We change our recommendation on Kayan to Neutral with a new PT of SAR14.3 (vs SAR19 earlier). We had placed Kayan’s rating Under Review following weak results in the past two quarters, which raised concerns about the efficiency of the facility. We expect Kayan’s net income to decline 47% yoy to SAR895mn due to lower product prices and margins. The stock is trading at 2019f PE of 21.1x, c50% higher than the peer group average of 14.0x.
Losses are a concern: Kayan reported losses in the past two quarters after three quarters of strong profits. In 2017, Kayan completed a large debottleneck project which helped to improve operational performance, reaching an operating rate of 113% and a net profit of SAR1.7bn in 2018. In fact, after the project, Kayan recorded strong quarterly income of SAR879mn in Q2 18 and an average quarterly income in 9M18 of SAR604mn. These results indicated that operational issues of Kayan were resolved and profitability would be sustainable. However, following the decline in product prices, Kayan reported a loss of SAR111mn in Q4 18 and a loss of SAR197mn in Q1 19. This is significantly different from our estimates of profits of SAR310mn in Q4 18 and SAR203mn in Q1 19, which could indicate that strong prices masked operational inefficiencies. Although we expect Kayan to report profits going forward and sustain an operating rate of 115%, the losses might indicate the potential need for further efficiency and debottleneck programs to mitigate the impact of prices volatility on earnings.
Earnings to decline 47% yoy in 2019f: We expect Kayan to report a net income of SAR895mn in 2019f, down 47.4% yoy. The reasons behind the decline and the revision in our estimates are 1) 7.9% decline in sales on lower prices, 2) weaker gross margin of 21.9% vs 27.4% in 2018, and 3) a loss of SAR197mn recorded in Q1 19. Kayan’s profitability should improve with higher polycarbonate and MEG prices, which represent c40% of sales. This is the key stock price catalyst going forward. Polycarbonate prices declined from a peak of US$3,500 in H1 18 to US$2,100 in Q1 19 due to weak demand from China. We believe polycarbonate prices reached the bottom and prices are expected to rebound to US$2,800 in 2019f. For MEG, the outlook is muted due to increasing supply from China and weak global demand although higher oil prices may provide some price support. We expect prices to decline 25.6% yoy to US$685 in 2019f vs US$921 in 2018.