EUR 850.00 For Business Accounts Only

Morningstar | Covestro Shares Fall 14% on Profit Warning; Shares Fairly Valued

No-moat Covestro shares are trading down 14% at time of writing due to the company announcing a profit warning. We have called out Covestro shares as overvalued for some time given we saw the share price implicitly assuming abnormal conditions in the MDI and TDI markets would last for several years while we expected the markets to normalize in the near term. Today’s profit warning confirms our view that the MDI and TDI markets are moving quickly to a balanced state. While the stock is now down 50% from the peak in February, we don’t see an opportunity yet. Shares are now trading in line with our EUR 47 fair value estimate.

Covestro trimmed all of its key guidance items for 2018. Most importantly, EBITDA is now expected to be below 2017 (EUR 3.44 billion) compared with previous guidance for EBITDA to be above 2017. Note that the company just increased its guidance in the second quarter, which shows the inherent volatility in the company’s commodity product markets and lends support to our no-moat rating. Other adjustments to guidance include a downgrade in volume growth to low single digit from low to midsingle digit and lower free cash flow. Free cash flow is now expected to be below 2017 (EUR 1.84 billion) compared with previous guidance for more than EUR 2 billion.

Reasons cited for the guidance downgrade include: (1) stronger-than-expected competition, (2) low water levels in the Rhine, and (3) provisions for the “Perspective” efficiency program. We would argue that stronger-than-expected competition is the primary reason for the market’s negative reaction as (2) and (3) are issues that have been previously disclosed and are well understood. By stronger-than-expected competition, we assume this is referring to new capacities entering the market with softer demand, which is in line with our thesis.

The group is trading down on Nov. 20 with all of our European chemical stocks in the red. We think this is partially due to market concerns over growth in China and lack of progress in the U.S.-China trade negotiations. We have previously highlighted our concerns with Covestro’s long-term outlook given the MDI and TDI market’s dependence on demand growth in China. In our view, global MDI and TDI demand growth will disappoint market expectations due to lower demand growth from housing and construction-related end markets in China. Consequently, we expect both the MDI and TDI markets to become oversupplied.

For details on our outlook for Covestro, please see “Covestro Has More Room To Fall” published in November 2018.