Since we last wrote about our investment case for Sasol in March, the company has dropped yet another bombshell to leave investors reeling – in an operating update on 22 May, Sasol indicated that its Lake Charles chemicals project, which is 94% complete, will now cost a total of US$12.9 billion. It’s the fourth time the project cost has been increased, and the second time in four months. The cost of the venture is now 45% above its original budget of US$8.9 billion announced in 2014.
MANAGEMENT CONCERNS
In general, it’s not uncommon for projects of this scale to go over budget. The world-scale cracker, which essentially breaks down ethane into ethylene, and six downstream units, are set to transform Sasol from a predominantly South African energy company to a global chemicals company. The particular reasons given for the latest overrun of US$1.1 billion do point towards poor management and execution, however.
In the update, the increases have been broadly divided into three categories:
- US$530 million relating to cost assumption changes compared to an earlier update in February. This includes a US$230 million investment allowance from the state of Louisiana which was counted twice in the budget. This is particularly concerning – how can a listed company of this size not pick up the duplication of an amount of this magnitude?
- US$470 million relating to new issues emerging since the February update. These include the knock-on costs of replacing defective steel forgings and increasing costs of finishing construction in general.
- US$300 million for contingencies such as bad weather, lower productivity and defective bolts that may need to be replaced.
On a slightly more positive note, a further two of the downstream manufacturing plants have started production ahead of the revised schedule (the linear low-density polyethylene plant came online in February). The ethane cracker, which is the main component of the project feeding its output to the downstream facilities, is still expected to be up and running by July. Of the three remaining downstream units, only the Ziegler plant is expected to see its schedule delayed by one month.
Sasol’s balance sheet will be stretched in the near term, and management therefore aims to cut all non-essential capital expenditure in the 2020 financial year. Overall, should there be no further cost overruns and/or a collapse of oil prices to below US$50 per barrel, there’s still sufficient liquidity to fund the remaining stages of the project with existing cash flows. The dividend is also unlikely to be cut.
In the update, Sasol’s management announced the sale of US$2 billion of non-core assets within the next 12 to 18 months. This doesn’t amount to a fire sale – it forms part of a larger capital review programme initiated two years ago. The sale estimate has, however, increased from the US$1 billion announced in February.
The management team also lowered its medium-term EBITDA guidance for the project from US$1.3 billion to US$1 billion in 2022. This is a result of the price forecasts used by external consultant IHS and is based on oversupplied near-term chemicals markets. The long-term view of US$1.3 billion remains intact, however.
INVESTMENT IMPLICATIONS
The financial impact of the latest cost increase translates to around R21 per Sasol share. In addition, cutting near-term chemical price expectations to reflect the views of management further reduces the value by R15 per share. The market response was more brutal in the aftermath of the update, however, with the share down by R55 (-13%), dropping to R375 per share at the close of day on 23 May. This reaction is understandable, given that the market may have been worried about further negative surprises. It does seem that further increases of this magnitude are unlikely, however, and that this time management really did throw the kitchen sink.
In our view, the update points towards a serious disconnect between executive management and what’s happening on the ground at Sasol. As our clients’ representatives, we’ll do everything in our power to keep management accountable and to make sure appropriate action is taken against those at fault.
The company’s update was disappointing, to say the least, but our long-term investment case remains intact. The cost of the Lake Charles project has far exceeded initial management estimates and has led to the expected internal rate of return decreasing further from 7.5% to 6–6.5% (depending on price assumptions used). However, this large capital outlay is now largely a sunk cost and has been included in the current price paid for the company.
Even with depressed chemical prices expected in the medium term, Sasol’s cracker project is expected to make US$1 billion EBITDA by 2022 – and similar cash flow as a result of tax rebates – translating to cash flow of around R23 per share. We anticipate Sasol will make around R65 per share overall in free cash flow by 2022. In our view, despite all the negative news, the risk-reward equation for investors remains skewed to the upside, and we’ll therefore maintain our exposure to the share.
