PBR - Braskem: ESG Challenges Take Center Stage In The Investment Thesis

2023-12-13 12:35:56 ET

Summary

• Petrochemical giant Braskem faces a perfect storm, grappling with environmental crises, governance complexities, and market pressures.
• Q3 2023 reports reveal Braskem's financial struggles, marked by weak results and a significant drop in shares, raising concerns about the company's future prospects.
• The collapse of Braskem's salt mine in Maceió adds a new layer to its troubles, with potential legal and financial repercussions, impacting the company's image and valuation.
• Shareholder dynamics, with Novonor's impending divestment and Petrobras' interest, create governance challenges.
• Elevated valuation, weak recent performances, and ongoing challenges prompt a shift to a bearish stance on Braskem.

Braskem ( BAK ) proudly holds its position as the sixth-largest player in the global petrochemical sector, distinguished as a leading producer of thermoplastic resins such as polyethylene ('PE'), polypropylene ('PP'), and PVC in Latin America.

The foundation of Braskem's strength lies in its robust attributes, primarily stemming from geographical and product diversification. This strategic positioning gives the company a comprehensive global market perspective and significant scale, solidifying its role as a key player in domestic and international thermoplastic resin markets.

However, it is imperative to acknowledge the speculative nature of this investment, particularly within the context of a downturn cycle, as previously highlighted . Environmental, Social, and Governance ('ESG') factors significantly influence the company's share price movements in the short to medium term.

Presently engaged in a potential buyout process, Braskem anticipates benefits for shareholders if the right offer materializes. Nonetheless, risks associated with corporate governance and the geological crisis in Alagoas, involving a salt mine collapse, pose substantial challenges that could potentially create a considerable impasse in the acquisition process.

The third quarter of 2023 unveiled weak results for Braskem, which are attributed to persistently low global demand as the company's fundamentals exhibit limited signs of improvement amid sectoral challenges. Ongoing pressures related to sustainability and environmental concerns are expected to impact liquidity and attract external investor interest, likely pausing the buyout progress.

Recent Financial Performance Highlights Challenges Faced by Braskem

Braskem's third-quarter results reflect a challenging period, primarily attributed to the dynamics within the petrochemical sector where the company operates.

The company grapples with diminished global consumption from elevated interest rates and inflationary pressures. Compounding these challenges are the startups of new polyethylene and polypropylene capacities in both the United States and China, intensifying supply pressures and impacting spreads.

Against this backdrop, Braskem's utilization rate remains remarkably low. Year-to-date, domestic chemical industry production hit a 17-year low, underscoring the severity of the crisis. Braskem's ethylene utilization rate is 68%, marking a 4-percentage-point decrease quarter-on-quarter and a substantial 10-percentage-point drop year-on-year.

Examining price trends in Brazil, the polyethylene and polypropylene spread experienced a significant decline of 23% compared to the second quarter of 2023. In the United States, spreads remained steady, unlike Europe, where polypropylene spreads witnessed an 8% decline in the third quarter of 2023. Meanwhile, in Mexico, polypropylene spreads dropped by 16% quarter-on-quarter.

Braskem reported consolidated net revenue of $3.41 billion, marking a 6% decrease from the second quarter of 2023 and a substantial 34% decrease from the third quarter of 2022. Brazil remains the primary market, contributing 55% to total net revenue, followed by the United States and Europe at 27%, exports at 12%, and Mexico at 6%.

With fixed costs having less dilution, the company's gross profit in the third quarter of 2023 was R$569 million, reflecting a 24% quarterly increase but a stark 74% annual decline. The gross margin stands at 3%, significantly below historical averages, and in the corresponding period last year, the gross margin reached 9%. Braskem reported a gross profit of R$2 billion for the first nine months, marking an 82% year-over-year decrease.

Braskem recorded an operating loss of R$620 million in the third quarter of 2023, attributable to high fixed costs. Recurring EBITDA reached R$921 million, down 53% year-on-year due to the mentioned challenges.

In the final analysis, Braskem's net loss for the third quarter of 2023 amounted to $2.4 billion, marking a significant increase of 214% compared to the second quarter of 2023 and 80% compared to the third quarter of 2022. These financial results underscore the considerable headwinds faced by Braskem in the current economic and industry environment.

Anticipating a Challenging Q4 Amidst Perfect Storm for Braskem

Braskem finds itself amid a perfect storm, facing challenges both on the cost side, driven by escalating oil prices, and on the demand side. These pressures directly impact the company's operations, which are characterized by high operating leverage and a substantial fixed cost structure.

The anticipated scenario suggests that challenges will persist throughout the fourth quarter of 2023 and likely extend into early 2024. Despite these difficulties, the company maintains a robust cash structure, boasting an average debt maturity of 12.3 years and a weighted average cost of 6.2% plus the exchange rate variation per year.

Braskem is fortified with a cash reserve of $2.7 billion, providing coverage for maturities over the next 75 months, while the company's net debt is $8.2 billion.

In the face of an uncertain immediate future, Braskem stands resilient, supported by its robust financial position. While the timing of a potential turnaround remains unclear, the company's financial health indicates its capacity to weather current market conditions.

As market conditions gradually improve, there is a likelihood of a turnaround in the company's margins and a reversal of the current losses. However, the exact timing of this improvement remains uncertain.

Trouble Brews with Maceió Salt Mine Collapse

Braskem's investment thesis has been significantly influenced by the prominence of Environmental, Social, and Governance ('ESG') considerations.

The company has actively engaged in various environmental projects, including initiatives focusing on Energy & Greenhouse Gas Control, Water Management, and the production of biodegradable thermoplastic resins. Despite these efforts, an ecological incident has cast a shadow on Braskem's trajectory.

A critical event in Braskem's history is associated with its rock salt mine in Maceió, the capital of the state of Alagoas in northeastern Brazil.

In February 2018, cracks emerged in a Maceió suburb following heavy rains, affecting three blocks with one crack extending 280 meters. Subsequently, these cracks widened and spread to additional suburbs. After comprehensive studies, it was determined that Braskem's rock salt extraction was the primary cause of the structural issues in these Alagoas neighborhoods.

On December 10, Braskem's salt mine in Maceió collapsed , and details about the extent of the damage are still pending. Media outlets report this incident as the "major urban-environmental tragedy of the world."

The crisis in Maceió prompted Braskem's removal from the Corporate Sustainability Index of the Brazilian stock exchange (B3), potentially diminishing liquidity and interest in the company's stock.

Further compounding the issue, the Environmental Institute of Alagoas imposed a fine of over R$72 million on Braskem, impacting the company's valuation. Braskem's decision to withdraw from participation in COP28 also signifies another negative signal for the company.

Amidst ongoing legal challenges, Braskem has allocated approximately R$6.5 billion for necessary relocation investments, well closures, monitoring, and financial compensation to residents. However, the crisis in Maceió poses financial challenges and tarnishes the company's reputation. The extent to which this crisis is reflected in the margin of safety embedded in Braskem's valuation remains uncertain.

In 2023, Braskem's shares experienced a substantial drop, totaling almost 28%, resulting in a market value of $2.78 billion. This figure is nearly equivalent to the gross debt recorded at the end of the third quarter, which stood at $2.21 billion. In this scenario, the concern extends beyond the realized loss; it encompasses the looming challenges and financial obligations that still lie ahead.

Governance: A Double-Edged Sword for Braskem

In the realm of Environmental, Social, and Governance ('ESG') considerations, Braskem is confronted with intricate shareholder dynamics. Novonor (formerly Odebrecht) and Petrobras ( PBR ) emerge as the principal shareholders, with Novonor holding 50.11% and 38.32% of voting and total capital, respectively, directly and indirectly. Conversely, Petrobras owns 47% of the voting capital and 36.1% of the total capital.

The historical collaboration between Petrobras and Odebrecht, instrumental in Braskem's inception and growth, now presents a risk. The influence of these stakeholders has taken an adverse turn in corporate governance, notably due to Odebrecht's involvement in national corruption scandals and Petrobras distancing itself from Braskem's core business.

Further complicating matters is Novonor's imminent obligation to divest its stake in Braskem, mandated by a court order as part of its judicial recovery plan to settle outstanding debts with creditors.

Recent developments indicate that several potential buyers, including Unipar and J&F, are no longer interested in the buyout. Additionally, the American private equity fund Apollo Global Management withdrew from the deal months ago.

The sole standing proposal is from ADNOC, the Abu Dhabi state oil company, offering R$37.29 per share of the company. This bid implies an equity value of 10.5 billion reais ($2.14 billion) for Novonor's 38.3% stake in the petrochemical firm, representing a premium of over 100% of the company's value.

However, a critical detail could potentially thwart ADNOC's proposal. Petrobras holds the right of first refusal and tag-along rights, granting it priority in share purchase or the ability to exit the company if control shifts to another shareholder.

Following President Lula's election, the likelihood of Petrobras acquiring Novonor's stake has risen, aligning with the current administration's interest in reinvesting in the petrochemical sector. Such an outcome poses a significant risk to Braskem's investment thesis, as heightened state interference may materialize, escalating governance challenges and imperiling the company's strategic direction.

The Bottom Line

Braskem currently finds itself at the epicenter of a multifaceted storm, grappling with challenges that cut across environmental, governance, and market dimensions.

From an Environmental, Social, and Governance ('ESG') standpoint, the company is confronting an unprecedented environmental crisis in Maceió, casting a shadow over its sustainability reputation and potentially dissuading investment funds.

Braskem is navigating a complex scenario on the governance front, with Petrobras expressing interest in increasing Novonor's stake. This development raises concerns about potential buyout prospects, extending into the following years, given the company's newfound vulnerability to a parliamentary inquiry ('CPI') and possible legal actions stemming from the socio-environmental impacts in Maceió.

Adding to the intricacy of the situation is the unfavorable petrochemical cycle, characterized by cost pressures arising from higher oil prices and subdued demand. This sets the stage for a challenging Q3 and a potentially weak Q4.

Braskem trades at a forward EV/EBITDA of 14.4x, a staggering 135% above its historical average. This elevated valuation challenges the long-term investment thesis rooted in robust fundamentals and solid cash generation. Consequently, I'm shifting to a bearish stance on Braskem, with a cautious outlook given the potential buyout process fraught with risks and uncertainties that may take time to materialize.

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