BASF - Consider Owning This German ~5% Yielder

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About: BASF SE (BASFY), BFFAF
by: Wolf Report
Summary

BASF is the largest chemical company in the world, at a market cap of ~€62B.

The company has a generous, nearly-5% dividend yield.

Going forward, the company presents an enticing investment opportunity at a somewhat undervalued stock price and warrants, at the very least, your attention as an investor.

As a German, BASF (OTCQX:BASFY) (OTCQX:BFFAF) is a company I've owned for some time. I did not truly load up on this giant however, until December 2018/January 2019. It's now my largest portfolio position when it comes to chemical companies, and this is a position I intend to increase further.

In this article, I'll show you why I consider BASF to be a long-term holding of mine, with excellent future potential and enough safety to consider a decent portfolio allocation. I'll, of course, go into the risks and challenges faced by the company to clarify potential headwinds going forward.

Let's look at BASF!

(Source: Evolva)

BASF - Over 150 years of Chemicals

The initialism BASF stands for the Badische Anilin und Soda Fabrik, which was founded in 1865 in Baden. The initial business plan was to use the local gasworks byproduct of tar to produce dyes. It quickly involved the production of Sodium Carbonate, Sulfuric Acid, Ammonia, and other chemicals, and became known as the company IG Farben in Leuna.

During the next 35 years, BASF/IG Farben would be associated with the production of explosives, wartime chemicals and become known as one of the many companies who collaborated with the national socialists during the second world war, benefiting from guaranteed volume and pricing during the time period. The company also produced the magnetophon, the first tape recorder in 1935.

The American authorities confiscated and dissolved IG Farben in 1945 following the end of the war.

The company was then refounded as BASF, which added synthetics such as nylon to its range of products, and developed polystyrene in the 1930s as well as inventing Styropor in 1951.

Many M&A's later, and we're looking at the largest chemical company in the world when BASF announced the purchase of the seed and herbicide divisions from Bayer.

Company segmentation

(Source: Investor Presentation Hamburg)

The company has reoriented its businesses into the above-mentioned segments, providing future clarity as to its operations. The company produces a wide variety of important chemicals and materials including, but not limited to:

  • Thermoplastics, Foams, and Urethanes
  • PA, PBT, POM, PSU, and PES, all of which are high-performance engineering plastics
  • A wide variety of Styrenics
  • Biodegradable plastics
  • Performance chemicals, including coatings and functional polymers/raw materials for detergents, textiles, leathers, pigments, adhesives, paper and construction materials
  • A division constructing customer-specific solutions, usually for the automotive and construction industries.
  • Agricultural products including fungicides, herbicides, insecticides, seed treatments and nutrigenomics.
  • Biotech including genetically modified vegetables, soybeans with herbicide tolerance and corn tolerant towards cold climates.
  • Oil and Gas, through a company subsidiary with the Russian partner Gazprom.

(Source: BASF Factbook)

This company is massive and active in a wide variety of industries. Ownership is heavily leaning towards institutions, with a massive 75% of company shares being held by large investors such as Blackrock. 36% of ownership is based in Germany and 17% in the USA.

The new company segmentation can be seen in terms of sales as well. It's extremely well diversified. Let's take a closer look.

(Source: Investor Presentation BASF Mailand)

So no single segment is responsible for even a quarter of company sales, making the company resilient for an operation of its size in terms of segment diversification.

Finances

There are many reasons why BASF can be considered a long-term positive investment. The most important reasons for me as a value investor are of course, fundamentally oriented.

First among these, is the company's ability to generate sector-beating growth/EBITDA. BASF achieves this, based on the company historical results.

(Source: Investor Presentation BASF Mailand)

Secondly is the ability to generate above-average levels of RoCE/RoI - or at the very least, the ability to generate returns above the cost of capital. The higher the returns in comparison to the cost of capital, the better.

( Source: Investor Presentation BASF Mailand)

Again, BASF achieves this. While RoCE hasn't been stellar during 2018, the overall trend is promising indeed. And since I'm primarily a long-term investor with a target period of 10-30 years of ownership (some forever), this is what I look for in a company.

Thirdly, we tend to look somewhat towards FCF/Company cash flow and see how the company trends look here.

( Source: Investor Presentation BASF Mailand)

And once again, BASF scores fairly high here. Fundamental issues in a company this size show pretty early on, in my experience. They may be risks in BASF, and the company may experience future headwinds in both smaller and larger areas. As a whole however, the company is a cash generator with an above-market average level of earnings growth. That's an excellent start.

Growth - China

Chemical production across the world is an area that's moving heavily towards China. All companies can see this, but few take as much advantage of this as BASF does. Currently, China is responsible for 41% of chemical production worldwide ( Source: Investor Presentation BASF Mailand), with Europe at a second position at a bare 18%. In 2030, the company expects roughly half of the world's chemicals, excluding pharma, to be produced in China.

In short, it pays off to have a global presence, and one skewed towards our Asian neighbors.

( Source: Investor Presentation BASF Mailand)

Once again, BASF delivers through a wide global network of centers, production sites, research facilities, and other operations.

Debt

Due to M&A's and other cost increases, BASF has increased its net debt to roughly €19.4 B due to the purchase price paid to German giant Bayer (OTCPK:BAYZF) and higher usage of the U.S dollar commercial paper program.

( Source: Investor Presentation BASF Mailand)

Even at this level, however, the company stands at a fairly positive equity ratio and has sufficient operating cash to cover the debt. At an operating cash/total debt ratio of 37%, the safety here can be considered sufficient. While the company has increased leverage to levels rarely seen before, the equity ratio of ~41% is sufficient for the time being.

Overall, BASF is less leveraged than most companies in the segment and about as leveraged as one can expect a large-cap company of this magnitude and in a period of change to be.

Recent results and developments - the reason for the drops

Let's look at some actual recent results for this company. Although I am positive on the company, 1Q19 was bad, with drops espeically in the materials and chemicals segments.

(Source: BASF 1Q19 Presentation)

While the increase in sales is a nice result, the drop in every other key metric tracked in the company's initial data is a bit of a blow. Mr. Market decided to take affront and punish the company accordingly, erasing over a month of stock price growth.

A yield of almost 5% for a company such as this is nothing to sneeze at - but let's look at some other things from the 1Q19 as well. There's more to a quarterly from a company this size than a profit chart.

Wintershall/DEA merger - finished

BASF is creating the leading independent European exploration and production company, where BASF owns 67% and LetterOne holds 33% of the ordinary shares.

The company will be active in the search for natural gas and crude oil worldwide and initially targets an investment grade credit rating. In the closing of the deal, there are no outstanding loans between the newly formed company and BASF/LetterOne, giving Wintershall Dea an excellent position to start building their core business in their new enterprise.

Segment results in Q1

Segment results for the quarter were mainly negative, with drops in several major segments.

(Source: BASF 1Q19 Presentation)

Chemicals is a good place to start, dropping 13% in sales in a single quarter, with both volume and pricing declines. This was due to lower volumes and pricing issues with certain product groups. However, the company Materials division did not do much better.

(Source: BASF 1Q19 Presentation)

Here we see a similar drop, related to reduced automotive demand and lower prices in certain material groups. The short-term trend here is actually somewhat worrying, with a huge EBIT drop in the segment. A small drop was also recorded in the Industrial Solutions segment due to small portfolio effects. Here, however, we can see a growth in earnings as the company was able to raise prices and volumes in its performance chemicals.

On a positive note, we have increases in sales in surface materials, related mainly to the price increases in precious metals, with Catalysts and Construction Chemicals providing 22% and 7% growth respectively within the segment.

To the company's more food/nutrition-oriented segments, we're looking at flat growth in the Nutrition & Care segment and very positive development in the Agricultural Solutions segment. BASF has already begun developing the segment, and this shows in the results.

(Source: BASF 1Q19 Presentation)

Outlook for 2019

The company reaffirms its 2019 outlook during Q1, expecting a slight sales growth and EBIT growth. However, this is of course provided that GDP growth and the other growth levels in production, as well as the exchange rate and Brent oil price, remain roughly at the same levels. A company such as BASF is very dependent on these key indices/prices and developments.

It is important to note is that the company expected many of these headwinds and geopolitical risks between the US and China. While the negative effects materialized, they were not in fact, unexpected. The slowdown from automotive during the first quarter was significant, and the 6% decline in production offset results for the company.

Also important to note is the geographical location where some of BASF production capacities are located, near the Rhine river. The company has been afflicted by the increase in flooding and yearly water level increases from this river, which did impact company profit segments and may do so in the future.

One is the impact that the Rhine water level and the temperature of the Rhine water can have on our cooling water situation. We've used the time since last summer to improve that overall and to reduce the dependency on the intake of the water from the river Rhine, so that's one mitigation measure that we have taken.

We've also invested in additional storage capacity at the Ludwigshafen site to be able to cope better with the situations like we've experienced them in Q3 and Q4 of last year. That is what we can do, there's not much more. Then what we do -- what we can do other than looking at the transportation situation and what we've done there is, we made additional reservations for barges and that should all help if we would find ourselves in a similar situation again in 2019 or one of the following years. So that was the Rhine water level.

(Source: Hans Engel, Q2 Earnings call)

The company expects the second half of 2019 to be significantly stronger in Chemicals than the first half.

I already mentioned that Q2 will also be tough for the Chemicals segment. This is in particular due to the fact that we have two cycle turnarounds in Q2 the Port Arthur cracker in the U.S. goes to a full five-year turnaround and the same happens in Antwerp. That was factored in when we gave the guidance for the Chemicals segment. We are expecting a second half that will be significantly stronger than the first half of the year 2018 in Chemicals.

(Source: Hans Engel, Q2 Earnings call)

In addition, the company guides for further of a slow start in the agricultural in terms of volume due to weather conditions. The volume decrease in Q1 was initially offset by price increases, but this may not be the case going forward.

Valuation

(Source: Google Finance)

Current valuation for the company in terms of historical P/E levels is looking acceptable. This is of course, far from enough. One can take into consideration, that BASF represents the worlds most valuable chemicals brand (Source: BrandFinance).

The background for this company from a historical perspective is quite interesting. Over the past 10 years, BASF has increased RoE from a level of 8.9% in 2009 to a level of 18.9% during 2017. Overall EBITDA margins have increased from 14.6% to 17.6% (though they've been as high as 18.3%). Earnings per share during this time have increased by almost ~330%. The company dividend at the same time has increased by 89%. While this does not represent dividend increases on the same levels as some, the increase is still respectable given company size and structure. The company has developed things very well.

(Source: GuruFocus)

At a 13.51x blended P/E ratio valuation, the company is valued significantly lower than its peers. With peers such as DowDupont (DWDP) at ~22x, Bayer (OTCPK:BAYZF) at almost 54x, and LG Chem (OTCPK:LGCLF) at above 18x, it's obvious that many other companies active in similar business are currently valued higher - while BASF still remains the most valuable brand and the largest in the world.

Similarly, the company trades at fairly low valuations in terms of P/B and below a 1.0X P/S.

(Source: GuruFocus)

As we can see above, the company has some advantages in terms of EV/EBITDA comparison in relation to several of its larger peers, making it a significantly healthier company than these (at least on paper).

BASF is fairly/somewhat attractively valued at the moment. Hold your horses, however, as I do want to add a few notices here.

Wrapping up the case

2019 is going to be a transitional year for BASF. My own position was invested at an average of ~€60/share, so even given today's somewhat depressed stock price, my position is well in the black. Despite BASF's current fair/somewhat appealing valuation, it's important to recall that the company faces quarters characterized by future headwinds - in the company's own estimation.

The company's overall long-term profitability isn't in jeopardy. BASF has incredibly strong cash flows, despite the environmental problems with the Rhine river, BASF can, and will (i believe) master any long-term headwinds that are thrown it's way.

The question I am asked on a frequent basis is whether now is the time to invest.

In this particular case, my answer would be a hesitant 'maybe'.

BASF is a great company. It's never wrong to invest in a great company at a fair value - which is what I believe that we have here.

At the same time, take a look around. Market volatility inbound. BASF themselves are guiding towards lower results in Q2 in key segments. Some divestments still aren't finished. There's the whole Rhine river level thing that needs to be handled, and while the company has plans, none of these are yet finished.

My advice for the patient and conservative investor would instead be to put this great company on your watch list - and set a price target of below €60/share.

There's no doubt in my mind that you need to own the largest chemical company in the world. You absolutely should. But given the company's future expectations as well as some key takeaways from the current market situation - why not wait and see? That's not even mentioning that the company already paid it's annual dividend this week, on the 10th of May. Next dividend is a year off.

Investors buying BASF when it yields more than 5% will likely be very happy. That's not saying you'd be unhappy now, but my current modus operandi in this market is to act and invest extremely conservatively and only in the most obvious opportunities of clear undervaluation.

Thank you for reading.

My Recommendation

Invest in BASF when the valuation/share price drops to a level of ~€60/share. Current levels represent a "Fair value" or "Weak buy", but given current market circumstances and the company's own forecasting, I believe it's worthwhile to wait and see what happens in the near term.

Disclosure: I am/we are long BFFAF, BASFY, BAYZF. 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.