Description

Polski Koncern Naftowy Orlen (PKN PW - based in Poland)

PKN is a European refiner / petrochemical producer that is benefiting from one-time supply outages and correspondingly generating super-normal returns that are >5x in excess of historical normalized levels (the stock is up >35% in 2015).  The market is complacently assuming 2015 is sustainable and PKN will generate future returns ~3x above normal levels.  In comparison, there is evidence of both gasoline cracks (witnessed ~4 + standard deviation move in 2015) and petrochemical margins normalizing with supply coming back on-line as well as less demand – this will lead to a PKN generating FCF / share in the $0.30 / share range (stock trades at ~$17 / share USD-equivalent).  My base case FV for PKN is $11 / share or >35% below current levels.    

Quick biz overview: ~7.2Bln USD market cap, and ~2.5Bln USD net debt factoring in recent acquisitions; Operates 6 refineries and a ntwk of service stations located in Poland, Czech Republic, Germany and Lithuania.  In addition to its refining operations, has signficant exposure to petrochems selling polyethyene, PTA (plastic bottle end-mkt) and MVO (fertilizer end-mkt).  PKN has been spending money on upstream oil / gas exploration in Canada and Poland (so far, these investments have been duds putting into question management’s ability to properly allocate capital).

Over-earning commodity: PKN is a commodity business that is signficantly over-earning.  ~55% of its profits are from European refiners and ~35% from Europe petrochem (~90% in total); both segments are benefiting from the “perfect storm” of temporary events (reduced supply and heightened demand in 1H 2015) that are in the early stages of normalizing.  (1) On the refining side, spreads reached 15-year high levels in 2015 largely driven by a >4-standard deviation move in gasoline cracks.  (2) On the petrochems portion of the biz, PKN is also benefiting from polyethylene margins that reached >4 – 5x normal levels in 2015.   For the overall business, the 8-yr historical ROIC is ~5% … in comparison, Q2 – Q3 2015, ROIC was well in excess of >30%.  The market is assuming the termporary supply issues are structural in nature and assumes PKN will sustainably generate ROIC of >20% moving forward (i.e. 2.5 – 3.5x normal levels)

My view relative to market: In late 2015, gasoline cracks got to 4 - 5 standard deviation levels versus normal – this was largely driven by global supply outages and will revert back to normal levels in 2016 and supply comes back online (plus new supply from Middle East).  As S/D comes back into balance, Europe refining margins will correspondingly compress by ~50%.  Additionally, the petrochems segment is witnessing heightened evidence of S/D normalizing that will result in 30 – 35% compression in margins.  The market currently is focused on the refining segment and less focused on petrochems that provides an attractive set-up as 2-ways to win.

Lofty expectations are baked in: The market is currently capitalizing ~$5.00 - $6.00 / barrel refining crack spreads (~20% ROIC) versus my base case of ~$3.00 / barrel (~10% ROIC versus historical average ROIC of ~5 - 6%).  The market is assuming PKN will continue to earn super-normal margins resulting in FCF / share of ~1.00 - $1.25 USD per share (versus a $17.40 USD equivalent share price).  In comparison, as margins normalize on both its refining and petrochemical segments with supply coming back on-line and less demand, PKN FCF / share will fall to $0.30 / share.

Catalyst

- gasoline spreads is the source of conviction / as this normalizes in 2016E, composite cracks will normalize at lower levels 

- additional calayst is around PE margins; notably, end-mkt polyethylene prices fell significantly less than crude / naptha in 2015 (given supply outages); as this normalizes in 2016, margins on the petrochem products will also compress to more normal levels