Methanex Corp.: Earnings Volatility Hides Massive Potential In Alternative Fuels

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About: Methanex Corporation (MEOH)
by: Value Kicker
Summary

Methanol is a good alternative maritime fuel. There is huge potential in this market, as capturing a small market share would greatly increase demand. Methanex is leading the way in developing the market.

Methanol has massive market potential in alternative vehicle fuels for emerging countries.

Methanex has been drastically sold down due to lower 2019 earnings. The issues that brought about the decline in earnings are temporary in nature, and thus, the stock is now undervalued.

Methanex Corp. (MEOH) shareholders have had a rough couple of weeks. The stock is down more than 58% from its high of $83.23. The decline in the stock was brought about by a series of news that was negatively received by the market, the first of which was the disagreement between Methanex management and M&G Investments (its largest shareholder) over the Geismar 3 project. Next, there was Methanex’s Q2 earnings miss. Methanex’s first-half 2019 Net Income is down 71% year over year ($96 million vs. $333 million). Finally, the stock was also severely negatively affected by the US-China trade dispute, as methanol prices are heavily dependent on the health of the global economy.

Intro

Methanex is the world’s largest producer and supplier of methanol to major international markets. Methanol is a chemical commodity that is largely produced by natural gas in most parts of the world (the exception being China, where it is produced from coal). Approximately 55% of methanol is used in the production of chemical derivatives, and the rest is used for a variety of energy-related applications, such as methanol-to-olefins (“MTO”), direct blending of methanol into gasoline, biodiesel, industrial boilers, and marine fuel.

The company has a market share of approximately 15% of the global methanol industry. Its production capacity is currently located in various places around the globe, namely New Zealand, the United States, Trinidad, Egypt, Canada, and Chile. The company also purchases and sells methanol on the spot market. The global nature of Methanex’s supply chain gives the company a competitive advantage in the industry by allowing it to source feedstock (in this case natural gas) from multiple locations and by allowing it to purchase methanol in the most cost-effective region (in the spot market), while still having a secure base level of supply.

The main risk in Methanex’s business is the volatility of methanol prices. In 2018, the company enjoyed a high methanol average selling price of $405, allowing it to reap high profits. 2018 EPS for the company was $6.92 per share. Unfortunately for 2019, the average realized selling price declined to $326 in Q2 2019 and $331 Q1 2019. In a declining methanol price environment, the company’s margins tend to be lower than in a stable price environment, due to the timing of methanol production and purchases versus the timing of sales, i.e., Buy high, sell low.

The declining prices, as well as Methanex’s own inventory-related issues (which impacted the mix between purchased vs. Methanex-generated methanol), led the company to a drastically lower first-half EPS of $0.84 in 2019. However, I feel the production issues are only temporary and that methanol demand has the potential to take off.

Demand in Methanol remains strong in the immediate future

In order to judge the long-term value of an investment in Methanex, we need to have a long-term view of methanol demand. The market for methanol is expected to register a CAGR of 5.64% during the forecast period of 2019-2024.

(Source: Methanex Investor Presentation March 2019)

The main sources for this increase in demand will be in its use as a cleaner energy source, particularly in Asia and other emerging markets. The two most promising methanol as an energy source trends are methanol as a marine fuel and as a vehicle fuel.

(Source: Methanex Investor Presentation June 2019)

Methanol as a marine fuel

The potential for methanol as a marine fuel came from the International Maritime Organization’s upcoming 2020 sulfur limit, where the limit for sulfur in marine fuel oil will be reduced to 0.50% m/m. There are various possible solutions to meet this new requirement, ranging from alternative fuels (of which methanol is one option) to exhaust gas treatment. In an interview with World Maritime News, Chris Chatterton, COO of the Methanol Institute, said:

The solutions on offer to the shipping industry range from the expensive and unpalatable to the elegant and ultimately highly sustainable.

Methanol is the option that has probably received the least coverage despite offering a pathway to a sustainable, 2020-compliant, low carbon future for the industry, achievable at manageable cost and with minimal changes to the operational profile of the majority of affected vessels.


Methanol is ready to go as a marine fuel now, and could be playing a much bigger role post-2020.


(Source: World Maritime News)

Compared to other alternatives to the shipping industry, such as Liquefied Natural Gas (LNG), methanol is already easily available worldwide and easily transportable bypassing the need to build supply infrastructure. Unlike LNG, methanol stays in a liquid state at ambient temperatures and is generally easier to handle.

Methanex is in the forefront of developing methanol as a maritime fuel via its wholly owned subsidiary, Waterfront Shipping. The company (alongside its industry partners) has developed a fleet of ocean-going vessels that are capable of running on methanol alongside traditional marine fuels. Converting existing ships or building new ships using methanol as marine fuel has proven simpler and cheaper than LNG, and the experience gained by the fleet operations of Waterfront Shipping has proven that methanol is well-suited as a low emission, high-performance marine fuel. The potential in the market is huge. According to the CME Group, should methanol propulsion systems only capture 5% of the global marine fuels market, this would amount to more than 30 million MT annual methanol demand equivalent - a massive change in an industry where global demand currently sits at 80 million MT per annum.

(Source: Methanex Investor Presentation March 2019)

Methanol as a vehicle fuel

With regard to methanol as a vehicle fuel, there is a tremendous potential for demand from China and other emerging economies. In 2012, the Chinese government initiated a methanol vehicle pilot program which would have vehicles running either a high-blend methanol fuel (M85 or 85% methanol) or on pure methanol (M100). The results of this pilot were positive, and thus the promotional policies for methanol vehicles and methanol as a transportation fuel which were released by eight government ministries and agencies. This could lead to thousands of methanol vehicles being manufactured and a huge demand for the product.

Chinese OEMs have produced a number of new light- and heavy-duty vehicle models, with 32 models certified by MIIT for commercial sales. Leading the mass production of methanol vehicles, Geely Auto (OTCPK:GELYF) has established production facilities capable of producing of 300,000-500,000 units of methanol engines and cars at manufacturing bases in China. Within five years, the fleet of M100 vehicles in China could reach 50,000 cars, trucks and buses, consuming more than 500,000 metric tons of methanol (166 million gallons/628 million liters).

(Source: Methanol Institute - A brief review of China’s Methanol Vehicle Pilot and Policy)

The caveat to this, though, is that China has its own methanol production capability. However, given that Chinese methanol is largely produced from coal (and is thus more harmful to the environment), environmental constraints may prevent the country from ramping up production enough to meet demand.

(Source: Methanex Investor Presentation March 2019)

In India, the transportation minister announced a national methanol blending policy of 15% (M15) in order to reduce vehicle emissions in the country. Similar to China, the country aims to produce local methanol from coal sources as well, and thus, will run into the same production constraints as China. If methanol as a vehicle fuel becomes widespread and successful in China and India, it will only be a matter of time before other emerging markets follow, as blending methanol to gasoline is a faster and simpler way to reduce vehicle emissions compared to electric vehicles.

Valuation

Given that Methanex's revenue is dependent on both the price of methanol as well as total tonnes sold, I used a regression model to model the relationship between price and tonnes sold.

(Source: Financial data from Methanex Annual Reports and author's own calculations)

Using the output of the regression model, I am able to forecast future revenue with the assumption that methanol sold will increase at a rate of 10% per annum and that price will remain at the average price of $353 per tonne. I’ve also set the EBITDA margin at 20%, which is slightly lower than the 5-year average rate, as well as using the debt repayments disclosed in the 2018 annual report. In terms of capital investment, I’ve allocated 2018’s amount of $250 million for all years moving forward. I’ve calculated the free cash flow, then discounted it using a discount rate of 13% (calculated by using a beta of 1.54, equity risk premium of 5.5% and a risk-free rate of 5%) with a terminal growth rate of 2%.

(Source: Financial data from Methanex Annual Reports and author's own calculations)

Based on my calculations, Methanex has a fair value of $48, implying a potential upside of around 40%. It has further potential upside, should methanol be widely accepted as either a marine fuel or vehicle fuel. I recommend this stock as a Buy with a fair warning given the company’s earnings volatility. The company has a decent dividend of 4%, which should help any potential investors stomach this. Methanex will be fine in the long run.

Disclosure: I am/we are long MEOH. 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.

Additional disclosure: Caveat emptor! (Buyer beware.) Please do your own proper due diligence on any stock directly or indirectly mentioned in this article. You probably should seek advice from a broker or financial adviser before making any investment decisions. I don't know you or your specific circumstances, therefore, your tolerance and suitability to take risk may differ. Although I write with conviction, due to timing issues my articles may not fully reflect my investment portfolio (I have a day job so I can't write all the time, etc.). This article should be considered general information, and not relied on as a formal investment recommendation.