BFFAF - BASF: Staying The Course

2023-04-20 23:50:37 ET

Summary

• Making up the balance after a tumultuous year, BASF management kept a lid on additional gas spend and ensured the company stayed its course.
• The strategic goal of divesting oil and gas producer Wintershall Dea was confirmed and capex plans were increased while maintaining the dividend.
• BASF has been prepping for a net zero society by growing retained earnings over the last decade, which it now will put to use.
• Although the main focus is now on the operations in Europe, BASF remains an international blue chip with a decent dividend yield.
• On top of this, management has demonstrated its ability to navigate BASF through crises making it a Hold.

BASF ([[BASFY]], [[BFFAF]]) faced a tumultuous year in 2022, but skillfully navigated headwinds. The outlook for 2023 is muted as the company faces new challenges, yet it appears the company has been preparing to support an increase in capex, fund the dividend and get a grip on carbon emissions.

Although the main focus is now on the operations in Europe, BASF remains an international blue chip with a decent dividend yield. On top of this, management has demonstrated its ability to navigate through crises making this company a Hold.

Energy prices affect the bottom line

Over the course of 2022 energy prices have been a hot topic whenever BASF was discussed. The first article yours truly wrote after Russia invaded Ukraine, ‘ Headwinds are mounting ’, assessed the effect of rising gas prices. In the article it was highlighted gas prices had been steadily rising for a while prior the war. Therefore, 4Q21 incremental gas spend was extrapolated to arrive at an estimate of €2Bn for 2022.

At the 4Q22 result presentation, BASF shared the actual additional gas costs as visualised in figure 1. The additional costs were close to the estimated value and as tempting it may be to take credit for the estimate, actually all praise goes to management who kept a lid on additional gas spend by acting timely, swiftly and prudently. Even before winter set in last year, when everyone expected gas prices to move up, it was evident management was skillfully navigating headwinds .

Making up the balance it follows the company incurred a €3.2Bn setback due to elevated energy prices. Undeniably this is a lot of money. Yet, if this amount is referenced against the actual gas prices seen last year, and considering how these prices skyrocketed during summer time, it seems relatively mild. Moreover, even at the most dire of times, BASF stock bottomed at about US$10 per stock, see figure 2.

Wintershall Dea writedown

In spite of the dependency on energy, BASF has been considering to offload its majority stake in oil and gas producer Wintershall Dea. Due to well-known circumstances this didn’t materialize and BASF now had to bite the bullet and incur significant impairment losses, from the annual report:

Net income from shareholdings amounted to –€4,939 million in 2022, after €207 million in 2021. The significant decline was due to special charges of around €6.3 billion, mainly from non-cash-effective impairment losses on the shareholding in Wintershall Dea AG. These were especially due to the deconsolidation of Wintershall Dea’s Russian exploration and production activities, which subsequently resulted in a revaluation of Wintershall Dea’s Russian shareholdings. Furthermore, write-downs were performed on the company’s European gas transportation business, including a complete impairment on the shareholding in Nord Stream AG and the financing of the Nord Stream 2 project.

In spite of this write-down, BASF did receive approximately €1Bn in dividends from this shareholding, as shown in figure 3. This number does not cover the additional energy costs incurred in 2022, but does alleviate the burden somewhat. On the other hand, with energy, and especially gas prices, having normalized compared to last year, the dividend distribution of Wintershall will decrease again.

More important however is the potential of an IPO to unlock value for BASF. As Wintershall has now deconsolidated all Russian assets, the company is moving to a position where an IPO is becoming more likely. Once more management confirmed this is still a strategic objective, but declined from giving a time-frame.

Before I’ve estimated the Wintershall enterprise value at €4.7Bn. This value already excluded the Russian part of the business. Based on the FY22 numbers, see figure 4, this value could potentially be achieved.

Unfortunately, the FY22 numbers are based on an exceptional price environment. With gas making up 65% of total production, the results of Wintershall Dea will be affected by the gas price that declined significantly since the turn of the year, see figure 2. If the previously derived EV/EBITDA ratio of 1.1 is used and applied to the 2021 numbers, a more modest value of about €2.4Bn seems an appropriate estimate.

Irrespective of the actual number, the divestment may return the most not by unlocking value, but rather by reducing risk. Especially with Europe rapidly moving forward with climate legislation , BASF management knows it will have to act and has started doing so already. Management clearly focusses on emissions in its targets, started investing in offshore wind farms and has made the divestment of the share in Wintershall a strategic goal. If anything, it is evident management will not wait until it ends up in court over climate litigation.

Capex and cash flow

A changing energy landscape requires massive investments especially for an energy intensive company like BASF. On top of this, two growth projects are defined which make up for more than half the future capex. Looking ahead, the Wintershall divestiture may come in handy to support the bottom line as capex is increased, see figure 5.

This spending plan stands in stark contrast to the 2023 outlook which presents a decline in earnings. EBIT before special items is forecasted to reduce to €4.8 - €5.4Bn. This number presents quite a decline from 2022 levels and honestly does not look appealing when the long term record is assessed, see figure 6. Similar levels of EBIT were last observed in 2019, but it must be said capex spending was only €3.3Bn back then. For 2023, the capex budget is nearly double this value.

Roaring Twenties

In light of the events over the last years, it seems also this century will have ‘Roaring Twenties’, or in Europe at least. With a pandemic behind us and a war raging on, focus is now turning to carbon pricing in Europe. Against this backdrop BASF is executing its investment program and will continue to maintain its dividend in my opinion.

Admittedly, one could argue the outlook for BASF is dire, but the company demonstrated it can perform well even when it faces significant headwinds. More important however, one can confidently expect BASF will continue to exist and maintain its dividend. The reasons are twofold.

First of all, Germans are known for their discipline when it comes to spending. Figure 7 shows the dividend has grown modestly over the years whereas retained earnings have nearly quadrupled since 2009. I believe management has taken a cautious approach after the Global Financial Crisis as the run-up in energy prices in 2008 highlighted the Achilles heel of the company.

The coffers are now filled and management has experienced what exceptional energy prices do to the bottom line. My thesis is retained earnings will be allowed to decline until 2025 after which capex ‘normalizes’ again. For example, the dividend was maintained and the existing share buyback plan was not stopped when uncertainty was highest last year.

The second reason why I believe BASF has been prepping for a net zero society by growing retained earnings is the frustration shared by the CEO in its annual letter to shareholders;

… many urgently needed modernization efforts in Germany and Europe have been delayed for too long – digitalization, the sluggish expansion of renewable energy and the necessary investments in infrastructure. We can no longer afford for approval processes to take a decade or for projects to be endlessly debated. In Germany in particular, we are still slamming on the brakes even though now is the time to accelerate.

Moreover, the European Comission’s Green Deal will unleash a flood of regulations on the chemical industry, putting an additional burden on us.

BASF simply wants to go faster in this transition than (German) politicians allow for. This inherently poses a risk as infamous German red tape will be a drag on performance. BASF is a German company, but especially in its ‘heimat’, performance is lagging. In the short term this will not change although the speed at which speed German officials have been able to ramp up natural gas import capacity has been remarkable.

Other risks

Besides the question of energy, the landlocked geographic location of the Ludwigshafen site, BASF’s largest, poses a challenge with respect to raw material supply. The site highly depends on the River Rhine for logistics and last summer BASF warned of potential production cuts due to low water levels, after it was forced to cut production in 2018. The company is taking action , but essentially the costs of logistics are rising and not just due to inflation.

The largest risk however may be presented by carbon pricing mechanisms being enacted by the European Union. One could argue the legislation, aimed at reducing carbon emissions, is protectionism under the banner of climate change. The thing is, as the bloc is fully aware the Emissions Trading System puts the European industrial complex in a disadvantaged position, a Carbon Border Adjustment Mechanism (CBAM) has been introduced. At the end of the day this mechanism consists of import duties on goods produced outside the EU.

However, this mechanism introduces two risks for BASF which can’t be quantified yet. First off, the cost of goods will rise for consumers in the European Union, plain and simple. Companies like BASF will have to place a mark-up on their products to pay for the costs of carbon.

Secondly, and potentially even more important, it remains unclear what will happen to export products. Eventually the EU will need to subsidize these, but it will also need to play by the rules of the World Trade Organization. Inevitably European legislators will have to come up with a solution, but how remains unclear. Bottom line, the current proposals for carbon pricing create uncertainty for a company that relies heavily on fossils and is not permitted to move forward at a pace it requires.

Conclusion

Making up the balance after a tumultuous year, praise goes to management who kept a lid on additional gas spend and ensured the company stayed its course. The strategic goal of divesting oil and gas producer Wintershall Dea was confirmed and capex plans were increased while maintaining the dividend and buyback plan.

Management has taken a cautious approach after the Global Financial Crisis as the run-up in energy prices in 2008 highlighted the Achilles heel of the company. As a result, frugality prevailed and retained earnings nearly quadrupled since 2009. This gives management flexibility to invest and prepare for ever tighter European regulations. The mere fact management wants to move faster in preparing the company for the energy transition does not nullify the risks created by European legislation, it does however display confidence.

Although the main focus is now on the operations in Europe, BASF remains an international blue chip with a decent dividend yield. On top of this, management has demonstrated its ability to navigate BASF through crises making the company a Hold.

For further details see: