Description

Methanex is the world’s largest Methanol manufacturer. The value of the stock can be viewed as including three components:
1) Value of its normalized earnings power (peak earnings estimated to be $2+, bef. share repurchase) – long position in the stock;
2) Value given to the potential commercial use of methanol in fuel cells – long position in a call;
3) A dragging issue about a possible ban of MTBE in U.S., which represents 15% of total methanol demand, or 55.56% of total MTBE-driven methanol demand in the world – short position in a put

It appears that the current stock price is mispriced by
- Under-valuing of the earnings stream;
- Applying zero or little value to the fuel cell potential – a free call;
- Exaggerating the ultimate impact – an over valuation of the put

At today’s stock price of $5.7-5.8, it is now trading at less than 10 times next year’s earnings estimate and at roughly 20% discount to its stated book value of $7+ per share, which is expected to grow by 15%+ to about $13 per share by ’04 (before share buyback). During the period of 2001-2004, Methanex will likely generate free cash flow (defined as operating cash flow after capex and required debt repayment which is zero until ’05) of over $1 billion, or $7 per share.

In the last peak ‘94 and ‘95, US Gulf methanol contract price reached $300 and $250 per ton, respectively. However, at today’s depressed demand environment, average realized methanol price during the first quarter of 2001 for Methanex rose to $225/ton, doubling the price seen in 1Q00. This was caused by extremely high natural gas prices in North America, which basically set methanol price at the break-even pricing for North American manufacturers whose average gas cost was $7/Mcf. As natural gas price is falling in the recent months, so does the methanol floor pricing in NA ‘cause demand at the moment can’t help methanol producers more.

Nevertheless, Methanex, thanks to cheap gas cost ($0.9/MMBtu) at its New Zealand and Chile facilities (capacity totaling 5.4MM tpa), is still earning a decent "arbitrage" spread on its methanol production compared to its NA peers. Based on an average NYMEX Henry Hub gas price of $4.5 during the second quarter of 2001, I expect Methanex to earn 25-30 cents per share, lower than the current street average estimate of 32 cents per share. Free cash flow during the quarter, however, will be more than $60MM, all of which should be added on the net debt free balance sheet, implying the magnitude of net cash balance at $60MM or $0.37 per share as of 06/30/01. This strong cash position reinforces the investment theme that an investor at today’s stock price is buying into Methanex’s free cash flow run-rate of $250MM+ per year (1.55/share) in a depressed year for the industry, at a stock price close to or below stated book value. The great financial flexibility also enables the management to go ahead with its plan to return excess cash to shareholders, likely via a tender offer share repurchase, in the second half of 2001. Based on 87% utilization rate (it is noted that at the bottom of last cycle (’99), Methanex’s operating rate was 89%) and $4.8/MMBtu NYMEX Henry Hub gas price estimate for the whole year of 2001, Methanex should earn $1.00+ per share in ’01. A $250MM buyback program could raise ’01 EPS upward to $1.30, assuming a repurchase price of $8-10 per share.

When economy recovers (in whatever year) and higher methanol prices are restored due to stronger demand (even taking into account a ban of MTBE in California before '04) and limited incremental supply (just 1.2MM tons of new capacities worldwide planned to be added before ’04), rather than those in 1Q01 set by extremely high gas prices, Methanex can potentially earn $3.00+ per share. This peak earnings power is calculated after taking into account share repurchases, which can continue at $250MM+ each year without any borrowing; if Methanex takes additional debt to optimize the capital structure, a bigger amount of share repurchase will be possible. Therefore, $3 peak earnings estimate could prove conservative.

From a different angle to look at Methanex, if there is no any share buyback, by the end of 2002, 2003, and 2004, Methanex will sit on net cash of $2, $3.5, $6 per share, respectively; by then, stated book value per share will be $8.5+, $11, and $13+ per share, respectively. Compared to the current stock price of just under $6, the valuation gap is just too big to be sustained over a longer period of time.

Regarding the MTBE concern, I believe the market price has fully discounted it and probably over discounted it. Given the recent rejection of California’s request for waiver of oxygenate requirement, the shortage of refining capacities in North America and unwillingness of refiners to invest in any unproven technologies/tehniques to avoid production disruption, it is actually quite likely that a complete of ban of MTBE in California and in U.S. would be delayed. Some Wall Street analysts figured that a removal of MTBE concern could add $1B value back to the firm value –which I have no idea whether or not it is true but conceptually 100% agree since this short position in the put is already imbedded into the stock price.

Finally, the call in fuel cell could give the stock a much richer multiple. And it could occur coincidentally with the peak earnings – which you don’t have to count on since you get it free.

Catalyst

Under the Canadian law, Methanex is not allowed to repurchase more than 10% of floating shares (i.e. < 12MM shares) within a consecutive period of 12 months. Consequently, Methanex will not be able to implement a new stock buyback plan until August (NEXT MONTH) and will not be able to acquire more than 10% of total shares except do this in a tender offer. The management has repeated in many occasions that they will return excess cash to shareholders.