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Morningstar | Covestro Has More Room To Fall

Covestro derives two thirds of its revenue from polyurethanes and polycarbonates. Polyurethanes are primarily used to make rigid and flexible foams for furniture, mattresses, car seats, and insulation for buildings and refrigerators. Polycarbonates are mid-grade engineering plastics that are used in electronics, automotive, and architectural glazing. As these products are largely commodified, competition is price-based. Covestro holds leading positions in market share and on the cost curve in certain products and regions. However, the cost curves can be relatively flat due to consolidated markets and similar plant sizes. Consequently, the firm is subject to volatile revenue and margins, given cyclical end markets and high fixed costs. We think Covestro's coatings, adhesives, and specialities, or CAS, segment is the most attractive. CAS has specialised products and diverse end markets, which results in higher and more resilient profit margins.Covestro is shifting to investment mode after nearly a decade of harvesting prior capital investments. Competitors are also investing with expectations for demand growth to remain robust, particluarly in polyurethanes. We think polyurethane demand growth may dissapoint due to our conservative expectations for growth in China, particularly in construction and housing-related end markets. Indeed, Covestro’s polyurethane's business derives 60% of its sales from these end markets. We think the polycarbonates segment may fare better in China, given lower exposure to construction and its products being positioned nicely to capture demand from the lightweighting trend. The company’s CAS segment provides stability in an otherwise-volatile operating environment. With more than 2,000 products serving more than 10 different end markets, CAS provides much-needed diversification. Products typically add high value to end products, while only representing a small portion of the end product price.