Neste (OTCPK:NTOIY) is a Finnish energy company focused on downstream activities, namely refining & marketing. It also has activities in renewable energy, being the world's largest producer of renewable diesel refined from waste and residues. Contrary to many of its peers, the company is not much dependent on the oil price and is a good way to diversify an equity portfolio.
It has a market capitalization of about $11 billion and trades in the U.S. on the over-the-counter (OTC) market. Its largest shareholder is the Republic of Finland with a stake of 50.1%, therefore controlling the company and meaning that Neste should not be a takeover target in the foreseeable future. Its closest peers are other European energy companies with sizeable refining operations, such as Repsol (OTCQX:REPYY), Galp Energia (OTCPK:GLPEY) or ENI (NYSE:E).
Neste's main assets are two refineries in Finland and two other renewable diesel production facilities in Singapore and Rotterdam. Its retail business has a network of more than 1,000 retail fuel stations around the Baltics, with a top 3 market share in almost all of its operating regions. Its product range includes gasoline, diesel, heating oil, heavy fuel oil and aviation fuel.
The company has invested more than $1.5 billion in renewable energy from 2007 to 2012 and has now a dominant global position in renewable diesel, which adds a growth angle to its business profile. The supportive regulatory backdrop in Europe and North America, which are key markets for Neste, provides a solid foundation for long-term growth. This business segment is important because it gives Neste more diversification than relying exclusively on refining activities.
Given that Neste is present basically on downstream operations, namely refining and renewable energy, means that is not directly affected by the low oil price environment. This gives it a very unique and defensive profile within the energy sector.
Regarding its financial performance, Neste has improved its results significantly over the past couple of years because low oil prices have resulted in improved refining margins. The European refining industry has overcapacity and this has led to weak refining margins over the past few years, but with the oil price decline this has changed.
Despite the overcapacity situation in the European refining industry, Neste has sustainable competitive advantages that have enabled it to recently increase its margins significantly. Indeed, Neste's oil products' total refining margin was $11.79 per barrel in 2015, an increase of 20% from the previous year. This is possible because Neste has two refineries with a good location, with easy access to cheaper Urals crude from Russia and high complexity system, which enables it to have an above-average production of higher-margin middle distillates.
This has been decisive for Neste's earnings' recent boost despite its lower revenues due to the oil price decline. This is very different from most of its peers, especially oil majors that have been negatively impacted by lower revenues and profits from their upstream operations.
In 2015, Neste's net sales were about €11 billion ($12.1 billion), a decrease of 25% from the previous year due to the oil price decline. Nevertheless, given the improved refining margins, its EBITDA more than doubled to around $1.2 billion, representing an EBITDA margin of 9.5%. In the previous year, its EBITDA margin was only 3.2% showing how leveraged Neste is to higher refining margins. Its net profit amounted to $620 million, a steep increase from only $66 million in the previous year. Its return on average capital employed (ROACE) after tax was above 16%, higher than its own target of about 15% in the long term.
During the first six months of 2016, Neste has delivered relatively good results, boosted mainly by its renewable energy division. Its revenues declined slightly and its refining margins were lower than in the same period of last year, but Neste was able to report a higher EBITDA boosted by its renewable products business. Its operating profit almost doubled compared to the same period of 2015 and cash flow was also much higher, reflecting good operating fundamentals for the company. Going forward, its renewable energy business should continue to be the growth engine, while its refining business may be more volatile because it is highly dependent on refining margins.
Regarding its dividend history, Neste cut its dividend in 2009 following the collapse in refining margins, but has since then delivered very good dividend growth. Its dividend per share increased significantly in 2011, 2013 and more recently related to 2015 earnings. Neste's last dividend was €1 ($1.11) per share, an increase of 54% from the previous year. This reflects its improved financial results, but also management's confidence in the company's outlook. At its current share price, Neste offers a dividend yield of about 2.5%. This is not among the highest within its sector, but has better growth prospects than some of its peers given that the company is not much dependent on oil prices to achieve earnings growth.
Additionally, its dividend payout ratio is quite conservative, given that in 2015 it was only 45% of its earnings. Its dividend policy is to distribute at least 40% of its annual earnings to shareholders, a conservative position that leaves some upside for its dividend even if earnings don't grow. Moreover, this dividend payout target is below the sector's average, which is around 60%, thus Neste can easily increase its dividend without being more aggressive than its closest peers.
Another positive factor for its future dividend growth is its improved cash flow generation profile, given that its free cash flow generation has increased significantly over the past few quarters. Neste has invested heavily until 2012 when it was building its renewable business. Since then, its capital expenditures (CAPEX) have dropped considerably and its free cash flow improved naturally. This means that Neste's dividend coverage and sustainability have markedly improved and the company has plenty of room to grow its dividend in the near future.
Additionally, positive organic cash flow generation has also enabled the company to reduce its indebtedness and its gearing ratio is now about 25%, at the bottom of its target range of 2-50%. Neste's strong balance sheet enables the company to possibly be more aggressive towards shareholder remuneration, given that it doesn't need to retain cash, being another positive factor for its dividend growth.
Neste is a small company within the energy sector focused on downstream operations of refining and renewable energy. Its stock is a defensive option in a weak oil price environment, given that its sensitivity to the oil price is rather low. This justifies a premium valuation given its relatively low risk and superior earnings growth potential.
Nevertheless, Neste is trading at 15x its forward earnings and 8.5x enterprise value (EV) to EBITDA, a valuation that is in line with the sector despite the company being more defensive than the majority of its peers. Additionally, its dividend growth potential is quite good, making it very attractive for long-term income investors who have already exposure to the energy sector and want to increase diversification within their portfolios.
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