Does Titan's profit depends on oil price?

Some analysts worried about the profitability of Titan due to the rising oil price. On the other hand, the Titan's management always claimed that the company's profit doesn't affected by oil price, but the supply-demand condition of plastics which will determine the polymer-naphtha margin (the price spread between its product and feedstock).

To check whether the management's statement is true, I've done some research on the historical naphtha price, polymer price, and crude oil price. The following chart show the relationship between polyethylene-naphtha margin and oil price from Jan-2004 to Nov-2007:

source: http://www.plastemart.com/

* The prices shown above are international prices in our region. The exact prices of Titan's may not be the same as the above, but shouldn't be much different (within 5%).

From the graph, we can see that the oil price has been rising from about USD$30 to about USD$90 per barrel during this period. Naphtha price moved exactly in the same trend. Polyethylene's price also changed in similar way, but sometimes experienced a time-lag of 1~3 months. When this happened, the PE-naphtha spread will temporarily move in the opposite direction to the oil price, then will back to the normal level when the PE price catch-up with naphtha.

(Example: during Sep~Nov-2006, the oil price dropped from $80 to $60, the PE-naphtha margin temporarily up from $650 to $850 per tonnes. During Jan~May-2007, the PE-naphtha spread drop from $800 to $600 while the oil price rise from $65 to $85.)

As a whole, although there's some short-term volatility, the average PE-naphtha spread remain quite stable during 2004 to 2007, while the oil price has risen for almost 200%. In fact, it showed a slightly upwards trend during this period.

So, it's quite clear that the profitability of Titan doesn't affected by the rising oil price. Instead, Titan's profit is highly depend on the Polymer-naphtha margin, which in-turn depend on the demand-supply condition of plastic market. Seeing that the world's polymer capacity is growing with a slower rate than the demand for plastics, the outlook for polymer-naphtha margin will be quite positive in the near future.

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[updated 29/10/2008]: Those who interested to view the more updated version of the polymer-naphtha-spread chart , please visit here. In the document, I had also included a worksheet showing the correlation between oil price and Titan's quaterly report. I'll update the document from time to time.

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Reasons investing in Titan

I start accumulating the share of Titan Chemical since early 2007. The average cost per share is about RM1.60. In this article, I will list down the reasons I decided to invest in this company.

1. Simple (Single) Business

The main business of Titan Chemical is production of polyethylene (PE) and polypropylene (PP). These products are what we generally call 'plastics'. Basically, it takes the raw materials e.g. naphtha and natural gas, breaks them into small unit of monomer, then combine those monomer become polymer substance.

During its expansion, Titan Chemical always stick to its core business. Last year, Titan acquired an Indonesian company named PT. Petrokimia Nusantara Interindo, which is then renamed to PT. TITAN Petrokimia Nusantara. PT. Petrokimia was the largest PE producer in Indonesia.

2. Leader in polyolefins industry

When Titan start its operation around 1990, its was the pioneer in petrochemical industry of Malaysia. Then it became the largest polyolefins manufacturer in our country. In recent years, Titan has gain about 50% share of our domestic PE and PP market.

Its newly acquired subsidiary, PT TITAN now holds about 20% of the domestic PE market share in Indonesia. After the acquisition of this subsidiary in 2006, Titan has now become the largest polyolefins producer in South East Asia (in terms of production capacity). With its economical scale, Titan can keep a low cost without compromise to quality.

3. Good Management Team

The founder of Titan, Datuk T.T. Chao, a Taiwanese, is a pioneer in the global petrochemical industry. He has built several successful business across continents of Asia and America in his 50-years entrepreneur-life. Let's have a look at his 'resume':

• In the mid-1950s, Chao was a co-founder of Taiwan's first polyvinyl chloride (PVC) business.
• In 1960's, he established China General Plastics Group, which included a number of the premier publicly-held petrochemical and plastics manufacturers in Asia.
• in 1980's, he entered the North American petrochemical industry with the acquisition of a polyethylene plant in Sulphur, Louisiana, and the creation of Westlake Polymers Corporation. (now listed on New York Stock Exchange)
• in late 1980s, he founded the Titan Group in Malaysia by building the country's first and largest integrated petrochemical complex in the state of Johor.
• in 1990's, he founded a joint-venture company consisting of a PVC resin plant and downstream calendering plant near Suzhou - Suzhou Huasu Plastics CO., Ltd.(SHPC)

Due to his outstanding contributions to the petrochemical community, he received the Petrochemical Heritage Award from the Chemical Heritage Foundation in 2005.
(press released: http://www.chemheritage.org/press/pr2005/pr_05_jan_17.htm)

Today, Titan Group is led by Mr. James Y. Chao (son of TT Chao). He has more than 30 years experience in petrochemical industry, and has assisted Datuk TT Chao in the founding of Westlake Goup, Titan Group and SHPC. Besides acting as the executive chairman in Titan, he is also the chairman of Westlake Group and Suzhou Huasu Plastics Corp.

Titan's former managing director, Mr. Donald Marion Condon, was named the American Express-Business Times "Malaysia CEO of the year" in 2005. He's re-designated as a director of Titan last year. Titan's present MD (appointed last year), Mr. Thomas Patrick Grehl also has 25-years experience in chemicals industry.

4. Profitability & Growing Potential

Despite the escalating oil price since 2004, Titan's profit keep growing during the same period. The raw material of polyolefins (naphtha) is a refined product from crude oil. Thus, the price of naphtha normally moves in conjunction with crude oil's price. The selling price of polymers will normally following the same trend, but a few months lagged behind. Hence, though the profit margin may become lower when the oil price is in a uptrend, it will be improved later.

More than half of Titan's production is for exportation. Among its customers, China is the biggest market, accountable for about 20% of its revenue. This is big positive sign for me. Firstly, being the fastest growing economic entity in the world, the demand for plastics in China is increasing in a higher rate than other countries; and Titan already enter into this market. The more important point is, Titan's production cost is lower than the China's local manufacturers. Thus, its selling price is competitive while having a sustainable profitability.

(This sounds impossible, but it's true. Besides its economic scale, one reason that Titan has a lower cost is because it is a pioneer in this industry. Titan's start-up cost is much cheaper because its plants are constructed 20 years ago. The new competitors today facing a much higher construction cost due to the high steel price.)

Currently, Titan's has a butadiene extraction plant and a propylene plant under construction, and is going to be completed soon. These two new plants is scheduled to test-run in Dec-2007, and their capacity is able to raise Titan's revenue by about RM1 billion (20%) next year. On the other hand, Titan's business in Indonesia is improving. I believe that its subsidiary (PT Titan) is going to turnaround soon, and begin to make positive contribution to Titan. And, Indonesia's market will provide a great growing potential for Titan in long term.

So, although the oil price is likely to keep rising, I believe that Titan will keep making bigger profit with the continuous expansions, coupled with its great operation and procurement strategy.

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I think Titan is undervalued at a share price of RM1.60. I decided to buy its share at this price due to the following considerations:

• The price is lower than its net asset value. (RM1.90 per share)
• The P.E. is lower than 7.0, based on its earning per share FY-2006 of 24 sen. (excluding the profit in the acquisition of PT Petrokimia)
• Its profit after tax will grow with a rate of 10 ~ 20% p.a. in the next few years, if the crude oil price is stabilized. (the grow rate will be higher if the oil price fall).

when the oil price fall back to a normal level, Titan's profit and its share price will rise dramatically . (I don't know when it will happen, but i really don't think the high oil price is sustainable). My own estimation, my investment in this counter will be three to five years.

AKN - My short-term investment.

I start accumulating AKN's share since March-2007. Now it is accountable for about 23% of my portfolio's value. My average buying price is RM0.51.

I noticed this company in early 2006. At that time, its share price is about 40 sen, very low compared to its historical prices in years 2002 ~ 2004 (around RM5) . The share price was so low because it's been suffering loss for two consecutive years. And the share price was lower than half of its net asset value.

So, I keep an eye on it. After one year studying and monitoring it, I decided to buy its share and keep it for about one or two year. (that's considered a short-term investment for me).

Here's my observations on AKN before coming into the buying decision:

AKN was a good company, manage to generate a stable income in many years during the past. Its share price fell deeply in 2005 due to the huge loss it suffered in that year. (about 80 sen per share). This loss was mainly aroused from two factors:

1. There's a fire incident on Jun-2005, destroying one of its operation premises located at Penang. This had cause damages to the machinery and ceased the factory from operation. Thus, the company had to out-source its operations to external parties, to meet the custormers' delivery orders. This has cause a big lost to the company due to the high cost of out-sourcing. As a result from this, the factory's operation had been temporarily stopped since 2006. also, The company had to compensate the factory's staff and workers who had loss their job.
2. The design, development & distribution division (DDD division) of the company, which is based in China, was suffering loss due to the tough competition from China's local companies.

The loss from the fire incident is big. But this is obviously an one-time-event, and shouldn't have any continuous impact in future. On the other hand, the loss suffered from the DDD division, though is much smaller, is likely to be a sustainable one. So, we had to see how AKN's management deal with this.

AKN's management had taken some steps to rationalise its operation since 2004. Among those rationalisation processes, I think the following two steps are the most important:

1. Winding-down the lost-making DDD division. The company's management had decided to dispose the subsidiaries under this division, and exit entirely from the related semiconductor chip & software business.
2. Acquisition of a new subsidiary, named Paramount Discovery Sdn Bhd - a company that provide polymer coating solutions for the production of powder-free gloves.

Firstly, to discontinue the operations of DDD division is a wise decision. This will free the company from the continuing loss of the subsidiaries under this division, and at the same time the cash generated from the disposition can help the company to reduce its dept. (hence, reduce financing expenses of the company)

Then, the acquisition of Paramount Discovery Sdn Bhd make the company venture into the strong-growing latex glove industry. Unlike the semiconductor sector, (in which most other subsidiaries of AKN are involved), latex-glove industry is almost unaffected by economical cycle. Paramount Discovery will generate a stable growing income for the company in the future years.

After the rationalisation, the company has turn-around successfully in the FY-2007 (ended March). That's the time I start buying AKN's share.

Here's some figures that make me feel safe to buy AKN's share at about 50 sen:

• the buying price is only half of its net asset per share (about 90 sen).
• Its loss-making division is to be disposed soon. The earning from Paramount alone, when reflected on its income statement, will be about 10 sen per share. Together with the earnings from other subsidiaries, AKN's P.E. ratio will be less than 5.
• After the rationalization plan, AKN's main business concentration is now switch from semi-conductor industry to glove industry. (The Paramount's earning now accountable for the highest portion of AKN's income.) Latex-glove industry is a sector that I'm quite familiar with, as compared to the semiconductor business. And, I'm very optimistic about the future growth of latex-glove industry in Malaysia.

So, I'm confident that AKN's performance for the FY-2008 will show a strong improvement from the previous year. (earning per share will be around 12 ~ 15 sen, I think). By then, its share price may rise to about RM1.50. I'll cash out my profit at that time, and put my money back into some long-term-investment counter.

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[updated 10/7/2008] : I had sold all my AKN in July-2008. For the reason of selling it, please read my post "selling stock".

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