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Covestro: Lies, Damned Lies & Valuation Ratios

Albeit cheap on the surface — with an enterprise value that equals 5x operating earnings — and backed by a fortress balance sheet, Covestro doesn’t come across as a genuine value investment.

The company benefits from an extraordinary but temporary pricing environment, in particular within its polyurethanes business where steep price increases make up for modest volumes growth. As a result, boomtime profits over the last three years do little justice to normalized earning power.

It is of course a common mistake to extrapolate peak earnings when looking at cyclicals or, in a like manner, to underestimate the likelihood of a reversion to the mean. A handy sanity check consists in monitoring the amount of assets employed. Barring a few exceptions, if profits surge while the latter hold steady, something too good to last will eventually end. This is precisely what happens at Covestro.

Odd capital allocation is another peculiarity of the company. Management advertises grand plans to expand capacity or proceed to acquisitions, but depletes resources by initiating a huge €1.5bn share buyback program as those trade above 70x their average earning power.

The board is perhaps trying to pump up return on equity in order to set the stage for a buyout. Covestro, after all, does not count among the heavyweights, and thus does not stand out as a natural consolidator. A sale above €80 per share would yield a tremendous return to shareholders in just three years of listing. Who’d blame them for trying?

In effect, prosperity extends to the whole industry, buoying appetite for mergers and acquisitions. Sales and profits rose strongly for the global top 50 chemical companies. Even pure commodity producers experienced record results. Such setup is rife for overpaid — if not outright foolish — acquisitions.

Covestro was spun-off from Bayer in 2015, in order for the German group to finance the acquisition of Monsanto and trade a low-margin, low-return chemical business for the more promising field of life sciences. The transaction enabled Covestro to substitute short-term loans from its former parent for long-term equity financing — a win-win for both.

A few months prior the listing, Bayer declared that it expected an issue price comprised between €25 and €30. It also indicated its intention to retain a meaningful stake of about 65%- 70% of equity capital. However, the group took advantage of fortunate market conditions to trim its stake almost entirely, now down to a trivial 7% ownership. Despite this intense selling pressure, Covestro’s stock appreciated fourfold in the nine quarters following the listing, from 26€ to 95€.

This time may be different. But if it’s not, investors who buy at current levels are asking for trouble.

(No position.)

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