Summary

LyondellBasell (LYB) is a compelling investment at 86. LYB is a well-run company, with a strong balance sheet, an advantaged feedstock position, and a portfolio of complementary businesses that lend stability and consistency to a business that is underpinned by a sometimes-volatile commodity. The Company has been a disciplined, consistent capital allocator, as it has invested in high-return projects, pays a substantial dividend (the dividend yield is currently 4.9%) and repurchases stock. Despite this, the equity is cheap, at around 8x our 2020 base case estimated earnings per share. We think that the investment community is too focused on the next 1 - 2 quarters as new North American ethylene capacity enters the market and pricing is likely to be under pressure during this period. At 8x earnings, we think this is more than factored into the valuation and leaves material upside over the next 12 - 24 months as demand grows and absorbs the new supply, the company benefits from new projects coming online, growth capital expenditures decline, and the company is left with more free cash to distribute to shareholders.

Business description

LyondellBasell is a chemical company with six business segments, generally revolving around the production of Olefins & Polyolefins (O&P) and related products:

While each of these segments warrant a detailed description, I will try to be succinct so as not to miss the forest for the trees.

The core of LyondellBasell is its Olefins and Polyolefins (O&P) business, which it conducts in two geographies:  Americas and EAI (Europe, Asia, and International). The two major products within O&P are polyethylene and polypropylene, which are both polyolefins. LyondellBasell has leading market shares in many of its products and markets.

 Polyolefins are important building blocks of middle class life worldwide and demand is expected to continue to grow, as more of the world’s population joins the middle class. These products are widely used in food and consumer goods packaging, as well as other items where convenience and freshness are important. In addition, they are used in a wide range of more durable applications, including infrastructure, consumer products, and transportation, to name a few. In general, as GDP per capita increases, the per capita consumption of O&P follows. O&P demand has historically grown at around 1.5x GDP and management believes that demand continues to grow at around 4% per annum.

The basic building block of O&P is ethylene, which has two primary feedstock “paths” to production. The first is derived from natural gas/natural gas liquids (ethane, propane, butane) which are processed into ethylene. The second path is crude oil into naptha and then into ethylene (coal/methanol is a third, high cost path). Given the abundant supply of cheap natural gas (more specifically, “wet” gas, containing natural gas liquids), the US has become one of the low cost geographies for ethylene and O&P production.

For LYB, about 60% of consolidated EBITDA comes from the worldwide O&P business (Americas + EAI) and about 66% of the worldwide O&P EBITDA is generated in the Americas. Given the feedstock differentials at current prices for Brent Crude and US ethane, a North American integrated polyethylene producer might have a $350 - 360 per ton advantage over a producer that is oil/naptha dependent (this is in relation a historical polyethylene spot price of around $1,000, depending on the grade and delivery point). In addition to this geographically advantaged capacity, the remaining 33% of LYB’s production is in EAI, which is generally naptha-dependent. This diversification provides a natural “shock absorber” for the North American business: when the spread between US natural gas versus Brent Crude is wider, the US business is more profitable and EAI business is less profitable, but the same generally works in reverse. As the commodity prices ebb and flow, the variances in the two geographies tend to partially offset each other. As a result, EBITDA of the combined O&P divisions, has been less volatile than either of the individual areas. From 2014 – 2018, worldwide O&P EBITDA ranged from $3.9 – 5.3 billion, a 26% decline from peak to trough versus a 33% and 40% for the Americas and EAI, respectively.

Global O&P EBITDA (Americas + EAI)*

*In 2017, LYB reclassified certain compounding businesses from the O&P segment and to the newly-created Advanced Polymer Solutions business.  In 2014 – 2016, I estimated the EBITDA from those businesses and backed it out so the numbers are comparable.

O&P Americas results in Q4 2018 through 2019 have been impacted by the ongoing US-China trade dispute. The EAI segment was also negatively impacted in late 2018 and early 2019 by a disruption on the Rhine River, in addition to generally weak economic conditions in Europe.

The Polyolefin markets are complex and I am not going to attempt to predict the price of a ton of polyethelene in six months. However, I believe that demand for polyolefins will keep increasing over time and that the 2019 and 2020 capacity additions will be absorbed if the economy keeps growing. I also believe that we are closer to the bottom of the cycle than the top of the cycle. Our base case modeling assumption is that EBITDA from the worldwide O&P business will be down 10% in 2020 and then return to 2019 profitability levels in 2021 and 2022.

Intermediates and Derivatives (I&D)

The I&D business manufactures compounds such as propylene oxide, oxyfuels, and various intermediates such as styrene, methanol, and ethylene oxide. These compounds utilize many of the same feedstocks and products as the O&P business.

Propylene oxide and its derivatives are often used in applications such as home insulation, insulating foams, auto parts, and polyester composites. Oxyfuels and related products are used in fuel blending, lubricant additives, and certain rubber formulations. Intermediates, like styrene, are used in a wide variety of applications such as food packaging, textiles, coatings, and polyester.

The I&D business has had pretty stable margins and earnings, as nearly half of these products are produced on a cost-plus basis. In 2017 and 2018, EBITDA for this division was $1.5 and 2.0 billion, respectively and is estimated to be about $1.5 billion in 2019. Management believes that the midpoint for this division is about $1.7 billion. I model this segment to be flat for the next three years

Advanced Polymer Solutions

This business segment was created in Q3, 2018, when the company acquired A. Schulman and combined it with polypropylene compounding businesses that were embedded in the O&P segment.

This division upgrades polypropylene into more advanced compounds used in various high-specification applications. The company estimates that about 50% of the division’s sales are to the automotive market, with packaging, electronics, and building/construction also contributing to demand.

This division should generate about $470 million in EBITDA in 2019, around $500 million in 2020, and close to $550 million as they continue to realize synergies from integrating the A. Schulman acquisition. (A recovery in worldwide auto sales would provide upside to those numbers).

Refining

The company owns one refinery on the Houston Ship Channel with capacity of about 268,000 barrels per day and a complexity rating of 12.5 (that is pretty high and should allow them to benefit if IMO 2020 impacts the refining markets). The earnings of a single refinery can be very volatile.  From 2013 - 2018, LYB’s refinery generated EBITDA ranging from $72 – 519 million, with an average of $250 million. In 2019, the refinery will most likely generate an EBITDA loss. In my analysis, I assume the refinery generates annual EBITDA of $100 million.

Technology

LyondellBasell licenses process technologies to other chemical companies and sells them the catalysts necessary to operate the plants. They have leading shares in process licensing in High Density Polyethylene (HDPE), Low Density Polyethylene (LDPE), and polypropylene. This is a high quality “franchise” earnings stream that has been growing consistently. EBITDA was $223 million and $328 million in 2017 and 2018, respectively and should be about $350 million in 2019. It should also be noted that LYB is working on some interesting technologies that relate to plastic recycling. If any of those turn out to be commercial, it could be another potential franchise stream (and could possibly lead to multiple expansion).

Putting it all together

In 2019, LyondellBasell should generate EBITDA of about $5.9 billion. This should yield gross cash flow of about $4.9 billion, maintenance CAPEX should be about $1.2 billion, dividends should be about $1.5 billion, and growth CAPEX about $1.7 billion. This leaves about $.500 billion left for share repurchases.

Over the next 3 years, LYB should enjoy increased EBITDA and free cash flow driven by:

• ·         New projects coming online and translating into increased EBITDA

• ·         Refining earnings recovering from a very weak 2019

• ·         Advanced Polymer Solutions realizing synergies

• ·         Technology segment growth (I model 5%, annually)

• ·         Growth CAPEX declining as their current slate of projects is completed.

• ·         Optionality on O&P market tightening (but I do not model that)

These factors should lead to a dramatic increase in free cash flow available to return to shareholders.

Here is how it might play out*:

*These estimates assume O&P profitability declines 10% in 2020 and then returns to 2019 levels in 2021 and 2022.

If LYB earned $15.40 in 2022 and commanded its historical multiple of 9x, it would yield a $138 stock, up about 60% from today’s price. If it happened over 2.5 years, it would yield a CAGR of about 21% plus about 4% from the dividend, generating a total return of around 25% compounded.

Concerns and Risks

·         New North American ethylene and polyethylene capacity came on line in H2 2019 and more is scheduled to come on in H1 2020. Spot prices in Q4, 2019 and Q1, 2020 have been weak – so Q1, 2020 may be weak and many analysts have been reducing their 2020 estimates.

·         More trade disputes. 2019 Americas O&P demand was impacted by the US-China trade dispute.

·         Weak auto sales. The auto market is an important end market for the Advanced Polymer Solutions business and some weakness in the 2019 results was attributed to a decline in worldwide auto sales.

·         Sluggish overall demand. Even though about 2/3 of LYB’s products are used in consumables, a growing economy is definitely a plus.