Lotte Chemical’s rise in output capacity seen to exceed local demand

This article first appeared in The Edge Financial Daily, on August 2, 2019.
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Lotte Chemical Titan Holding Bhd
(Aug 1, RM2.79)
Maintain hold with a lower target price of RM2.83:
Lotte Chemical Titan Holding Bhd (LCT) delivered a core net profit of only RM44 million in second quarter of financial year 2019 (2QFY19), not much better than 1QFY19’s RM33 million.

For the first half of financial year 2019 (1HFY19), LCT’s core net profit declined 83% year-on-year (y-o-y) to just RM77 million, mainly as a result of decline in prices for products such as polyethylene (PE), polypropylene (PP), benzene, toluene and butadiene that arose from weak Chinese demand, and the diversion of US petrochemical exports to Southeast Asia in light of China’s imposition of 25% import tariffs on US petrochemical exports.

The price declines were greater than the decline in the price of naphtha, LCT’s major feedstock, leading to a margin squeeze for all products. The margin squeeze was the smallest for PP, but was acute for PE, benzene and butadiene.

In addition, depreciation costs rose y-o-y due to the commissioning of the third PP plant in Pasir Gudang, Johor from Sept 1, 2018, while the effective tax rate rose as reinvestment allowances with respect to the plant were fully utilised in 4QFY18.

The y-o-y decline in profits came despite a higher plant utilisation rate of 89% in 2QFY19 (versus 82% in 2QFY18) and 87% in 1HFY19 (versus 82% for 1HFY18).

Petronas Chemicals Group Bhd (PetChem) is expected to start up its PE and PP plants by the fourth quarter of 2019. PetChem will commission its 900,000 tonnes per annum (tpa) PP plant, which will add to LCT’s 640,000 tpa PP plant, upon which LCT will see its market share of PP production capacity in Malaysia decline from 100% (monopoly status) to 42%.

LCT’s market share of PE production capacity in Malaysia will also decline from 50% currently (with PetChem taking the other 50%) to 30%, once PetChem commissions its 350,000 tpa linear low-density polyethylene plant and 400 tpa flexi-high density polyethylene plant at Pengerang, Johor.

We expect the increase in production capacity to be in excess of Malaysia’s domestic demand, triggering price competition between LCT and PetChem for domestic and export sales, particularly to regional markets like Indonesia.

The spot high-density PE-naphtha spread averaged US$538 per tonne in 1H19 (-27% y-o-y) and we have cut our spread assumption from US$676 per tonne to US$576 per tonne.

However, the July spread averaged US$506 per tonne, putting our forecasts at risk of further cuts. The PP-naphtha spread of US$615 per tonne in 1H19 was down 10% y-o-y, and we have left our spread assumption unchanged at US$676 per tonne, although the average July spread of only US$578 per tonne was a cause for concern.

Meanwhile, spot butadiene spread of only US$504 per tonne in 1H19 (-40% y-o-y) led us to cut our spread assumption by 15% to US$576 per tonne. — CGSCIMB Research, July 31