2023-11-07 10:48:56 ET
Summary
- Covestro has outperformed the S&P500 by almost 5% since the beginning of the year.
- The company has seen a non-trivial outperformance of over 40% compared to the broader market.
- Covestro is a cyclical business with exposure to various industries and has good margin and profitability.
Dear readers/followers,
If you had asked me at the beginning of this year which companies I believe would outperform the market significantly over this year, I would not have believed Covestro AG ( OTCPK:COVTY ) ( OTCPK:CVVTF ). In fact, I would have said that Covestro probably needs more time to recover, even if I firmly believe that this company does have an eventual upside.
However, where we are in early November is that Covestro has seen outperformance - not massive, but almost 5% to the S&P500. I expanded my position in the company, as I specified in January, in accordance with the following specifics.
While it i s near-impossible to know how far down a market can push a stock, the fact that a stock is undervalued is something I believe myself to be quite apt at seeing. As the stock dropped, I slowly expanded my position in the company, building up a very decent ~1% position that is now up around 20% in total, including dividends and other considerations.
(Source: Seeking Alpha Covestro Article ).
Since that time, this is the outperformance we've seen for the company.
Covestro has since I started investing in the company, as I predicted (though as I said, it has done far better than even I expected), outperformed the broader market. In my last article, the company has a non-trivial outperformance of over 40%. I don't blame anyone for not investing in the company - it's a risky investment - but here, I'm going to update my thesis on the company, which includes lowering my price target while still maintaining a Buy.
3Q23 update on Covestro - The company is doing fairly well
If you recall my initial material on Covestro, this company is the former material science division of Bayer Aktiengesellschaft ( BAYRY ). It's not any sort of new company nor a group without experience - it has roots going back over 60-80 years, depending on what you look at, and while it has issues related to some of its legacy, it's a very attractive business.
Like other basic materials and chemicals, it's a cyclical business with exposure to PU, TPU, Foams, pellets, and additives with end markets in the industrial sector, including things like Automotive, Construction, Cosmetics, Electronics/Appliances, Energy and Healthcare, as well as Furniture, Railroad, and Sports/Leisure.
If you follow my writing, you know that I'm a very big investor in basic materials. My holdings include sizeable chunks of BASF SE ( OTCQX:BASFY ), Solvay SA ( OTCQX:SOLVY ), Wacker Chemie AG ( OTC:WKCMF ), Dow, LyondellBasell Industries N.V. ( LYB ) and others active in similar fields. I've also been expanding my positions in South American businesses, as long as they are fundamentally qualitative (meaning solid fundamentals and a good overall conservative upside).
Covestro has the qualities that make a good basic materials business. Outside of the current 2022 results, it has good margin and profitability. Not for the latest annual results, but generally speaking.
The last quarterly results obviously show different trends.
Covestro, which trades under the native ticker 1COV in Germany, has both narrowed its FY23 guidance, clarified a quarterly sales amount of €3.6B for 3Q, and over a quarter billion euros of company EBITDA, and over €300M of quarterly Free operating cash flow. (Source: Covestro 3Q23 ).
While the more commoditized areas in basic materials are experiencing problematic cyclicality, this quarter shows us growth in niches - where the company is growing.
These upsides can't hide the fact that recessionary trends are putting pressures on volume - that's still a thing here, with global volumes down 3.8% due to weakness in construction/infra and many sectors still flat. There's also pricing pressure due to a mix of destocking, current overcapacity, and lower demand which lowered sales, on a YoY basis, by 22.7%, with performance materials the strongest negative contributor here. FX is, unfortunately, another problem here - the company has a positive pricing delta still, but this can't weigh up the volume pressure and FX, even with volume leverage of 12% for the third quarter. This is also how these results fit into the annual forecasts and results here - 2023E isn't going to be a superb year for any basic materials business or chemicals business with this sort of overall mix - but Covestro shows investors, as they did this quarter, that their mix can at least in part overcome the currently negative macro in major areas through good results in others. It highlights to importance of a good sales mix, which Covestro has. (Source: Covestro 3Q23 ).
Thankfully, we're seeing improvements in raw material and energy pricing trends. None of those are even close to the crisis levels we saw in 3Q23, almost exactly 12 months ago. Now instead of costs, we have pricing problems as the company's pass-through mechanisms don't work with the weak demand.
Covestro is trying to act where it can - we're talking operational savings, we're talking lower inventories and production. One of the company's largest segments is working through what can only be described as a trough.
Solutions and Specialties are working much better - despite sales declines, the segment EBITDA is actually positive sequentially and has been growing since the trough back in 4Q22. The strongly positive FOCF is a product of stringent WC management despite an overall lower EBITDA. Covestro managed to reduce WC/Sales by almost 200 bps despite the current trends, much of it thanks to lower inventories, receivables, and payable volumes. (Source: Covestro 3Q23 ).
CapEx is in line, and there's a slight reduction in company net debt. Overall, and as you can hear, things seem to be going well for a chemical company on a downcycle - even better than some others. The company's net debt is 3x to EBITDA here - it's cyclicality, but there are no covenants in place with regards to the company debt, and Covestro remains Baa2-rated with a confirmation from Moody's in June of 2023. (Source: Covestro 3Q23 ).
Macro level comments next - I want to clarify that there is an ongoing negative outlook development for most of the company's end markets. We're talking about the four markets of automotive, construction, furniture, and electronics. None of those markets are expecting a significant clear upswing here, as I see it. Global GDP is slowing down, even with a recent slight bump in the company update. Automotive is the only sector that's showing even slight improvements in this update, everything else is going down.
Still, full-year expectations are for an annual EBITDA of over €1B. This is better than I initially expected, and is characteristic of a mid-cycle trend here.
Here is the updated guidance.
To be clear, the company is still working alongside a trough level - but because it seems to be outperforming what most investors were expecting the company to do, we're still seeing a positive trend. We're also seeing that in the valuation trends and targets - which we'll get into here.
My question becomes, and what I have been researching, is if the company might be seeing a bit too high level of valuation/pricing for the performance specifics it's currently managing, and what it is expecting for the next year or two, put into context to what the market is expecting in the same time.
Problems and concerns to be on the lookout for when it comes to this company, in accordance with this? According to my calculations, and at current EBITDA and margins, we're talking that every percentage point decline represents a €50M decline. We'll want to keep a close eye on those margin developments to see how they develop for the cycle. If Covestro continues to get more expensive here (again, a too high level of valuation), investors need to be ready.
However, an impressive but small point. Covestro stopped its share buybacks. It's very rare for a company when having decided on buybacks, to potentially halt buybacks due to the valuation of the stock (in this context meaning that valuations are "too high") but the company decided at the end of October to end its ongoing share buyback programme. There are some moving parts here with regards to the AGM, but there was enough commentary with this not being the time that leads me to believe the company is clearly seeing that after going up over 40% since the trough and my investment, this is not a good time for share buybacks.
Let's move to valuation.
Covestro's valuation is no longer as great
So, straight out of the gate, let me remind you that my price target for Covestro this year is €70/share for the high point - but because this price target is now about 10 months old, I haven't really impacted this for the current risk-free rate or the updated thesis for the near term. I'm going to be slightly reducing the target to €65/share. Covestro's native share is currently trading close to €48/share. When I wrote about the company last, it was close to €33/share.
With regards to my target, I remind you that the mean price target for Covestro back last fall was €40/share, with a low of €27/share. I started out at €70/share. The current S&P Global targets come in at a low of €40 - a low of €40 , and going up to a high of €68/share. The current mean is close to €55/share. I beat my own drum when it's justified, and do believe that these trends at least in part justify me showing you that these analysts have difficulties being longer term. Last fall, when the company was cheap, only 4 out of 19 analysts were at "BUY". Most at "HOLD" or "SELL".
Today, 9 analysts are either at "BUY" or "Outperform" - when the company is up 40%. The right time, ideally, to "BUY" Covestro is not today. It was last fall.
The company's outlook is very complex. We're moving from a trough to a mid and eventual upcycle, but the forecasts are very difficult here.
While I'm very happy I bought the company cheaply, these trends also beg the question if my capital, which is now 1.4x larger, can be better invested elsewhere. There are plenty of opportunities out there.
I'm not changing my rating. I still believe the company is a "BUY". I still believe it's long-term undervalued. But I am saying that Covestro is neither "cheap", and I'm also capping the upside at 15-18% for the longer term, annualized. The company needs to outperform relative to its forecasts to really deliver impressive returns here - and with the near-term of future of the dividend in question, the upside here is far less clear than when we bought last time around. That's the reasoning behind my lowering my price target to €65/share - the overall upside available on the market in terms of risk-free rates at this time, and wanting that 15% annualized RoR . Just as with any cyclical business, I'm working in part with a projected free cash flow on a normalized basis here - then discounting this at a suitable rate for where I believe the risk in the company lies - in this case, 10%. Given the forecasts as well as these estimates, a €65/share price is where I end up with a conservative target - and that's also accounting for some of the risks.
I would say while the company constitutes a "BUY" here, you should look at potential alternatives - because there are safer ones out there.
Thesis
- Covestro is a cyclical but qualitative chemicals company in key industries - and it's being incredibly undervalued at today's prices. Despite recovering over 30% since the relative lows we've seen, Covestro remains undervalued to peers, and as I see it, to its forecasts - but is still at a higher risk than some more conservative investments. Investors should weigh their options and risk tolerance for this, as for any investment.
- Because of this, I give the company a PT of €65/share at this time - changed for the first time in 10 months, since my first article on Covestro - and go for a "BUY" here.
- While this investment requires significant degrees of patience and tolerance, I still believe outperformance to be possible on the part of the company
Remember, I'm all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansions/reversions.
This means that the company fulfills every single one of my criteria, making it relatively clear why I still view it as a "BUY" here.
For further details see:
Covestro Q3 - An Update After Outperformance