In my first analysis of Covestro (OTCPK:CVVTF), (OTCPK:COVTY) back in October, I pointed out that the stock offers compelling upside despite the challenging environment because there was too much negativity priced in. In retrospect, this was not my worst call, and the stock went up more than 75% in the last 10 months.
But to be fair, a considerable part of this gain was due to takeover speculations. Starting on the 20th of June, the second-largest producer of oil, Abu Dhabi National Oil Company (ADNOC) expressed interest in acquiring Covestro.
But even though these rumors have a high influence on the share price, I also see a compelling investment case regarding the fundamentals, which started improving. This strengthens the hope that the down-cycle has seen its low and starts recovering. In the following update, I share my opinion on both topics: the takeover speculations and the fundamental site.
How to play the takeover rumors?
The 20th of June began as a very poor day for investors of Covestro since the stock was already down 8% in the first hours of the day. A German competitor reported disastrous earnings, and cut its fiscal year guidance, stating the expected recovery of the industry for chemical materials is unlikely to happen as incoming orders were much weaker than anticipated. Since nearly every German big player tried to reassure their investors at the beginning of the fiscal with a promising outlook for the second, this was a shock for the whole industry.
But then came the news that ADNOC was interested in buying Covestro and made an informal offer in the mid-fifties. In a first reaction, the share price rose from its daily lows of more than 28% near €50 and closed at €45. The fact that there is about 20% price potential left to reach the offer price shows that investors are only partly convinced that there will be an agreement at these price levels. Nevertheless, it proved that Covestro is still a company with great quality and upside potential despite the current problems in the industry.
The management stated a few days later that the offer was way too low to think about negotiations. I shared management’s opinion since 10 billion is a price level that Covestro had in February 2022 back when there already were many concerns about a coming down-cycle. Now that the cyclical low is likely overcame, the stock price might be able to reach this price level on its own in 1-2 years.
After all, Covestro had a net income of 1.6 billion Euros in 2021. However, ADNOC continued to show interest and steadily increased their offering. The current offer of €60 (11.3 billion) still seems pretty low, but it might be enough to start negotiations like two major shareholders of Covestro recently recommended. Analysts share a similar opinion and point out the negotiations are likely to tend to a price of €70 before reaching an agreement.
The market cap would then be 13 billion, which seems reasonable, and I would be willing to sell my shares at these levels. Assuming a share price of €67.5 ($73.2) there is an upside of more than 35% which are great prospects for shareholders. I think the management will agree to some talks with ADNOC which will be already enough for a little share price bounce. Whether there will be an agreement is a much more complex question because ADNOC´s willingness to pay is uncertain and Covestro’s management seems very convinced of their company and seems to have clear price expectations.
There is therefore a certain probability that the price expectations of both parties are too far apart. In the short term, this will cause a sharp decline in share price, but I am sure that the price will not return to the thirties but will remain in the mid-forties due to increased fundamentals and investors’ confidence.
Fundamental side: Not glamorous but new cycle likely to start
When Covestro issued its guidance for 2023 in March, I was a bit shocked at how disappointing and vague it was. I began to question if I was not too optimistic about the recovery because the macro environment improved much slower than anticipated, especially in Germany. I was a little relieved when management updated the guidance in late April with more concrete numbers. It was still not looking bright but more encouraging than in March. Especially, EBITDA and Free Cash Cashflow guidance seemed fine.
But as already mentioned this guidance is based on a strong recovery of the sector in the second half and after main German competitors like BASF (OTCQX:BASFY), LANXESS (OTCPK:LNXSF), and Evonik (OTCPK:EVKIF) cut their fiscal year targets due to a weaker-than-anticipated second half, Covestro’s guidance remained questionable. Surprisingly, Covestro did not cut their targets, although they are also concerned about the weak second half. They said the numbers are now likely to reach the lower range of the targets, which seems fine in my opinion since the environment especially in Germany is horrible.
Prices for electricity and gas are significantly down compared to last year, but still not competitive compared to other countries. The German Ministry of Economy stated that energy prices are likely to rise until 2040 which is a shocking perspective. However, Covestro makes good progress in supplying their production locations increasingly with renewable energies in the future with external long-term contracts, which would make the company much more independent.
The other problem is the lack of demand. The following chart shows the incoming orders for the chemical materials’ industry in Germany.
It shows a worrying reluctance on the part of the companies, which is worse than during the pandemic lockdowns and nearly comparable to the financial crisis. It is even more worrying as order backlogs are also historically low and at financial crisis levels, according to a monthly survey conducted in June. So it would be naive to expect a quick recovery here, and Covestro is likely to continue to generate losses in this country. However, Covestro is diversified regarding its production locations and sales regions, which lower the dependence from the disastrous situation in Germany.
One of the most important things of the last reports is that despite declining sales, EBITDA margin likely peaked in Q4 2022 at -1%. In Q1 2023 it went back to 9% and stabilized at 10% in the second quarter. Even for the third quarter, the margin should stay at these levels, which is a good sign since the margins are the most important metric at cyclical companies. This recovery can be seen in both of Covestro’s segments.
Sales also stabilized sequentially, indicating the company might return to sequential growth in the second half. Since analysts expect an annual revenue of €15.4b the fourth quarter should grow year-over year creating a good setup for 2024. I expect full-year EBITDA at €1.3b which will be an annual decline, the margin will be constant. Free Cashflow is expected to reach €250 million after 138 million in 2022 which is an improvement but might not be enough for a compelling dividend.
Even if management takes the upper range of 55% payout ratio it would be only €0.74 per share which is a historic low yield of 1.5%. So dividend investors have to be patient up to FY 2024 where consensus is at €650 million free cash flow. A price/free cash flow ratio of 14.4 is not very expensive as 2024 is expected to be only a mid-cycle year, so there should be more growth in 2025.
While Covestro gets support by declining prices for raw material prices, overall selling prices saw a stronger decline, leading once again to a negative pricing delta. Looking at the last quarters, it seems like the negative trend found an end in Q4 2022 and starts to tend in the direction of a positive delta. While this might be a bit too early to celebrate, it is a promising indicator.
Overall, improving metrics indicate the beginning of a new business cycle despite the challenging macro-environment in Germany. Market expectations remain very cautious, still creating a good investment case for the company even if the takeover plans of ADNOC will fail. So, I remain bullish for 2024 and 2025 and see substantial upside.
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