Neste Corporation: Still Undervalued?

by: Samu Wilhelmsson

Renewable Products as the main driver for growth.

The beneficial regulatory environment supports further growth.

The model suggests intrinsic value of €118.35 per share.

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The stock of Neste Corporation (OTCPK:NTOIY) has gained +490% during the past five years, and it has a current market capitalization of $24 billion. Neste Corporation (HEL:NESTE) is listed on the Helsinki Stock Exchange, and it trades in the U.S. on the over-the-counter market.

The company's market value hit its all-time high on January 2019, but it is fair to think that the stock is still undervalued. The recent growth in the segment of Renewable Products in a beneficial regulatory environment supports further growth for the largest producer of renewable diesel in the world.

Promising growth prospects

In addition to traditional oil refining and retail sales, the unique business model of Neste includes Renewable Products, which has been the main growth driver for the company during the past years. During the first three quarters of 2018, the operating profit from Renewable Products grew +35% despite the preparations for the turnaround of the new Singapore-2 refinery.

Currently, the Renewable Products segment only contributes to 21% of the company’s total revenue, whereas traditional oil refining and retail sales form 79% of the total revenue. However, when it comes to the operating profit, Renewable Products has a 53% share of the operating profit of Neste. The company expects the growth in Renewable Products to continue when the turnaround of the Singapore-2 refinery is completed, due to the increase of production capacity by 1.8 million tonnes by 2022. However, deeper evaluation of the investment is difficult at this point due to many existing uncertainties considering future demand, and consequently, future supply.

The company has aimed to focus more on the Renewable Products and to be the market leader in the segment by 2030. The strong focus on the segment can be seen in the growth of the share of Renewable Products in the total revenue:

2017 2016 2015 2014
Total revenue (MEUR) 13.217 11.689 11.131 15.011
Renewable Products (% share) 25% 23% 21% 15%
Oil Products (% share) 64% 63% 67% 75%
Marketing & Services (% share) 30% 30% 34% 29%

The current regulatory environment has been beneficial for the market of renewable energy products, and this has increased the margins for Neste. Renewable Products also benefits from the recent development in the prices of crude palm oil and soybean oil, which has decreased costs of production. The return on net assets for Renewable Products was 34.8% during the third quarter of 2018.

Analysts have previously been more cautious on the earnings forecast on previous years due to the existing regulatory risks on the demand for renewable energy products, especially in the United States, which is the biggest market for Neste after Europe. By beating analysts’ expectations during the earlier quarters of 2018, the company has proven the sustainability of its growth and its resilience to the feared political risks.

Neste has established a strong brand and has a dominant market share in the market for Renewable Products. Currently, there is no serious competition in the market, but more competition could emerge soon. The International Energy Agency expects the market for renewable energy to grow rapidly for the next 5 years, also in the ethanol industry where Neste operates. However, a strong presence in the market makes Neste’s position resilient to future competition and boosts the company’s competitiveness.

Difficult to value

The price targets of the 16 analysts who are covering the stock currently range between a share price of €50 and €90.

Determining the value for Neste is as difficult as determining the valuation for Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Google (GOOGL). The problem with the valuation is that the company is currently unique and operates in a new market of renewable energy. The lack of benchmark firms makes the valuation of Neste difficult, since the business model is very different from that of traditional oil refineries.

I will estimate the value with discounted cash flow with free cash flow, since free cash flow can be considered as the cash that could be returned to investors. By discounting the estimated future free cash flows with the cost of equity, we can estimate the intrinsic value per share of Neste. We have chosen the fiscal year 2017 as the basis of our calculations.

The clear advantage of the method is that the model isn't influenced by non-economic factors such as politics or changes in the regulation for Neste's business environment. However, a disadvantage with the method is the fact that predicting the future cash flows for Neste currently remains relatively uncertain since the market for Renewable Products is still regarded as rather new.

The Discount Rate from Capital Asset Pricing Model

We start by calculating the discount rate from the Capital Asset Pricing Model.

  • Cost of equity = Risk-free rate + beta x (equity risk premium)

For the risk-free rate, we use the commonly used yield of the U.S 10-Year bond, which is at the moment 2.71%. As regards the equity risk premium, we use the 5.55% estimate from January 2019 of Aswath Damodaran. The historical beta of Neste is observed at 1.10 from Reuters. From these figures, we calculate the discount rate as 8.77%.

  • Cost of equity = 2.66 + 1.10 x 5.55 = 8.77%

Growth in the future free cash flows

In my calculations, I have my base case with an estimate of an annual growth of 6% in the company's earnings. Free cash flow is calculated by subtracting the operating costs, capital expenditures, taxes and the changes in net working capital from earnings.

Year 2017 2018 2019 2020 2021 2022 2023
Growth rate of earnings (%) 6% 6% 6% 6% 6% 6%
Earnings MEUR 13203 13995 14835 15725 16668 17669 18729
Operating costs MEUR 11864 12316 13055 13838 14668 15548 16481
Depreciation MEUR 370 370 370 370 370 370 370
EBIT MEUR 1171 1246 1320 1400 1483 1573 1667
CAPEX MEUR 466 494 524 555 588 624 661
Current assets MEUR 3530 3779 4005 4246 4500 4771 5057
Current liabilities MEUR 1951 2094 2219 2352 2494 2643 2802
Net working capital MEUR 1579 1685 1786 1893 2007 2127 2255
Change in net working capital MEUR 104 106 101 107 114 120 128
Free cash flow MEUR 600 900 965 1023 1084 1149 1218
Growth rate (%) MEUR 0.50 0.07 0.06 0.06 0.06 0.06

During 2017, cost of goods sold was 88% of earnings, and the same proportion is expected to hold true in the future too. EBIT margin was 9% during 2017, and the same margin is used for future calculations.

Neste has historically depreciated long-term assets by around €370 million annually, and we assume that there will be no change in depreciation in our horizon. Current assets were approximately 27% of the annual revenue and the current liabilities 17% of the annual cost of goods sold during 2017, and we assume the same shares for the future.

We assume that the capital expenditures are expected to grow at the same rate as the earnings to ensure the increased production, so we use the same 6% rate on the annual growth of capital expenditures. In our calculations, we have disregarded the effect of the Singapore-2 refinery on capital expenditure and earnings due to the high level of uncertainty.

Our calculation shows that the unlevered free cash flow (with the current 14% income tax rate of Neste) is estimated to grow at the constant 6% level from 2020.

The valuation seems attractive

By applying the 8.77% annually compounded discount rate that represents the cost of capital for the firm, we find the present values of future cash flows for Neste. The terminal value is calculated using the Gordon Growth Model with an assumption that the free cash flow will continue to grow by 6% to perpetuity. By adding the present values of future free cash flows with the terminal value of the free cash flow, we arrive at an enterprise value for Neste of €30.8 billion.

Year PV of FCF PV of Terminal Value of FCF
2017 600 / (1.0877)
2018 900 / (1.0877)^2
2019 965 / (1.0877)^3
2020 1023 / (1.0877)^4
2021 1084 / (1.0877)^5
2022 1149 / (1.0877)^6
2023 1218 / (1.0877)^7
+ (1218 x 1.06) / (0.0877 - 0.06)
EV 30756

The next step is to subtract the net debt of the company to find out the fair value of Neste.

EV MEUR 30756
Debt MEUR - 412
Fair value 30344
Shares outstanding 256.4 million
Fair value per share EUR 118.35

By dividing the fair value by the number of shares outstanding, we find that the intrinsic value of Neste Corporation is €118.35 per share, which indicates a significant undervaluation. Currently, the stock trades with a forward P/E of 19 and with EV/EBITDA of 11x at a price of €81.82 per share.

Future earnings are still highly uncertain

The key risk in our model concerns the estimation of the annual earnings growth. Historically, Neste's earnings growth has not been stable, mostly due to the fluctuation in the oil refining business, which still represents over 60% share of the annual earnings. Oil refining is highly sensitive to the movements of the EUR/USD exchange rate and the price spread between Ural and Brent oil.

The estimation of the future growth is highly difficult, and the 6% annual growth in earnings is an uncertain estimate. Earnings of Neste have grown over the past 10 years at a compounded average growth rate of only 0.88%. Furthermore, the 5-year CAGR in earnings is actually negative at -5.84%. However, I would see that the growth in Renewable Products hasn't been as significant during the past fiscal years as it has been during the latest quarters.

During the turnaround of the Singapore-2 refinery, it might be difficult to find new growth drivers for Renewable Products before 2022. The growth in the company's cash flow is currently uncertain.

Furthermore, the growth prospects of Renewable Products are highly volatile to regulatory changes. An unfavorable change in regulation could hinder growth of Renewable Products. This would have a significant effect on the growth of the operating profit of the company, and predicting these changes is extremely difficult. One example is the changes in the Blender's Tax Credit in the United States, since the revenue from Renewable Products has been highly dependent on the Tax Credit. Since the future of the Blender's Tax Credit remains uncertain, short-run estimations are difficult.


Renewable Products are the main driver of growth for Neste Corporation. The operating profit from the segment has increased rapidly and is expected to increase in the future due to new investments. However, predicting the pace of future growth is quite difficult.

The growth prospects for the corporation seem excellent already with a 6% annual growth in earnings, and I would suggest that despite the recent surge in the stock price, it is still undervalued. Patient investors willing to stay on board might enjoy fair returns on their investments for years to come.

Neste Corporation reports its Q4 earnings from 2018 on the 6th February, 2019.

This analysis was performed with the stock listed on the Helsinki Stock Exchange (HEL:NESTE). Investors using the over-the-counter market for Neste with NTOIY could also expect a similar undervaluation of 44% for the stock with the calculations presented in this article.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.