Many dividend investors have never heard of LyondellBasell Industries (LYB), even despite its 4.5% yield and 18.5% annual dividend growth rate over the last three years.
However, many times the best long-term investments aren’t necessarily the best known stocks.
Rather, they are boring industrial firms that toil in obscurity and supply the lifeblood of a growing world economy.
Many of Warren Buffett’s dividend stocks here fit this description exactly.
Let’s take a look at one of the more interesting high-yield dividend growth names, LyondellBasell, to see if this chemical maker may be appropriate for conservative investors looking to live off dividends in retirement.
Founded in 2005 in London, LyondellBasell is one of the world’s largest diversified chemical suppliers and refiners. The company manufacturers various commodity chemicals, as well as a number of plastic resins used in many different types of consumer and industrial products.
LyondellBasell operates five business units: Olefins & Polyolefins Americas, Olefins & Polyolefins Asia, Europe, and International (EIA), Intermediates & Derivatives, Refining, and Technology.
Olefins & Polyolefins are basically 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.
In addition to producing these valuable chemicals, LyondellBasell is also one of the best when it comes to the process of manufacturing them, which is why it’s the world’s leader in licensing olefin catalysts and catalyst production methods.
As you can see, while LyondellBasell’s business is pretty well diversified, the vast majority of its sales and operating profits come from its Olefins & Polyolefins and Intermediate Products businesses.
|% of 2016 Sales
|% of 2016 Operating Income
|Olefins & Polyolefins Americas
|Olefins & Polyolefins EIA
Source: 2016 Annual Report
Its Americas segment is the major cash cow thanks to the U.S. shale boom, which is providing lots of cheap natural gas that results in low input and power costs.
On the flip side, refining margins are under pressure due to the worst oil crash in 50 years, which is compressing refining spreads.
At first glance, LyondellBasell’s top line is volatile and may make you think the company is in trouble with two straight years of double-digit sales declines.
However, it’s important to realize that Lyondell sales are naturally volatile because of the cyclical prices of the commodities it produces.
What you really need to focus on is the company’s bottom line, which shows strong growth in operating margins and free cash flow per share over time. What explains this disconnect?
Remember that Lyondell’s profits are driven by several factors, mainly the spread between input costs and its final products.
For example, a major input cost (as well as its main source of power) for the company is natural gas, which it uses to create many of its products.
Meanwhile, the final price of its chemicals is often tied to oil prices because competitors in most foreign markets where LyondellBasell ships its products depend on oil rather than natural gas for their production processes.
So when natural gas prices are low (as they have been for nearly a decade thanks to the U.S. fracking revolution) and oil prices are high, then the company’s profits are maximized.
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 far higher and steadier than its volatile sales would have you imagine. It’s all about the natural gas-oil spread.
And we can’t forget that as one of the world’s largest specialty chemical manufacturers, Lyondell enjoys large economies of scale, courtesy of its vertically-integrated business model.
You can see that the company’s large scale, advanced manufacturing technologies (which have been developed since the 1950s), and cost-advantaged assets in the natural gas-rich U.S. have resulted in some of the best efficiency in the industry.
|Return On Assets
Lyondell enjoys not only impressive profitability, but also generally steady earnings in many different types of oil price and refining margin environments thanks to its efficient operations and spread-driven business.
More importantly for dividend investors is the fact that Lyondell has proven it can generate consistent free cash flow, which is what ultimately pays for secure and growing dividends.
Better yet, 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.
That’s due to a growing world population and rising wealth in developing markets, which creates 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.
As these large countries continue to modernize, even a small increase in polyethylene demand per capita will require new industry capacity. In fact, LyondellBasell notes in its 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 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 U.S. global plastic exports are projected to more than double from $60 billion a year to $123 billion, and LyondellBasell is poised to be one of the main beneficiaries of this trend.
However, perhaps the biggest reason to like Lyondell is that its management has proven itself to be the most shareholder-friendly of any company in its industry. You can see that LyondellBassell has returned a greater percentage of its capital to shareholders over the last five years than major rivals such as DuPont, Dow Chemical, and Celanese.
That includes a substantial buyback program which has reduced the share count by 27% in just the past four years. These share repurchases have helped to boost FCF per share, keep the dividend payout ratio healthy, and allow for strong yet still safe dividend increases.
Despite its high capital returns, management continues investing for the future. For example, LyondellBasell currently has two major projects it’s working on, representing about $3 billion in growth capex, that it expects to generate 17.6% EBITDA margins and increase overall EBITDA by about $525 million (8%) in the coming years.
While LyondellBasell has a lot going for it, there are two major risks to consider.
First, at the end of the day, LyondellBasell still operates in a commodity business, one in which its ultimate margins are set largely by the market.
In other words, there is only so much efficiency and cost cutting that management can squeeze out of operations to control the company’s profits. Many of the biggest drivers are simply out of management’s control.
The two most important things that will impact the company’s margins are natural gas prices and oil prices. This is because Lyondell’s most important product is ethylene, which is made from the natural gas liquid ethane.
In recent years, high oil prices meant that U.S. ethylene producers saw record profits. This is because high oil prices resulted in very high Naphtha prices, an oil-based plastic input that competes with ethylene.
Meanwhile, record U.S. natural gas production resulted in a massive glut of ethane, resulting in very low input costs and swelling profit margins.
The gradually growing world economy also kept demand trends stable, creating a very favorable supply-and-demand balance in the industry (especially for U.S. producers).
However, in recent years these low ethane prices have caused a boom in Gulf Coast petrochemical plants, as companies attempt to take advantage of the profitable opportunity to create some of the world’s cheapest petrochemicals and export them overseas, where prices are much higher.
This means that ethane prices are likely to rise over time (as demand catches up to supply), while persistently low oil prices could mean that Lyondell faces lower margins for several years.
As they say in commodity markets, high prices tend to cure high prices. You can see that global ethylene capacity (dark blue bars below) is expected to increase substantially over the next five years, pressuring operating rates (grey line) over the medium-term.
If demand (blue line) for these 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, be aware that much of Lyondell’s aggressive pace of buybacks has been financed by debt, as the company took advantage of the lowest interest rates in history.
This has resulted in steadily rising debt levels over the last few years.
Given that interest rates could rise from here, the company’s rate of buybacks, and thus EPS growth, will likely slow in the future.
And we can’t forget that in the event of a major economic downturn, such as 2008-2009, highly leveraged, capital-intensive industries can face major hurdles, or even bankruptcy.
In fact, LyondellBasell, which was formed by the $20 billion acquisition of Lyondell Chemical by Basell in 2007, 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 (more on this later) are nowhere near the levels that sunk the company all those years ago.
Still, given the cyclical nature of the industry, shareholders will want to keep a close eye on Lyondell’s debt levels in the future because they make up an integral component of the dividend’s safety profile.
LyondellBasell’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
LyondellBasell’s Dividend Safety Score of 73, suggesting its dividend is generally safe and dependable, and certainly one of the most secure in its industry.
Since emerging from bankruptcy in 2011, you can see that LyondellBasell has paid steadily rising dividends.
While industry conditions have admittedly been very favorable during this time period, the key to Lyondell having such a secure dividend is twofold.
As you can see, management has been careful to maintain conservative payout ratios around 30% to 40%, both in terms of EPS and FCF.
This helps provide a large cushion in case profit margins and sales decline, such as during the next inevitable economic recession.
In addition, despite the rising debt levels of the last few years, Lyondell still maintains a strong balance sheet, with low leverage ratios, a very strong current ratio, and a high interest coverage ratio.
The company’s debt maturity profile is nicely spaced out (only $1 billion of long-term debt is due before 2020), and LyondellBasell also notes it has $5 billion in available liquidity it can tap.
Given the highly capital-intensive nature of this industry, to truly understand the strength of Lyondell’s balance sheet we need to compare its debt levels to those of its peers.
As you can see, LyondellBasell’s leverage ratio is about half that of its rivals, while its interest coverage ratio and stronger than average current ratio earn it an investment-grade credit rating.
|Debt / EBITDA
|EBITDA / Interest
|Debt / Capital
|S&P Credit Rating
Sources: Morningstar, FastGraphs
This means that Lyondell’s cash flow is more than sufficient to service its debt, pay its generous, 4% dividend, and still leave plenty of flexibility to grow.
LyondellBasell’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
LyondellBasell’s Dividend Growth Score is 82 suggests that that shareholders can expect better than average payout growth in the future.
As you can see, the company’s dividend has increased at a fast pace in recent years, compounding by 18.5% annually over the last three years.
Just be aware that those impressive dividend growth rates are unlikely to continue in the future.
That’s because the company’s EPS and FCF growth rate going forward is likely to be much smaller than in the past, when the oil/natural gas price ratio (higher is better for profits) soared to unprecedented levels (from 10 to 30 between 2005 and 2012) and industry operating rates expanded.
Earnings and free cash flow per share seem more likely to grow at a mid-single-digit rate over the long-term, and the company’s dividend is likely to grow at similar rates.
However, that’s a good thing as management isn’t likely to want to push the FCF payout ratio above 50% and risk its dividend safety going forward.
Over the past year Lyondell has greatly underperformed the market, staying close to flat while the S&P 500 has generated a return near 15%.
Today, LYB’s stock trades at a forward P/E ratio of 8.0 (a large discount to the S&P 500’s forward P/E ratio of 17.7) and offers a dividend yield of 4.5%, which is higher than the stock’s five-year average dividend yield of 3.1%.
When something looks too good to be true, it usually is. In this case, the market appears to be pricing in expectations that LYB’s earnings, which have perhaps been inflated over the past year with tight supply-and-demand and a favorable oil-gas spread, could be set for a decline over the medium-term.
With that said, if one assumes LyondellBasell’s earnings per share can still grow at a mid-single-digit rate over the long-term, today’s valuation doesn’t seem unreasonable.
In fact, the stock has potential to deliver long-term annual total returns of 8% to 10% (4.5% dividend yield plus 4% to 6% annual earnings growth), about in line with the market’s historical 9.1% annual return since 1871.
However, the path certainly won’t be linear given the industry’s volatile characteristics, perhaps making LYB a less desirable income choice for conservative investors seeking capital preservation and steadier returns.
Concluding Thoughts on LyondellBasell Industries
I tend to shy away from almost all commodity companies, especially those with high debt loads, capital-intensive operations, and dependence on uncontrollable macro factors.
However, even despite its bankruptcy in 2009, LyondellBasell seems like an interesting enough business to keep on my watch list.
I like its 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 plastics over the coming decades.
Finding a safe, growing dividend that offers a 4.5% yield is no small task in today’s market, either. However, I still can’t get myself to really consider buying the stock today; at least not in one of the more concentrated dividend growth portfolios I oversee.
I worry that the boom years in terms of earnings and dividend growth could be behind the company as new industry supply enters the market over the coming years, challenging today’s tight operating rates and favorable margins.
If demand were to unexpectedly slow during this time, the stock could really get hammered (and perhaps become really interesting for value-focused income investors).
Despite many of its favorable qualities, LyondellBasell is still a rather volatile stock that is sensitive to many factors outside of its control.
Conservative income investors with more concentrated dividend portfolios might consider these 30 other high dividend stocks while they continue watching LYB for an even better pitch.