Description

Westlake Chemical (WLK)

Investment Thesis

The recent rapid decline in Brent crude has led to a significant pullback among US petrochemical companies as investors fear that we have seen peak profitability for producers along the ethylene value chain. We think the recent selloff in WLK specifically is overdone, and believe that investors are extrapolating a “new normal” of lower earnings power, which does not take into account WLK’s opportunity for continued EBITDA/FCF expansion even in a lower ethylene margin environment. With significant balance sheet flexibility, a history of very accretive acquisitions, successful brownfield debottlenecking projects, MLP optionality (and lower cost of capital), we believe that this is an attractive entry point for a company that will continue to benefit from sustained cost advantages and generate industry leading ROIC.

Company Description

Westlake Chemical (WLK) is a 100% vertically integrated manufacturer of olefins, vinyl’s, polymers and fabricated building products. WLK operates through two main segments, Olefins and Vinyl’s. The Olefins segment manufactures ethylene, polyethylene, styrene and associated co-products. WLK processes cheap raw materials into higher valued chemicals, and building products used in flexible and rigid packaging, auto products, coatings, resi and commercial construction, and other goods.

Olefins Segment

The Olefin segment is the core of WLK, driving the majority of EBITDA and is where WLK generates the highest returns due to its significant cost advantages vs. global peers. Ethylene is the most widely used petrochemical globally in terms of volumes, and is essentially the building block for higher valued chemicals such as polyethylene, ethylene dichloride (EDC), vinyl chloride monomer (VCM), and styrene. 100% of WLK’s ethylene capacity goes into the production of the aforementioned chemicals. WLK is the largest North American producer of autoclave low-density polyethylene (LDPE), a premium chemical used in high performance packaging, which earns a premium margin ($0.05-$0.10/lb) vs. more commodities like chems such as high-density PE (HDPE) and linear low-density PE (LLDPE). WLK has 1.5b lbs. of LDPE capacity, which makes up about 62% of total PE capacity vs. industry comps such as XOM (40%), DOW (33%), and LYB (30%).

Vinyl’s Segment

The Vinyl’s segment produces PVC resin, VCM, EDC, chlorine, caustic soda and ethylene. WLK also manufactures and sells building products such as PVC pipe, fittings, profiles, fence and deck, and window and door components. WLK’s main manufacturing facilities are in Calvert City, LA and Geismar, LA. Following its acquisition of Vinnolit (more on that later) WLK is the market leader in emulation PVC and large diameter PVC, both of which are premium products that earn higher margins (10% roughly) vs. commodity grade PVC resin and small resi PVC.

Shale Gas Boom – A Long Term Tailwind for US Petrochem Industry

Innovation in shale gas extraction technology has led to a well-known boom in US natural gas and NGL production. This rapid production growth has led to a massive decline in natural gas (and derivative) prices, while global crude prices have been relatively robust, resulting in a high oil-to-gas ratio. As a result, WLK (and other petrochem comps) has enjoyed a massive cost advantage as US ethylene producers use ethane as its core feedstock (priced off natural gas) rather than naphtha (priced off Brent) which is the core feedstock of the higher cost global producers. This has led to a strong export market for ethylene derivatives and higher margins for US producers.

Specifically, the boom in natural gas production has subsequently resulted in a surplus of ethane in the US, which has led to sustained lower prices ($0.25-$0.30/gal) which has dramatically lowered US cash costs from $0.35-$0.40 in peak gas price cycles to $0.10-$0.15 currently. At the same time, higher cost producers in Asia & Europe have seen cash costs of $0.40-$0.60 due to higher (crude based) naphtha. Because over 60% of ethylene production occurs in Asia/Europe, global contract pricing is based off these higher cost producers, leading to average ethylene contracts of $0.50-$0.60/lb, implying a $0.35-$0.45 margin capture for WLK. This wide margin opportunity has been a major contributor to WLK’s EPS growth ($1.67 in 2010 to $4.55 in 2013). However, the recent decline in Brent (and the concurrent drop in naphtha) has sparked market fears that we have seen peak ethylene margins, and thus peak EPS for WLK. While we believe WLK has the ability to grow through a lower margin environment through capacity expansion, accretive acquisitions, and from balance sheet flexibility (more on that later), it is appropriate to cover the implications of lower crude prices on ethylene margins.

Ethylene and the Effect of Lower Brent Prices

• Lower Naphtha – The decline in Brent (-25% YTD) had led to pressure on naphtha prices (roughly -29% YTD) which lowers the cost of ethylene production for overseas competitors and thus, is negative for advantaged US ethylene margins

• Ethylene Margin Sensitivity to Brent- Each $10/bbl drop in Brent lowers ethylene margins by approx.. -$0.05, so the recent fall in Brent is equivalent to roughly a -$0.15 drop in ethylene margins based on spot pricing.

• Flow Through to US Ethylene Contracts- This decline in spot ethylene pricing will likely result in lower contract pricing (and lower ethylene margins) with a lag. Q3 contracts were robust in the US due to outages in the USGC and from a firmer PVC contract market. About 90% of US ethylene is moved by contract (10% by spot) which further explains a portion of this lag.

• Recent Declines in Spot Markets – The spot market is falling due to lower Brent, but also in anticipation of ethylene units coming back online in December (WMB’s Geismar, and CP Chem). While spot is expected to fall by $0.10-$0.15 in 4Q14 from 3Q levels, contracts are more likely to drop by $0.03-$0.04 in October, and a similar drop in November. For reference 3Q14 contracts for ethylene settled at $0.54, spot fell $0.05 to $0.66.

The uncertainty of where Brent is likely to normalize has increased the implied risk of lower ethylene margins, however WLK has proven its ability to grow EBITDA through successful capacity debottlenecking projects, accretive acquisitions, and now has the ability to monetize assets (and benefit from a lower cost of capital) through its MLP Westlake Chemical Partners (WLKP).

Brownfield Expansion – History of Successful Debottlenecking and Future Opportunities

WLK has significantly improved its earnings power by expanding capacity and optimizing that capacity as a fully integrated ethane based ethylene producer. In the last two years, WLK has added 420m lbs of ethylene capacity (15% of total) through successful debottlenecking projects. Management has historically preferred brownfield expansion as it is inherently less expensive, minimizes risk, and doesn’t require the lengthy regulatory process of adding Greenfield capacity (which of course demands higher capex outlays).

Recent History of Capacity Expansion

-1Q13, WLK expanded capacity at its Petro 2 ethylene units at Lake Charles by 240m lbs/annually

-4Q14, WLK build a new chlor-alkali plant in Geismar, LA with annual capacity of 350k ECU’s or 700m lbs

-2Q14, WLK completed three debottlenecking projects at Calvert City, KY; expanded PVC capacity by 200m lbs, ethylene capacity by 180m, and completely converted the ethylene plant from propane to ethane feedstock.

-Late 15’/early 16’, WLK plans to expand C2 at Petro 2 again, expected to add 250m lbs of capacity.

These projects are expected to contribute $300m-$400m of EBITDA over 2014-2016.

Accretive Acquisitions – Vinnolit

WLK acquired Vinnolit, the 4^th largest PVC producer in Europe and a leading producer of premium emulsion grade PVC in May 2014. WLK paid 490m EUR or roughly 6x EBITDA (8% of WLK EBITDA). This acquisition expanded WLK into Europe, a market where the company had no previous exposure. But more importantly, the deal was immediately accretive, adding $0.35-$0.45 of EPS. This also gives WLK the opportunity to enter a market that is in the midst of consolidation (INEOS/Solvay), and capacity rationalization. This gives WLK a good base in Europe, with further upside optionality from any improvement in European demand conditions. Vinnolit is just the most recent example of WLK proving to be successful, efficient capital allocators with a solid track record of accretive acquisitions.

Balance Sheet Flexibility

WLK has a rock solid balance sheet with $50m net cash ($813m cash - $763m total debt), adjusting for the Vinnolit acquisition, net debt/EBITDA will rise to 0.4x, and is expected to be net cash positive again in 2015. WLK has a $400m senior secured revolving credit facility, which has an option to be increased up to 4x, in increments of $25m-$150m, and all current capex projects are to be funded with cash. Gross debt is also optimally structured with only $249m of 3.6% senior notes due 2022, followed by $100m 6.5% senior notes due 2029, $250m 6.75% notes due 2032, and more small debt obligations due in 2035.

Robust FCF – Potential Deployment

FCF is expected to be in a range of $600m-$650m in 2015, resulting in a pro-forma FCF yield of 6.9%. WLK has the opportunity to deploy this FCF towards additional acquisitions, brownfield expansions, new Greenfield capacity, dividend growth, or buybacks.

It should be noted that buybacks are rather unlikely considering the Chao family (founders) own 70% of shares outstanding, hence it is unlikely in our view that they would want to reduce the float (however there is still $60m of buyback authorization left).

MLP Optionality

WLK crated a pure play ethylene MLP, Westlake Chemical Partners LP (WLKP) which gives WLK the ability to monetize ethylene assets at premium EBITDA multiples. WLK created its MLP through an optimal (and intriguing) structure. WLK, the C-Corp parent, created Westlake Chemical OpCo LP which owns WLK’s three ethylene crackers and its Longview pipeline. WLK has an 89% interest in the OpCo entity, while WLKP owns 11%. At the WLKP level, WLK controls 52% of the LP interest, with the balance going to the public. WLK plans to periodically dropdown its interest in OpCo to WLKP, and will use its cash proceeds towards organic growth and/or acquisitions. As with all dropdown driven MLP stories, the C-corp benefits from selling assets at premium EBITDA multiples. For example, WLK can dropdown assets at 10x EBITDA, a 3x-4x multiple differential vs. WLK’s historical EV/EBITDA levels. WLK will also benefit from its ownership of WLKP LP units, and from distribution growth through its LP stake as well as its ownership of WLKP’s incentive distribution rights (IDR’s). The leverage to cash flow growth through IDR’s is a core tenet of C-Corp benefits from MLP conversions, as eventually the c-corp will be entitled to an increasing portion of quarterly distributions as those payments grow. Specifically, WLK will hit the 50/50 splits (entitled to 50% of all incremental cash flow) when WLKP distributions hit $0.4125 or above. The structure of IDR’s incentivizes WLK to grow distributions at WLKP through dropdowns, which will likely be funded through equity issuance at the WLKP level (further increasing WLK’s portion of incremental cash flow).

While at first glance, one might suppose that the typical MLP investor would shun a more volatile “commodity” exposure, the structure of WLKP diffuses most of that risk. WLK has signed a 12 year agreement to purchase 95% of OpCo’s ethylene production at a fixed rate of $0.10. This should give MLP investors visibility into future cash flows, which should grow on par with high growth MLP comps (10%+).

WLKP also gives WLK additional optionality for future M&A as it could use WLKP equity as a valuable currency for incremental ethylene acquisitions, which would most likely be dropped down to WLKP.

We believe WLKP adds $8-$9 of equity value to WLK in the next 5 years potentially.

Valuation

We utilize a SOTP methodology using a bear-base-bull case scenario for EBITDA multiple assumptions.

We believe it is appropriate for WLK to trade at a relative premium to its peers over the long run, as WLK’s 100% US integrated ethane based cash costs should be attributed with a higher multiple. Also both of WLK’s core products (ethylene and LDPE) earn a higher margin than WLK’s more global (and more naphtha based) high cost peers. The creation of WLKP should also give WLK/WLKP some additional downside risk mitigation, and also should benefit WLK from future cash dropdown proceeds.

Catalyst

Higher than expected contract ethylene prices, M&A, additional brownfield expansion projects, greenfield projects, balance sheet optionality, capital deployment (dividend growth, buybacks), MLP dropdowns.