Description

FW51 first posted Methanex on VIC in July 2001 in a perceptive writeup. Over the past two years, Methanex has continued to execute its plan and will benefit from the long term US natural gas shortage and worldwide methanol production shortage. Methanex is a Canadian company that is the world's largest producer and marketer of methanol. Their major production facilities are in Chile, Trinidad, and New Zealand. The supply demand situation in methanol is so favorable (despite the slow global economy) that the recent loss of one-fifth of Methanex' production capacity (in New Zealand) may have even had a favorable impact on their profits because global methanol pricing increased to clear the production shortfall. All values below are in US$.
I believe a Fair Value is at least $18, based on a conservative PE of 6 on 2004 and 2005 average EPS of $3. Consensus estimates for this year's earnings are slightly less than $2.00. I think it will be in the range of $2.25 - $2.60. Why have I used such a low P/E? Methanol is a commodity product with volatile pricing. Average pricing over the years has been around $150/ton; currently it is around $240/ton. I believe pricing will stay strong for several years due to very strong supply-demand scenario; however Methanex may face the same problem homebuilder stocks face, with investors expecting the good times to end in the near future. If that perception changes, the stock could break $25.
You’d expect, and be right, that higher natural gas pricing is generally bad for the chemical industry since it depends on natural gas as an input for many of its products (for example, see Barron’s p. MW3, May 26, 2003). Natural gas is not easily transported across the ocean. US tanker and storage capacity for Liquefied Natural Gas (which can be easily transported) is limited. Expanding storage for LNG is expensive and time consuming, both financially and politically. However, many chemicals produced from natural gas, such as methanol, can be easily transported by sea. Worldwide, natural gas is still plentiful and cheap. Thus, there is an arbitrage opportunity for chemicals with a high natural gas content and tight capacity constraints that are produced in plants both in the United States and overseas. Methanol prices in the United States will be high because natural gas costs are high. US producers cannot reduce prices because their costs are so high. Remember that there is no excess capacity in the industry. In early 2003, Methanex's natural gas cost was less than $2/mmbtu vs. US producer gas costs of over $5/mmbtu. 15% of global methanol capacity is currently in North America.
At December 31, 2002, global methanol capacity was approximately 37 million tons. In early 2003, it was determined that the main natural gas field (Maui) supplying most of Methanex's New Zealand plant had several years less supply than expected and 60% of Methanex's natural gas for that plant was cut off. 1.1 Million Tons (about 3% of global supply) was lost resulting in global capacity of 35.9 Million tons. No capacity expansions are expected this year in the global methanol industry. In 2004, 2.7 Million Tons (1.1 Million owned by Methanex) will be added and in 2005, 1.8 Million Tons will be added (0.8 Million owned by Methanex). There will probably be capacity subtractions offsetting much of these additions, however.
Methanex has a history of entering into agreements to supply companies currently operating their own methanol plants and then having those plants idled. For example, in December 2000, Methanex acquired methanol marketing rights and other assets from ICI. In April 2001, ICI idled its 0.5 Million Ton methanol plant in the UK Also, in 2000 Methanex entered into an arrangement with BP/Sterling to supply their methanol needs and exercised their option to idle their 0.45 Million Ton plant in Texas. Methanex maintains a reasonable supply-demand balance this way. It is likely that next year the Lyondell plant (0.75 Million tons) will be idled as a result of the supply agreement Lyondell and Methanex recently entered into. The CEO today stated that they believe there will be at least two plant shutdowns (almost by contractual arrangement with Methanex) in 2004, almost offsetting the capacity Methenax is adding in 2004.
Demand growth for methanol for chemical derivatives, which represent approximately 75 percent of global methanol demand, is driven primarily by growth in global gross domestic product and the strength of the global economy. Since 1993, global demand for methanol for chemical derivatives has grown by approximately 5 percent per annum. Because MTBE (a gasoline additive) represented the remaining 25% of the demand for methanol, the January 1, 2004 ban on MTBE in California and several other states had cast a shadow of Methanex's future. In 1999, approximately 40% of Methanex US’ sales of methanol in the United States were to third parties using methanol for the production of MTBE.
It is alleged that methanol used in gasoline leaches into the environment. The methanol industry argues that when gasoline containing MTBE is discharged into the environment some of the MTBE may dissolve in the surrounding ground water. The MTBE often travels faster than other gasoline components and has a characteristic taste and smell. MTBE detection in water may be considered the indicator of gasoline in the environment. In the United States, industry and political proponents of ethanol have been pushing for a nationwide ban on methanol, which would increase demand for ethanol. However, in the rest of the world MTBE production has been increasing and in December 2001, the European Union confirmed the suitability and continued use of MTBE as a fuel component. As of April, Methanex estimated that California MTBE demand was down by 50%, which would result in reduced methanol demand of approx 0.75 Million Ton /year (2% global demand), with a similar reduction next year. Despite this, worldwide methanol production is expected to grow this year and next. Methanex is assuming that MTBE will be banned totally in the US over the next five years.
Based on 2002 worldwide demand of 30.5 million and demand growth of 1%,1%, and 3% (historically demand has grown 4% annually; Methanex assumes 2% growth through 2008) over the following three years worldwide demand would be 30.8, 31.1, 32.0 Million tons. This would result in projected utilization rates of 85.8%, 80.6%, 79.2%. That is without considering capacity subtractions. Methanex estimates required industry capacity utilization at 88% and 90% in 2003 and 2004 and points out that prior to 2002, the industry was not able to operate for sustained periods at higher than 80-84%.
Assuming that half of Methanex's added capacity is offset by capacity subtractions results in projected utilization rates of 81.7% and 81.1% in 2004 and 2005 respectively. This is still very high by industry standards and is probably one of the reasons why CMAI (Chemical Market Associates, Inc.) is projecting that next year's methanol prices will remain above $200. The tight supply situation should continue until at least 2006; there are rumors of new plants opening in Saudi Arabia, Iran, and Australia (one by Methanex). These big projects however have a way of being deferred or disappearing completely however. Methanol plants cost several hundred million dollars and 2-3 years to build. Today, Methanex' CEO announced that they are very close to meeting their investment criteria for a plant in Australia with capacity of slightly more than 1 Million tons. It will cost a bit less than $500 Million. They recently renegotiated a natural gas contract to supply this plant; the new terms were very favorable according to the CEO. The Board will probably decide at their July meeting.
Some Q1 highlights: Net realized pricing of $223/ton; Net Earnings $76 million; EBITDA $125 million; Cash Flow from Ops: $112 million. Remember that this was done despite the New Zealand factory's natural gas being partially shut off and despite MTBE being reduced by legislative fiat. Some other numbers: Depreciation and amortization: $23 million; Net Interest: $4 million; Taxes: $23 million. Diluted shares outstanding: 130 million shares; $0.58 Diluted EPS. As of March 31, 2003 Total Debt was $559 Million, Cash was $465 Million, Total Assets was $1,899 Million. Less than $84 Million of the Assets were intangibles.
This quarter's earning are hard to project. Methanol pricing, while still very strong, has eased slightly. In March, Methanex net realized prices were $235/ton. New Zealand production will be at only 40% of capacity for the full quarter. This will tend to increase the effective tax rate. On the other hand, the decision to exercise the option to fully own and control the reminder of the Titan project (0.75 Million Tons) in Atlas will increase margins on that product from the 3% marketing commission they had been getting to something approximating their normal margins (Gross Margin 37% in Q1). Incidentally, methanol from Trinidad can be exported duty free to North America and Europe. Also, while the normal Trinidad tax rate is 35%, there is a tax holiday until 2005. The Trinidad acquisition was effective May 1. It's hard to know how all of this will balance out for Q2. Diluted Q1 EPS was $0.58; it wouldn't shock me if Q2 was lower, perhaps less than $0.50, However from Q3 on, EPS will be sharply higher. But wait, there's more. Assuming Methanex shareholders approve, on June 30 Methanex will buy back and retire the remaining 7% (at a below market price of $9.85) of Methanex that Nova Chemical still holds.
Methanex's hurdle rate on assets is 14%, using the long term average methanol price of approximately $150/ton. For the first half of 2003, I believe they will earn $1.05-$1.20. In the second half of the year they should earn approx $1.20 - $1.40 for a total $2.25 - $2.60. This is higher than the consensus estimate of just less than $2/share. Next year, assuming continued strong methanol pricing (very likely based on the capacity situation I've described), they should earn around $3.00, because their large low-cost Atlas facility will be operational. Dividends this year will be at least $0.45 per share ($0.20 normal quarterly plus $0.25 special dividend).
Management is strictly focused on methanol. They will not diversify into areas where they have little expertise; excess cash will continue to be given to shareholders either through share repurchases or dividends. Shares outstanding have declined from 170 Million at year end 2000 to 130 Million last quarter; they will shrink by another 9 million at the end of June once Methanex purchases and cancels the remaining shares owned by Nova Chemical.
Suppose these high methanol prices don't last and pricing comes down to more normal levels (probably after 2005). In 2002, Methanex's average realized price was $155 per ton (close to the long term average). Cash Flow from Ops was $245 million and EBITDA was $270 Million. In 2001, Methanex's Average Realized Price was $172 per ton; Cash Flow from Ops was $219 Million and EBITDA was $238 Million.
Based on their 2002 cost structure, Methanex would have EBITDA of $240 Million midway through the price cycle. At the bottom of the cycle EBITDA would be $80 Million and be profitable. Based on the projected 2005 cost structure, EBITDA would be $350 Million midway through the price cycle. As a reminder of what can happen when pricing is strong, Q1 alone had EBITDA of $125 Million. By the way, Methanex discloses methanol pricing information weekly on its website.
Scheduled Maintenance Capital Expenditures are $75 Million through 2005; Strategic Capital Expenditures (mostly capacity expansion) are $344 Million for the same period. This excludes Australia, which has not yet been approved. So, you can see that even at mid-point pricing, Cash Flow exceeds Cap Ex. There's every reason to believe that over the next three years pricing will be far above the historic average.
Over the last few years, Nova Chemical has been Methanex's largest shareholder. Until today, Nova owned 37% of the outstanding shares. This has been perceived as a drag upon the stock since there was a perception that Nova was looking to sell out. Today, 38 Million shares were sold by Nova to independent investors in a secondary offering. Besides eliminating this drag, liquidity will also be improved. On June 30, with Methanex shareholder approval, the remaining 9 million shares will be bought and retired by Methanex. This should serve as a catalyst for Methanex shares.
What could go wrong? (1) There could be some sort of catastrophic problem at one of their plants in Chile, Trinidad, or New Zealand. (2) The global economy could become significantly weaker, reducing demand. (3) Much of the natural gas to the Chile plant is supplied from Argentina, a country that is at risk economically and politically. (4) MTBE could be phased out much faster than expected. (5) Natural Gas pricing in the United States could crash, removing one of the supports for methanol pricing and drivers for idling methanol plants.

Catalyst

(1) Exiting of Nova Chemical as principal shareholder; (2) Continued tight methanol capacity; (3) US Natural Gas shortage