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LyondellBasell Industries N.V. (LYB)

LyondellBasell's (LYB) origins date back to 1953 when company scientists Karl Ziegler and Giulio Natta made breakthrough discoveries in the creation of petrochemicals polyethylene and polypropylene. 

Today the company is one of the world’s largest diversified chemical suppliers and refiners with over $34 billion in revenue. LyondellBasell manufactures various commodity chemicals, as well as a number of plastic resins used in many different types of consumer and industrial products.
Source: LyondellBasell Investor Presentation
The company owns 55 manufacturing plants around the world that produce products sold in approximately 100 countries.
Source: LyondellBasell Investor Presentation
LyondellBasell operates five business units: Olefins & Polyolefins Americas, Olefins & Polyolefins Asia, Europe, and International (EIA), Intermediates & Derivatives, Refining, and Technology.

Olefins & Polyolefins are petrochemicals that are turned into polymers, such as ethylene, polyethylene, butadiene, polypropylene, and other chemicals used to make plastics. These chemicals are used in many consumer products and durable goods around the world including: packaged goods, electronics, cars, construction materials, and agriculture products. 

Intermediate Products manufacturers propylene oxide (used in foams and plastics) and its derivatives, oxyfuels, and intermediate chemicals, such as styrene monomer, acetyls, ethylene oxide, and ethylene glycol (used in antifreeze).

In addition to producing these valuable chemicals, LyondellBasell's manufacturing process is so good that it is the world's leader in licensing olefin catalysts and catalyst production methods.

The vast majority of the firm's sales and operating profits come from its Olefins & Polyolefins and Intermediate Products businesses.

  • Olefins & Polyolefins Americas: 42% of 2017 EBITDA (earnings before interest, depreciation, and amortization), 4% growth in 2017
  • Olefins & Polyolefins EIA: 32% of 2017 EBITDA, 10% growth in 2017
  • Intermediate Products: 21% of 2017 EBITDA, 12% growth in 2017
  • Refining: (2% of 2017 EBITDA, 118% growth in 2017) produces refined products including diesel fuel, heating oil and jet fuel.
  • Technology: (3% of 2017 EBITDA, -15% growth in 2017) develops and licenses chemical and polyolefin process technologies and manufactures and sells polyolefin catalysts .

LyondellBasell's Olefins & Polyolefins Americas segment is the largest source of cash flow due to the U.S. shale boom, which provides very cheap natural gas liquids (petrochemical inputs) and low power costs. As a result, approximately 44% of the company's pre-tax income is generated in the U.S. 

The refining and technology segments are the most volatile segments due to the cyclical nature of their demand and margins. However, both segments together account for just 5% of cash flow. 

Business Analysis

The petrochemical industry may not be one that many income investors have considered, given that its products are rather abstract and unfamiliar. In addition, the highly volatile nature of its margins, which are largely tied to commodity prices and capital utilization rates, might at first make LyondellBasell seem like a poor dividend growth investment.

However, the company does enjoy two competitive advantages that make it one of the industry's best choices for dividend investors who can stomach some volatility. LyondellBasell's first advantage is its global reach, which includes numerous U.S.-sourced manufacturing facilities.

Many of these plants are located directly in states with large gas production (such as Texas, Louisiana, and Ohio) or nearby in the Midwest where they have bountiful access to cheap U.S. natural gas liquids (NGLs). 

NGLs are byproducts of natural gas production and include chemicals such as pentane, butane, and propane. These are the raw materials that petrochemical companies turn into polymers, resins, and other plastic pre-cursors.

The U.S. shale gas boom has resulted in a bumper crop of low-cost NGLs, as well as very low gas prices, providing U.S. petrochemical plants with a meaningful cost advantage over their Asian and European rivals. In fact, only the Middle East has lower cash costs to produce ethylene.
Source: LyondellBasell Investor Presentation
In addition, the price of petrochemicals such as ethylene and propylene are usually indexed to global oil prices. So when natural gas prices are low (cheap input costs) and oil prices are high, then the company’s profits are maximized.

As oil prices have recovered somewhat from their recent crash, petrochemical margins have risen because NGL and natural gas prices have remained low.

When oil prices decline, the selling price of its products declines as well, but so do input costs (generally speaking). This explains why the company’s margins have been higher and steadier than its volatile sales would have you imagine. It’s all about the natural gas-oil spread.

The second competitive advantage the company has is management's ability to optimize operational efficiency. This means generating strong output rates (high capacity utilization) while maintaining one of the industry's best safety records. 

In fact, over the past few years Lyondell has experienced about 70% fewer accidents than its peers, while operating its facilities at 92% to 95% of capacity. Due to the high fixed costs of petrochemical plants, maximizing production from existing assets is a key profit driver.

Thanks to its low input costs and efficient operations, Lyondell enjoys some of the industry's best profitability. For example in 2017, its operating margin was 14.7%, nearly double the industry average of 8.0%. The chemical producer also achieved a 29% return on invested capital, and generated a 10.6% free cash flow margin, which is quite impressive for such a capital-intensive business.

Lyondell's management is also very good at investing shareholder capital wisely to profitably grow the business over time. Between 2012 and 2016, Lyondell completed eight new plants or expansions that increased its U.S. ethylene capacity by 2 billion pounds per year, or 20%.

In addition, the company has a $7.1 billion backlog of planned organic growth projects that it expects to boost its cash flow by $1.6 billion, or 22%. All while generating EBITDA margins north of 20%, meaning that these projects will pay for themselves within five years once they are complete.
Source: LyondellBasell Investor Presentation
The other way to grow is through acquisitions. In February of 2018, Lyondell announced it was buying A. Schulman, a leading provider of polymers (such as polyethylene and polypropylene) for $2.25 billion in cash. 

That represents a valuation multiple of 11.0 times adjusted EBITDA, which is expected to fall to 6.3 within two years assuming the company achieves its expected $150 million in annual synergistic cost savings.

Acquiring A. Schulman will also double Lyondell's polymer business while decreasing its dependence on the automotive sector from 90% of segment sales to 53%. The end result is an ability to reach more customers, improve diversification, and generate more stable cash flow. 

                                                  Lyondellbasell's Polymer Business
Source: LyondellBasell Investor Presentation
The polymer industry is one that is one that is both large, at $65 billion per year in revenue, but also fast growing, at about 6% per year.
Source: LyondellBasell Investor Presentation
This latest acquisition will make LyondellBasell the world's largest polymer maker with about 7% market share. The company's low market share is due to the highly fragmented nature of this industry but also means that there should be opportunity for future consolidation.

The A. Schulman deal has already received regulatory approval and is expected to close in the second half of 2018. Thanks to the boost in future profits, as well as the benefits of tax reform (which lowers the company's effective tax rate from 26% to 21%), Lyondell raised its dividend 11.1% for 2018.

And speaking of the dividend, LyondellBasell is one of the most dividend-friendly petrochemical companies you can find with nine payout increases since 2011. Management has said that maintaining the payout, even during challenging industry conditions, is the company's second highest priority, behind only maintenance capex.
Source: LyondellBasell Investor Presentation
However, management is also focused on investing for the future. The company's third spending priority is growth capex, including its large backlog of highly profitable projects. All of these projects are focused on exploiting the booming demand for various petrochemicals for which global demand is growing at between 5% and 7% per year.

Thanks to the shale revolution and America’s massive supply of cheap natural gas, the U.S. plastics industry is poised for solid growth in the coming decades. A growing world population and rising wealth in developing markets are expected to drive higher demand for plastics over time. You can see that per capita consumption of chemicals, plastics, and fuels in major markets such as China and India significantly lags Western nations today.
Source: LyondellBasell Annual Report
As these large countries continue to modernize, even a small increase in polyethylene demand per capita will require new industry capacity. In fact, LyondellBasell noted in its 2016 annual report that “current demand forecasts call for about 50 new world-scale PE plants through 2021 – just to meet projected demand.”

Another factor benefiting the domestic plastics market is that foreign competitors cannot compete as effectively with U.S. producers since their input costs are higher (remember, foreign producers do not benefit from the glut of cheap natural gas in the U.S.).

As a result, between 2014 and 2030 the American Chemistry Council expects U.S. global plastic exports to more than double from $60 billion a year to $123 billion, and LyondellBasell is positioned to be one of the main beneficiaries of this trend.

Despite the number of long-term growth projects available to throw money at, maintaining a strong balance sheet, which is essential for cyclical and capital-intensive companies, remains a top priority. Management's relatively conservative use of leverage, plus the company's diversified sources of cash flow, earn Lyondell a BBB+ investment grade credit rating. 

Thanks to its financial conservatism and healthy access to capital, Lyondell is able to comfortably invest in future growth while still returning cash to shareholders at the most generate rate in the industry. In fact, between 2011 and 2016, over 70% of the company's cash flow was used for buybacks and its fast-growing dividend.
Source: LyondellBasell Investor Presentation
Overall, LyondellBasell is among the best-run companies in the petrochemical industry and provides essential chemicals that help form the backbone of the modern global economy. 

The business enjoys several competitive advantages which should ensure its long-term relevance, including one of the most experienced and shareholder-friendly management teams, great economies of scale, a strong balance sheet, access to low-cost growth capital, and advantaged input costs thanks to the U.S. energy boom. 

With the strong long-term growth catalysts behind the U.S. petrochemical industry, Lyondell could be an interesting choice for high-yield income portfolios. However, its business has several risks to understand first.  

Key Risks

While Lyondell is certainly one of the top companies in its industry, the chemical maker still faces three major risks investors should be aware of.

First, Lyondell sells commodity products whose prices are set on global markets. In other words, the company is a price taker, not a price maker, so its profits are at the mercy of both its input costs (NGL and natural gas prices) and product prices (based on global oil prices).

Should NGL prices rise in the future, or oil prices decline (they fell 76% between mid-2014 and early 2016), then Lyondell's margins could substantially fall. While management has indicated that maintaining the dividend is a top priority, a severe and prolonged industry downturn could turn up the pressure one day. 

In addition, while petrochemical prices may be benchmarked off global oil prices, at the end of the day they are set by the supply/demand balance of the industry. Management predicts that new petrochemical capacity will outpace demand growth between 2018 and 2020, which means that Olefins & Polyolefins margins could decline. 

Competitors also have the ability to run their operating rates too high, meaning create even larger supply gluts that could harm petrochemical profitability in the future.

If demand for Lyondell's commodity chemicals were to unexpectedly drop during this period of capacity expansion, then the industry’s supply-and-demand balance could really be thrown out of whack.

In this scenario, which would occur if there was another recession, there would be severe price pressure on these capital-intensive, debt-burdened manufacturers (including LyondellBasell) looking to fill their expensive plants.

Rightsizing capacity in capital-intensive industries is very difficult and can take years of time; companies have invested hundreds of millions (or even billions) of dollars into their plants and are reluctant to take them off-line or shutter them.
Next, investors should be aware that one of the hottest growth markets for petrochemicals is China. According to Alex Lidback, VP of chemicals at Wood Mackenzie, "The Chinese market is very short of polyethylene as a whole, so they need the imports to meet their demand growth."

However, if the U.S. and China end up in a trade war, then Lyondell and other petrochemical suppliers might end up harmed by import tariffs on their U.S.-sourced exports to China. That's because, according to CNBC, about 40% of the 106 listed products on China's recently unveiled retaliatory tariff list are plastics, petrochemicals, petroleum products and specialty chemicals.

Finally, given that Lyondell has indicated that it's looking to be more aggressive with acquisitions in the next few years, every merger comes with execution risk. Specifically, management may end up overpaying for a deal, or expected cost synergies might not be realized.

Failed mergers often lead to big writedowns and losses for investors. In fact, LyondellBasell was formed by the $20 billion acquisition of Lyondell Chemical by Basell in 2007 and ended up filing for chapter 11 bankruptcy in 2009 as demand for its products from industrial customers collapsed and the company was saddled with too much debt.

Now in fairness to the company, it emerged from bankruptcy in 2010 and its debt levels are nowhere near the levels that sunk the company all those years ago (under $10 billion today compared to nearly $30 billion in 2009).

While Lyondell's new management team has a relatively strong track record of wise capital allocation decisions, even the best operators can still make mistakes from time to time.

Closing Thoughts on LyondellBasell

Conservative income investors are usually best off avoiding almost all commodity companies, especially those with big debt loads, capital-intensive operations, and a high dependence on uncontrollable macro factors.

However, even despite its bankruptcy in 2009, LyondellBasell looks like an interesting dividend growth stock to pay attention to. The company's exposure to low-cost natural gas in the U.S., the efficiency of its assets, its healthy balance sheet, the shareholder-friendly management team, and the secular growth of the petrochemicals industry over the coming decades are all attractive qualities.

However, investors interested in the stock must remain aware that earnings and dividend growth could slow in the years ahead as new industry supply enters the market, challenging today’s tight operating rates and favorable margins.

If demand were to unexpectedly slow or the oil-gas spread contracted during this time, the stock could really get hammered (and perhaps become really interesting for value-focused income investors).

All things considered, LyondellBasell could be an appealing candidate to consider in the cyclical materials and industrials sectors as part of a well-diversified dividend growth portfolio. Investors just need to respect the company's volatility and sensitivity to factors outside of its control, sizing their positions accordingly.

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