Vitalii Makarov/iStock via Getty Images
Vitalii Makarov/iStock via Getty Images
In this article, I'm taking a look at Covestro (OTCPK:COVTY). I went long the company some time ago, though my position is still relatively limited in overall size. Still, it's a company that has an excellent underlying upside, attractive operations, and what I would consider an appealing thesis.
So let's move into fundamentals.
Covestro AG, simply put, is the former material science division from Bayer (BAYRY).
That's about as simple as you can make it.
The company is a chemical/basic materials company with operations in polyurethane and polycarbonate-based materials, with end products such as isocyanates and polyols for what's known as cellular foams, TPU polycarbonate pellet, and additives, which are in turn used in paints and adhesives.
End markets that use Covestro products included Automotive, Construction, Cosmetics, Electronics/Appliances, Energy and Healthcare, as well as Furniture, Railroad, and Sports/Leisure.
Practically every industry/segment on earth in some form uses what the company produces.
Covestro is not unique in any fashion in terms of its products. It's one of many companies doing the same thing - and some competitors include BASF (OTCQX:BASFY), Solvay (OTCQX:SOLVY), Wacker Chemie (OTC:WKCMF), Dow (DD), LyondellBasell (LYB), and similar plastics companies. Moats in this industry come in the form of vertical integration, feedstock hedges, and certain patents - not necessarily product moats, because none of these companies have a patent on their basic products.
Covestro is a $12B revenue company with 16,500 employees.
It's headquartered in Leverkusen, Germany, and has a Baa2 credit rating with a stable outlook. It's not the best in the business - but not the worst either.
The company has been listed since 2015, and Bayer sold its remaining stake in Covestro around 2018, with the company's pension fund having a 6.8% stake that's managed separately.
Covestro is, in essence, a very good example of a cyclical chemical company.
I've written on chemical companies such as this before, but allow me to break things down very simply.
Covestro, like other peers, covers important parts of the polymer value chain through their production of various forms of rigid and semi-rigid polyurethane foam and polycarbonates.
PU Foam Island Water World
It's that. It's also similar to types of foam that you've seen in spray cans, for sound insulation/dampening, in sponges, and in similar applications. The product can be made very rigid - or very flexible. You see polyurethane foam every time you pick up a sponge.
Everything from drinking bottles to bullet-proof glass.
These products are ubiquitous, every day required products across virtually every industry in the world. As an example, Covestro produces the granules that are used for making the world's LEGO bricks.
Polyurethane (or Methylene diphenyl diisocyanate/Toluene diisocyanate) is a local business. What I mean by this is that PU products, such as foams, generally are not shipped. Their physical mass and transportation costs, especially with recent trends, necessitate local production and short logistical paths. This requires PU companies to run sites across the world in order to satisfy demand.
Covestro is a low-cost producer of PU products.
These products can, and usually are shipped. It's a global business.
The way that these businesses work is that they tendentially are capital-intensive businesses with expensive assets and substantial CapEx, and dependent on their ability to pass along longer-term feedstock pricing volatility and deliver products in a good supply/demand balance. Company's like Covestro are considered in terms of their cash costs, which are based on 100% utilization of name-plate asset capacity. How this plays out is a key performance indicator as to how competitive a company like Covestro is in terms of its peers.
Covestro isn't the largest in terms of revenues or market cap, but it does have some world-leading positions and sites. The company's production split is a heavier focus on PU and coatings/adhesives, making up 50% and 33%, with PC making up about 22% of production. The company reports in these three segments, as well as an "other" segment.
Performance for the company has been very typical for a cyclical in a recovery sort-of situation. Results in 2020 and 2021 were driven by recoveries in key industries but weighted down by inflation and SCM issues. However, Covestro was able to deliver on some 2020 targets, and 2021 trends look excellent but hard to compare.
Current expectations are for a 215% EPS growth, but that comes from a massive decline over 2019 and 2020 following the pandemic.
The company pays a generous dividend of between 3-5% depending on valuation, and the current 2021E dividend is expected to grow significantly, following a low €1.3 dividend in 2020.
Covestro has been focusing among other things, on profitable M&As and efficiency measures. The company added cost-cutting measures, but most of the results of these were offset in 2021 by investments in digitization as well as standard maintenance CapEx. Even the headcount reduction is only temporary, as recent M&As will bring the number of employees back to the high levels.
Still, 2021 is going to be a very strong year for Covestro. Demand is excellent - but feedstock/material availability is another thing entirely.
On a high level, Covestro is one of the world's foremost companies producing three key materials. These are MDI, TDI, and Polycarbonates.
Covestro is number 3 in MDI, after Wanhua and BASF, number 1 in TDI, and number 2 in Polyether polyols.
Covestro is the world leader in Polycarbonates, offering over 1,000 different grades of polycarbonates. Peers include Sabic and Mitsubishi.
Covestro is the world leader in CAS (Coatings, Adhesives, and Specialties), specifically aliphatic isocyanates. This is used primarily in coating applications, because of its excellent character in producing UV-resistant and durable PU coatings.
The company's past is bumpy.
As part of its Bayer history, the company was the premier influenced segment by the decline in CDs and DVDs. This began in 2005 and ended around 2013. Profitability for its PC dropped to negative 6.6% as a result of this decline, and focus for years was on profitability and margins. The segment didn't regain momentum until 2015. The company's rocky past from 2005-to 2015 is why analyzing historicals for the company is a difficult task. There are too many non-recurring, impacted years to create an accurate forecast based on historicals.
Covestro is cyclical - but over the past few years, it's made itself less reliant on specific PU products and lines through a heavier focus on its CAS segment. It should be seen as cyclical, and there will most certainly be significant ups and downturns, but the underlying core to the company is stronger today than it was at any time as a part of Bayer AG.
The global oversupply of products back in the financial crisis forced many companies to the gallows back during the time. Theoretically and factually, this has left Covestro as a major player with the ability to stake out a through-segment dominating market position in a less-competitive environment - as seen by its positioning in key segments.
However, as an analyst in the space, I can make a number of qualified assumptions about trends in the space, that will impact Covestro (as well as other companies).
First, we'll see a narrowing supply/demand gap. Because this is such a high-capital, know-how, feedstock integration, and technological capabilities, it's not an attractive field for players to get into. The relevant players are already in, and I see only capacity additions and consolidation from now-relevant players. The fact is, the space only has very few global relevant companies.
Second, the future looks good. PU/PC products and Polymers overall are the materials of the future, and they're used in everything from bottles to automobiles and even the construction of homes. Based on the current global trends and the way things are going, Covestro has an excellent market position to take advantage of some of the coming dynamics in the space.
Third, the company's roller-coaster of profitability across the business cycle is unlikely to change fundamentally as we move forward. The best Covestro can hope for is that efficiencies, savings, and asset flexibility help to flatten out some of those valleys of profitability - and the company is doing just that, focusing on customer centrism, its ESG goals by switching to renewable Co2 for Foam components, to mention only one movement here.
Fourth, it's unlikely that the current positive pricing environment across several segments is unlikely to disappear quickly, due to inflation, availability, and demand.
Covestro should be seen as a cyclical investment, best bought at low valuations to garner a high yield and potential return as the company rockets to high demand-driven levels. Recent results are driving it towards such a level. The company has reported massive amounts, over 1 billion euros in FCF on a 9M21 basis, in line with significant outperformance expectations for 2021.
Its M&A for RFM is closed, and net debt rose no more than €400M as a result of this, bringing equity to 48% versus 44% pre-M&A. The company has plenty of cash available, as well as an undrawn facility of €2.5B.
Covestro has recently raised its outlook, due to absolutely solid industry margins.
However, nothing should change your expectation that this will be a demand-driven, cyclical investment with ups and downs. This also includes expectations for the company dividend.
Covestro Dividend S&P Global/Tikr.com
S&P Global/Tikr.com
Forecasts such as this one should be viewed with some skepticism beyond 2022, though I do believe that we can view 2021-2022 with a relatively high amount of certainty. While recent actions, including the increasing share of specialties business which comes at a very different type of stability, do make the company easier to forecast, nothing will change its fundamentals as long as it's in PU/PC, which still accounts for more than 50% of annual company revenues.
For some of you, that might make the company unappealing as an investment. Not for me.
I will show you why, in this article, if we consider 2021-2022 indicative, the company is currently trading at a significant discount and should be considered a buy. The market's view is understandable - but not logical.
It's time to move into the valuation of the business.
My own forecasts align with the perspective held by most analysts in the sector. I believe that based on current supply chain tightnesses and pricing environments, Covestro is quite likely to substantially outperform YoY in 2021 and 2022. I've added a large near-term bump in EBITDA to account for RFM, but I've cut down the long-term company growth rate to less than 2% on the high end in my DCF model to reflect GDP growth as well as the cyclicality of the business. I've also discounted the company's peer-average multiples by 8-10% to reflect this cyclicality further - so take all of the numbers that are about to be written, and consider them highly discounted.
Company WACC comes in at around 7.63% based on a cost of debt of around 5.6% - which is high, but understandable given the risk. I've added a 1% higher CapEx/sales growth rate to reflect the need for investments and efficiencies for the next few years.
However, even when considering the company in a conservative light such as this, you need to realize that Covestro is currently trading at a 2021E P/E multiple of around 8X. That's 5-8X below peer averages. The closest German peer, BASF, trades at 13.9X, and some Swiss and Belgian peers go up as high as 25-36X P/E.
Trading at a current share price of €53.7/share, the implied DCF even with a 10% discount is more than €70/share on the low end, up to around €75 on the high end. Using NAV, we go at the very least to €60/share and using EV/EBITDA peer multiples, we can reach as high as €77-80/share. The picture this gives us is clear. This company is currently being undervalued.
I personally like to underweight DCF and focus on near-term forecasts and peer multiples when it comes to a company such as this. From this view, I come to an average target of €70/share. This target is relevant for the coming year, and 2022, barring that nothing changes in terms of forecasts.
The ADR for Covestro is COVTY, which is a 0.5X ADR, meaning every ADR is half of a native share. This ADR is somewhat thinly traded, so the best option is investing in the native stock, if at all possible.
Aside from this, what I describe here isn't just relevant for Covestro, but for companies in similar positions in this value chain, or adjacent value chains. LyondellBasell is certainly one company that's a good example of adjacencies to Covestro, even if they are somewhat different.
The characteristics of an asset-heavy/CapEx heavy business with varying degrees of supply/demand cyclicalities and volatilities aren't unique to one specific field though. Once you understand the ebb and flow of one - it's quite easy to understand the same thing of another. For me, it was understanding the dynamics for products such as Acetic Acid, Ethyl Acetate, Acetic Anhydride, and Methyl Acetate as well as Dimethylamine/Trimethylamine that lead to studying Polycarbonate/Polyurethanes and specialties products.
This article is a shortened version of an original premium article posted on the 1st of February 2022 on our private marketplace services, iREIT on Alpha.
I hope I've cleared some things up here. I do agree with some of the risks seen by other analysts here - but not all. The new reporting structure I view as fine. Bottom line is, this is a market leader in a cheap position, poised to profit in 2021-2022.
I expect a full valuation of no less than €70-€75/share, and I target a 15-18% annualized RoR including dividends here. Once the company delivers this, I will reassess this investment and look at the market situation we're in at that point.
I want to emphasize the fact that the targets I've given here are heavily discounted, owing to this business's cyclicality. Their correlation to positive global trends such as mobility and digital/electronics is very strong, and this company is really set to potentially outperform.
While BASF is less volatile and more of a global market leader, Covestro is an excellent alternative in areas where BASF isn't present or is far smaller.
I view Covestro as a solid "BUY" here with a PT of around €70/share.
The company discussed in this article is only one potential investment in the sector. Members of iREIT on Alpha get access to investment ideas with upsides that I view as significantly higher/better than this one. Consider subscribing and learning more here.
This article was written by
36 year old DGI investor/senior analyst in private portfolio management for a select number of clients in Sweden. Invests in USA, Canada, Germany, Scandinavia, France, UK, BeNeLux. My aim is to only buy undervalued/fairly valued stocks and to be an authority on value investments as well as related topics.
I am a contributor for iREIT on Alpha as well as Dividend Kings here on Seeking Alpha and work as a Senior Research Analyst for Wide Moat Research LLC.
Disclosure: I/we have a beneficial long position in the shares of BAYRY, LYB, DD, COVTY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. Short-term trading, options trading/investment, and futures trading are potentially extremely risky investment styles. They generally are not appropriate for someone with limited capital, limited investment experience, or a lack of understanding for the necessary risk tolerance involved. The author's intent is never to give personalized financial advice, and publications are to be viewed as research and company interest pieces. The author owns the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in the articles. The author owns the Canadian tickers of all Canadian stocks written about.