Description

I first did a write-up on MEOH in July 2001 and robter511 did a great follow-up in June 2003. As the stock has tripled to $18 from $6 more than three years ago, obviously the easy money has been made. The big question now is: what's the upside for MEOH stock going forward? My conclusion is the stock will rise to $25-30 over the next 12-24 months, which would represent further upside in a range of 35-65+%. This is predicated upon a long term methanol price assumption of roughly $170-175/ton (between 2007-2010), which translates into Methanex's earnings power in the area of $3/shr (on 70mm shrs o/s after share repurchases), and a reasonable P/E ratio of 10x on this sustainable earnings stream.

Absent a global recession, which seems a remote possibility at least for now, demand for methanol will be at least 2-3% p.a. With announced new supply, the market will remain relatively balanced over the next several years, albeit not likely to be as tight as it is now. This means marginal suppliers with the highest cost structure will set floor methanol price.

What's not covered in both robert511's and my previous writings is a long term projection of methanol prices (beyond 2005). I believe long term methanol price will be at minimum $150/ton; most likely, it'll be set at $170-175/ton, if not higher. This is in contrast to the previous trough price at $115/ton and the current Street estimate of $130-140/ton in 2008. Two reasons are given as below:

1) By the end of 2005, NA high cost suppliers will mostly have exited the market, therefore leaving China and Easter European manufacturers as the highest cost producers. As a result, the new floor price for methanol will be determined by capacities in China, East Europe and Russia. All-included, these countries represent 40% of global supply and they can only breakeven at minimum $150/ton methanol price. The primary reason for the high cost is backward logistic infrastructure in these countries, which raises transportation cost. For example, in China coal is used to produce methanol and methanol manufacturing is typically integrated into the mining operation and located close to coal mines. However, most end users of methanol in China are located in the eastern coast area. Because of severe bottlenecking problems and consequently rising railroad cost, it actually costs less money for end users to import from oveaseas than buying from domestic suppliers. Russia has the same problem with long distance transportation.

2) Theoretically, since methanol is produced out of natural gas, it has BTU equivalent value. Most turbines can burn both distillate fuel and methanol, with quite minimal switching cost (to burn methanol requires dedicated storage tanks, which cost little). If crude price stays above $40/bbl for longer time, methanol could be more attractive if compared to distillate. Though this has never occurred in the history, and historic relationship between distillate and methanol prices doesn't appear to support this, given the structural change in the global oil market, an arbitrage opportunity between methanol and distillate could arise. (Remember, back to the last oil crisis in the 70s, methanol industry was so small that its BTU equivalent value was rather meaningless at that time)

One significant macro change since my own writing back in July 2001 has been a rising oil price, driven by a combination of factors including strong energy demand growth from China and India and seemingly peaking out of OPEC's spare capacity, particularly for light-sweet crude, which leaves global oil supply more vulnerable to any short term disruption (troubles in Iraq, Venezuela, Nigeria, or even in Norway). Personally, I believe WTI oil price will continue to trend upward to an average $60-70/bbl with an extremely wide range between $35 and $85 before 2008, as compared to the recent price of just under $45. But let's use more conservative WTI oil price assumption of $40-45/bbl, then trough methanol price could be supported at $150-170/ton. (Methanex has a very nice chart included in its most recent investment presentation slides published on its website, in which you can see the linear relationship between distillate price and theoretical BTU-equivalent methanol price).

By 2007, Methanex will have capacity of 5.8mm tpa from low-cost sites in Trinidad and Chile. At a methanol price of $170-175/ton and cash cost under $100/ton, Methanex will generate annual EBITDA of $400+mm [=($170/t-$100/t) x 5.8mm tpa] and annual earnings in the neighborhood of $200mm.

Methanex should be net debt free by the spring of 2005. Absent a new plant construction, maintenance capex is just $25mm per year vs. D&D around $100mm. Between 2005-2007, Methanex will likely generate excess cash flow in a total amount of approximately $1BN. At an average price of $20, Methanex could buy back 50mm shares to shrink its share count down to 70mm from currently 120mm. I will expect the management to launch a Dutch auction at latest in 2006 to accelerate the share repurchases pace. Currently, Methanex has a normal course buyback programme that limits the repurchases within 10% of total shares during 12-month period ending next May.

As a result, its EPS by 2007/2008 should be close to $3/shr [=$200mm/70mm] and EBITDA per share at $5.50-6.00/shr. At 10x P/E or 5-6x EBITDA, it'd be a $30 stock. Even with some haircuts, it'd be still safe to get at least $25 stock.

A quick update on the near term earnings estimates. The market is currently very tight with dangerously low inventory. Methanex is well on track to earn over $2/shr and around $3/shr in 2004 and 2005, respectively. This is compared with the current street consensus earnings estimates of $1.97 and $2.22 in 2004 and 2005, respectively. Key assumptions to reach my estimates include:

a) The current '05 NYMEX natural gas future strip of $6.50+/mcf should support a methanol floor price of $260/ton [=$6.5/mcf gas price x 36.5 input factor + $25 operating cost] in '05. The realized methanol price for Methanex, on a conservative basis, should be around $235/ton. If demand is stronger than expected and the market tightening continues in 2005, methanol price could have further upsides.

b) '05 Production is expected to be 6.5mm tons, up from 5.5mm tons in 2004.

c) Cash cost is estimated to be around $135/ton (higher 'cause of profit sharing with gas suppliers and some high cost capacities still running in part of '05 before their shutdown).

Catalyst

1. Near term (4Q04 and '05) earnings upward revisions;
2. A possible Dutch auction in 2006 to accelerate the share repurchases;
3. Market's eventual recognition of Methanex's long term sustained earnings power in the area of $3/shr;
4.A financial buyer who unlike usual private equity firms, doesn't necessarily need an exit strategy, could be attracted by Methanex's strong & sustained cashflow and take over Methanex. Such buyers could include AIG, Berkshire Hathaway, etc.