Jack McKay sends: Methanex (NASDAQ: MEOH) is a Canadian-based company engaged in the production and distribution of methanol. Methanol is a chemical compound with formula CH3OH (often written MeOH) and is a commodity. Methanol is used for a variety of applications. According to Wikipedia, Methanol is used mostly in making other chemicals - some 40 percent of methanol production is converted into formaldehyde, which in turn is used for diverse products such as paints, plywood, and plastics. Methanol is used as a fuel, fuel additive, and an input in the biofuel process. Methanol is also used as a chemical solvent, antifreeze agent, and a food source for denitrifying bacteria in wastewater treatment plants. Because methanol can be converted into gasoline as well as ethylene and propylene (two important chemicals usually derived from petroleum) increased production of methanol will be both desired and necessary as fossil fuel reserves are depleted and governments provide incentives for use of fossil fuel alternatives. Methanex shares have traded between $20 and $31 over the past year, and currently trade for $26.56.

Methanol Inputs
Just as methanol and methanol-derived products will be of great demand in the future, the inputs to methanol production may also increase in price. Currently, methanol is mainly derived from fossil fuels (coal and natural gas), although alternative methods of methanol production area possible. According to Wikipedia, “Although conventional natural gas resources are currently the preferred feedstock for the production of methanol, unconventional gas resources such as coalbed methane, tight sand gas and eventually the very large methane hydrate resources present under the continental shelves of the seas and Siberian and Canadian tundra could also be used. Besides methane all other conventional or unconventional (tar sands, oil shale, etc.) fossil fuels could be utilized to produce methanol.”

Methanex Production
When Methanex’s plants are operating at full capacity, Methanex makes most of its methanol in Chile (~60 percent of 2006 production, ~45 percent of 2007 production). Methanex has several facilities in Trinidad, and a facility in New Zealand.

Methanex’s Chile plants are the problem children, so we’ll start with the others. In Trinidad (Atlas and Titan plants, per chart above), Methanex operations are going swimmingly. According to the 4Q 2007 report, “Our methanol facilities in Trinidad represent over 1.9 million tonnes of low cost annual capacity. These methanol facilities continue to operate well and operated above design capacity during the fourth quarter of 2007. Our Atlas methanol facility produced 278,00 tonnes, or 104 percent of design capacity, and our Titan facility produced 220,000 tonnes, or 104 percent of design capacity.”

The New Zealand facility has capacity for 530,000 tonne per year of production. Maintenance on the facility was performed in Q4 2007, so only 57% of capacity was realized. This maintenance ended November 2007 and is not an issue going forward. Methanex has secured ample natural gas supply (used in the production of methanol) to allow production through mid-2008. Methanex stated in its Q4 2007 report that they are in discussions to procure enough natural gas to extend production at the current facility or begin operations at a larger (900,000 tonne per year) New Zealand facility. Methanex’s comment on New Zealand operations in January was: “The future of our New Zealand operations continues to be dependent upon methanol industry supply and demand and the ability to secure natural gas on commercially accepted terms.”

Methanex’s Chile plants have a quarterly capacity of 960,000 tonnes, but production since June 2007 has been curtailed due to natural gas supply issues. 60 percent of natural gas used at the Chile facilities has been imported from Argentina. However, while Methanex believes its Argentinean natural gas suppliers are producing sufficiently, the company says it believes that key pipelines in Argentina are full. No natural gas from Argentina has reached Methanex since June.

When the Chile plants are operating at full capacity, 40 percent of natural gas supply comes from within Chile - mainly from the Chilean state-owned energy company and one private company. The Chilean state-owned energy company has also been unable to provide Methanex with expected natural gas supply because of “deliverability and production issues,” however both companies provided Methanex with more natural gas in 4Q 2007 than 3Q 2007. Methanex is working closely with its Chilean suppliers to sponsor increased exploration and production of natural gas in Chile at locations near Methanex’s plants.

Methanex currently has reached financial close on a project to build a 1.3 tonne Methanol facility on the Mediterranean Sea in Egypt. Commercial operations are expected to begin in early 2010. Methanex has 60 percent interest in the project, but will purchase and sell all methanol from the facility.

Methanol Pricing
Currently, methanol prices are slightly down from multiyear highs set in December 2007, but are still relatively high and the multiyear pricing trend is positive. The current global energy and materials boom has contributed to the positive trend.

Methanex issued a substantive commentary regarding the effect of worldwide supply additions, high energy prices, and growth in China on long-term methanol pricing in the 4Q 2007 report:

“During 2008, we expect additions of approximately 1.7 million tonnes of methanol capacity outside of China. The next increment of world-scale capacity is a 1.7 million tonne per year plant under construction in Saudi Arabia and we expect product from this plant should be available to the market in the second half of 2008. We also believe that global methanol demand growth combined with the potential shutdown of high cost capacity as a result of high feedstock prices could offset this new industry supply during 2008. We believe global demand for methanol for traditional uses remains healthy and is underpinned by high growth rates in China and high energy prices. We believe that high energy prices are positive for and are currently supporting healthy demand for energy related derivatives such as dimethyl ether (DME) and fuel blending, biodiesel, and MTBE. We believe methanol demand in China will continue to grow at high rates as a result of very strong traditional demand driven by high industrial production growth rates and additional demand related to non-traditional uses for methanol such as gasoline blending and DME. We also believe that there is increasing pressure on the cost structure of the Chinese methanol industry and the cost to export as a result of escalating feedstock costs in China, the continued appreciation of the Chinese currency and a decision by the government of China to reduce tax rebates offered to Chinese exporters of methanol during 2007. At the beginning of the fourth quarter of 2007, China was a net importer of methanol. However, in the current environment of very high methanol prices, we believe China has the incentive to operate at higher production rates and export methanol and that towards the end of the fourth quarter, we believe that imports have been reduced and exports have increased. We believe in a lower price environment substantially all domestic methanol production in China will be consumed within the local market and that imports of methanol into China will grow over time.”

Financials
Even as Methanex has encountered natural gas supply constraints in New Zealand and (more severely) in Chile, the company has sustained its profitability.

Revenues have increased from $1.66 billion in 2005 to $2.11 billion in 2006 to $2.27 billion in 2007. Revenue in the latest quarter, 4Q 2007, was a strong $731 million. Earnings have grown from $164 million in 2005 to $483 million in 2006 to $376 million in 2007. Cash flow metrics reduce some of the variability of earnings and provide better insight into the company’s finances. Operating cash flow rose from $359 million in 2005 to $469 million in 2006 to $527 million in 2007. Ignoring construction costs ($202 million in 2007, $21 million in 2006; most or all costs related to the Egypt venture) free cash flow was $427 million in 2006 and $451 million in 2007. Including all capital expenditures (including construction costs), free cash flow would be $225 million in 2007 and $430 million in 2006. I make the capital expenditure distinction because the capital expenditures related to the Egypt venture are not necessary to sustain Methanex’s business. While the costs incurred in the construction of the Egypt plant are very real (and Methanex has capitalized their expenditure), the Egypt venture is a long-term positive for Methanex and the near-term cash flow effect otherwise obscures Methanex’s free cash flow generating ability. Methanex’s three-year financial summary is shown below.

Methanex has a current market cap of $2.6 billion. Management focuses strongly on building shareholder value, and has reduced the share count from 125.7 million to 98.31 million over the past 5 years. Methanex has a dividend yield of 1.9%. Methanex has cash of $488 million and debt of $582 million.

Conclusion
Methanex has a trailing operating cash flow multiple under 6x and a trailing free cash flow multiple under 7x when excluding Egypt costs. Such low cash flow multiples are not deserved because Methanex will likely increase future production through easing of natural gas supply constraints and (longer term) the new methanol plant in Egypt while potential negative effects of downward methanol price movements are mitigated by hedging and made unlikely by the projected increase in demand for methanol. I originally purchased Methanex in January when shares had fallen to $22. Shares have since risen to over $26 today. Methanex is a buy for investors focused on long-term share price appreciation because of its strong fundamentals and cash flow generation ability.

Key Stats:
Market Cap: $2.60 billion
Trailing Earnings: $376 million
Trailing Operating Cash Flow: $527 million
Trailing Free Cash Flow: $451 million (excluding Egypt venture costs)

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Disclosure: I own shares of Methanex.