BFFAF - BASF: Weather Threatens EU Operations Geopolitics Its China Expansion Plans

2023-09-20 06:56:18 ET

Summary

• BASF's stock price is trading at a deep discount due to geopolitical tensions and risks, making it too risky for investment, even though company-specific fundamentals by themselves look attractive.
• BASF's financial performance has declined, with net adjusted earnings and sales volumes decreasing significantly.
• The decline in production and global demand, along with potential natural gas price spikes, pose further challenges for BASF's future outlook.

Investment thesis: BASF SE (BASFY) one of the most solid European industrial companies before the Ukraine war, now trades at a valuation level that is just over 1/3 of its maximum stock price reached in 2018. Such a deep stock price discount for a historically strong company would ordinarily trigger investor interest, as a potentially great rare opportunity to invest in a solid company at a deep discount price. Times are unfortunately anything but ordinary. The EU-Russia economic rupture over the Ukraine war left the EU in a precarious position, where it will always be potentially one cold winter away from economic disaster. BASF responded in part by seeking to expand in other places like China, but recent geopolitical frictions, ranging from EU tariff threats to Germany's FM making arguably deeply offensive remarks towards China's leadership may jeopardize BASF's position in China as well. For as long as these risks and tensions remain, BASF stock continues to be too risky in my view. Furthermore, if these risk factors continue for a prolonged period, BASF's business may experience permanent damage.

BASF is suffering financially, but it is still profitable as of the first half of 2023.

For H1, in 2023, BASF saw its net adjusted earnings decline to 2.4 billion euros, from 4.6 billion euros in the same period of 2022. Sales volumes declined by 19% for the period. The impact on sales volumes was mostly due to a decline in prices, but production volumes also declined significantly.

The decline in production is in line with global trends, but especially the trends we are seeing in Europe, where the decline has been the steepest. China seems to be the only place where the chemical industry is still growing.

The main factor impacting its profits seems to be a lack of global demand, leading to a price drop. BASF in particular has probably had to contend with a decline in demand, but also a natural gas price surge last winter, which could occur this winter again, depending on weather conditions.

Other financial trends of note, include a significant increase in net debt, from 16.3 billion euros in Q2, 2022, to 20.2 billion euros in the latest quarter. The company's future outlook was mostly revised to the downside in its H1 presentation.

As things are currently going, the already downward revised forecast may probably turn out to be overly optimistic, especially if we see another natural gas price spike in the EU as we head into winter.

EU gas storage capacity is nearly full, but it is barely adequate to meet forecast demand, assuming a typical average winter.

Europe is by far BASF's most important market, therefore what happens there tends to dominate its financial results.

The European market is facing the constant threat of a natural gas shortage scenario, since the break in EU-Russia economic ties. Thanks mainly to a very mild winter in the 2022-2023 season, Europe's gas storage levels have been more than adequate for most of this year.

As we can see, current storage levels are very near full capacity levels, however by the end of the year, assuming an average winter in terms of consumption, we are set to return to historical storage levels and stay at those levels through the winter and into spring. If however, winter will turn out to be colder than average, the EU can easily plunge into a severe energy crisis, which will leave BASF, together with much of the EU petrochemicals industry more exposed than most other companies & sectors of the economy.

It should be noted that a colder-than-average winter in North America, combined with a colder-than-average winter in Europe is the potential catastrophic scenario, given that the EU is now increasingly dependent on US LNG imports. If storage levels start to drop in the US and prices start to spike, those LNG shipments will likely be curtailed. BASF could potentially be asked to shut down production entirely in the EU, perhaps for a prolonged period in such a scenario. Even if production shutdowns do not occur, the natural gas price spike we will likely see is likely to severely impact its financial results. This is a long-term threat for BASF, which it is set to face every year for the foreseeable future.

The threat of an EU-China economic war is emerging, with the trend starting to take shape this month.

BASF's investment options within the context of an arguably tough business environment for the entire global petrochemicals industry have seen a trend of mostly pivoting towards the Chinese market. Its largest investment is a $10 billion project in Zhanziang, China that will provide syngas & hydrogen. BASF already has a presence in China, therefore its China exposure goes far beyond this one project

As it is increasingly the case, for investors as well as companies, a fast-paced deterioration in the global state of geopolitical relations seems to be catching a growing number of people and business entities in offside. In BASF's case, the increased risk factor regarding its China sales & operations started with an EU announcement that China's EV industry is set to be subjected to an investigation regarding Chinese subsidies. It is widely expected that it will lead to stiff tariffs on Chinese EV sales in Europe or other protectionist measures. China's reaction has been robust, given that it expected Europe to become a major market for its EVs.

To top it all off, Germany's FM, Analena Baerbock called China's premier a dictator in a recent interview. Coupled with the EU's decision to engage in economic derisking, which the Chinese see as an economic decoupling, perhaps just slightly softened, it is likely to lead to a vicious cycle of deteriorating economic relations. My take on it is that when it comes to EVs, China will most likely give up on Europe as a growing export market, since it is likely to face obstruction. It is also likely to hit back by targeting European companies exporting products to China or operating inside China. BASF could very well become one of the companies being targeted in retaliation.

Investment implications:

Not long ago, most investment decisions largely involved an analysis of market fundamentals, combined with company-specific considerations, with little regard for much else. That was before we entered a new era of the world's great economic powers moving from competition to outright trying to harm each other. We arguably entered this new era with the outbreak of the Ukraine war, with many actions that led up to this new state of things, starting at the beginning of the century, arguably making the point of outright confrontation between great powers unavoidable. Thus, we now have to not only do our homework regarding company specifics, as well as the big picture fundamentals, but we also have to consider geopolitical risk.

BASF is arguably an example of precisely such a company. As I pointed out in an article I wrote a few months back, it may have to resort to writing down some of its European assets, due to the dramatic shift in Europe's energy supply situation, due to its break with Russia on the economic front. This reality will probably become far more evident once Europe goes through a harsh winter.

In response to the risky situation it is faced with in its home base in Europe, BASF seems to have ramped up its pivot toward China, which makes fundamental sense, given that it is proving at least thus far to be one of the only major economies or regions that is still seeing an expansion of its chemical industry. While the fundamentals fit, geopolitical events of just the past week suggest that such multi-billion euro investments in China as BASF is currently engaged in, could become the target of retaliation by the Chinese government, if we do not see a reverse course from the current path of rising economic and geopolitical tensions between the two sides.

Assuming that BASF's leadership understands the emerging risks, the situation presents it with quite a dilemma. It could accept becoming a shrinking company, as its European operations will most likely have to be reduced this decade, to adjust to the lack of security of natural gas, without attempting to expand elsewhere. It could decide to avoid risking exposure to the next potential geopolitical hit and halt its China expansion plans. Or it can hope for the best, and go ahead with those plans, in the hope that things will not deteriorate to a point where China and the EU will engage in an all-out effort to mutually undermine each other economically. Either way, the risk for the company & investors is great, with the result being far from predictable.

As we can see, BASF stock is currently trading at a P/E ratio of just under 12, which is not very expensive from a strictly fundamental point of view. A dividend of over 7% makes it an especially enticing potential longer-term investment. At the same time, as I write this, Germany's Bundesbank just warned German companies to cut their exposure to China, citing some of the recent tensions that are emerging. Between BASF being left exposed to a perpetual EU energy insecurity crisis, and being stuck with a dilemma regarding its China expansion, within the context of what looks like fast-deteriorating relations between the EU & China, there is no telling how big of an impact all these external factors might have on its business. In an extreme case, it could even become severe enough to drive it into bankruptcy. There is of course always the chance that there will be a sudden relaxation of tensions and many of the risk factors will dissipate as everyone steps back from the brink, in which case BASF stock would have some significant upside from current levels. Things do not seem to be headed in that direction currently, but rather toward a continued deterioration in the global business environment, therefore the potential risk/reward ratio for this company remains unappealing.

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