares through 2017 without levering the balance sheet, leaving the company generating ~$9/share in free cash flow in 2017.
Management is focused on maintaining an investment grade rating and believes the company can do so at 2.0x-3.0x net leverage. At 2.0x leverage on normalized EBITDA of $1.1 billion, the company could borrow another $1 billion or more to initiate a substantial issuer bid and buy back more than the 10% of the float that MEOH is currently allowed under normal course issuer bid guidelines.
The company recently filed a shelf prospectus to borrow up to $750mm, and later issued $600mm of unsecured notes with proceeds to be used for remaining Geismar capex and general corporate purposes. Geismar capex is more than covered by 2015 and 2016 cash from operations, and I believe the company will pursue a more aggressive share buyback in the next year. CEO John Floren’s comments on recent investor calls have suggested as much. From an April 30, 2014 analyst call:
“So I think leaving [cash] on the balance sheet, growing, is not an option. So taking the cash and growing the company, we have growth projects in front of us to add 2 million tons in a possible – and we have 2 other growth projects between Medicine Hat 2 and Geismar 3 or Chile 4 relocations. So when we issued a share buyback of 5%, we considered a higher buyback, but we preserve the ability to grow the company at the same time that we’re going to buy back shares. I think I gave a couple of indications on our replacement costs, as well as our potential for EBITDA and cash flow generation being very high.
So at current price of $61 or $62, yes, we're -- we think the shares -- buying back shares is good value for our shareholders.”
From the Q3 earnings call on October 30, 2014:
“Nothing has really changed in our view on what are our uses for cash. So I will remind you we also have bought back shares all of October. Unfortunately we are in a blackout that we couldn't the change the daily number. So I think we will continue to look to complete that normal course issuer bid of 4.8 million shares. Beyond that the uses for cash are the same. We'd like to grow the company, beyond G2 it looks pretty difficult in the short term to have something to dedicate some capital to that. Dividend, meaningful, sustainable and growing and that's what we have done and then excess cash through buyback. So under a number of different pricing scenarios that you can run we are going to have quite a bit excess cash to be able to do all three and depending on it we have a project or not, we will have more cash to buy back shares. So at the current price I am really anxious to buy back shares.”
My one-year target price assumes MEOH trades at a 7.5x multiple of Q2 2016 annualized EBITDA – that is, giving full credit for Geismar 2 running at full rates – one year from today. As of today, MEOH’s commodity chemical company peers (Axiall Corporation and CF Industries) trade at 7.0x one-year forward EBITDA. Peers Huntsman, Lyondell, and Westlake trade at a 1.5x discount, reflecting their increased cyclicality and weaker FCF profiles. I believe this multiple will be justified a year from now because of company-specific factors that will significantly grow Methanex’s production, earnings, and free cash flow profiles over the next several years independent of the general methanol cycle. While 7.5x may seem like a full multiple following the recent sell-off in chemicals, my non-MLP base case valuation of $69/share would represent a robust 11.3% levered FCF yield.
Below are three valuation cases based on $270, $300, and $330 spot China methanol. Bears have recently been focused on a rough rule of thumb that the methanol price should be 4x Brent – this is a demand-side relationship based on energy equivalence and ignores the cost curve in China, which has prevented sustained realized price corrections in the past. As long as the Atlantic basin remains net short methanol – which seems highly likely as new capacity builds are significantly less attractive in a low methanol price environment – North American and European premiums of ~$70/ton should hold. My upside case assumes an incremental 500k tons of production from the remaining 2mm tons of capacity in Chile if Argentine gas export restrictions are loosened.
As a check on valuation, management cited estimated replacement costs of greenfield and brownfield facilities at $1,000+/ton and $600+/ton before MEOH’s own 25-30% cost escalation on its Geismar relocations. Assuming 30% inflation, greenfield plants should be expected to come on at ~$1,250-$1,300/ton. My base case non-MLP valuation of $69/share implies TEV/ton of capacity of $847. Note this is based on 8.4 million tons of capacity, effectively zeroing out the remaining 2 million tons of Chilean capacity. At $45/share, MEOH currently trades at $580/ton of capacity.
|MEOH Valuation - No MLP||
|Asia spot methanol ($/ton)||$270||$300||$330|
|Europe spot methanol ($/ton)||$340||$370||$400|
|N. Amer. spot methanol ($/ton)||$340||$370||$400|
|MEOH weighted avg. realized price||$322||$352||$382|
|Q2 2016E annualized EBITDA ($mm)||$748||$943||$1,199|
|Total capacity (000s tons)||8,480||8,480||8,480|
|Cash at 9/30/15 ($mm)||$434||$476||$533|
|Debt at 9/30/15 ($mm)||$1,539||$1,539||$1,539|
|Equity value ($mm)||$4,505||$6,007||$7,983|
|Shares outstanding at 9/30/15 (mm)||88.8||87.7||86.6|
|Equity value per share at 9/30/15||$51||$69||$92|
|Premium/(discount) to current||+13%||+52%||+105%|
|Pro forma FCF per share||$5.90||$7.75||$10.08|
|Implied FCF yield to target price||11.6%||11.3%||10.9%|
|MEOH Valuation - MLP Scenario||
|Q2 2016 annualized non-MLP EBITDA ($mm)||$503||$646||$852|
|Q2 2016 annualized MLP distributable cash flow ($mm)||$225||$276||$327|
|MLP equity value||$2,503||$3,071||$3,634|
|Cash at 9/30/15 ($mm)||$431||$473||$579|
|Debt at 9/30/15 ($mm)||$1,539||$1,539||$1,539|
|Total equity value ($mm)||$5,165||$6,852||$9,061|
|Shares outstanding at 9/30/15 (mm)||88.8||87.7||87.7|
|Equity value per share at 9/30/15||$58||$78||$103|
|Premium/(discount) to current||+29%||+74%||+130%|
Pro forma for Geismar 1 and 2, I believe Methanex will generate ~$1bn in EBITDA and $650-700mm in free cash flow, representing a 15%+ FCF yield on today’s share price. I believe that bear arguments that 1) Geismar 1 and 2 will never come online, or will only come online at disastrous cost, 2) low oil prices will limit demand for higher-growth energy applications of methanol, and 3) a wall of North American methanol supply coming online in 2016-17 will depress realized methanol pricing miss the mark.
* Announcement of production from Geismar 1 in January 2015
* Continued strong realized methanol pricing in the face of weak Brent oil prices
* Sell-side analysts rolling valuations to 2016 estimates, which will pick up the full 2 million tons of new, high-margin capacity
* Expected announcement of either a leveraged share buyback or of management’s decision to pursue an MLP of Geismar 1 and 2