Assume you are an analyst at a brokerage firm. One of the companies you follow is ABEX Chemicals, Inc., which is rapidly growing into a major producer of petrochemicals (principally poly ethylene). You are uneasy about competitors in the petrochemical business, their aggressive expansion, and the possibility of a recession in the next year or two. In response, you compile a summary of relevant industry statistics. Your analysis suggests prices of petrochemicals produced by ABEX will likely decline over the next 12 to 18 months. Primarily for this reason, you consider ABEX's credit standing as risky. You also note that ABEX common stock recently declined from $15 to $9 per share. Because of this price decline and subsequent instability, you further extend your credit analysis of ABEX. You focus on the external environment, company fundamentals, and stock price behavior. A description of your findings follows: External environment. While uncertainty about the economy persists, you conclude the key issue for the petrochemical industry is not demand but overcapacity. As revealed in Exhibit I, polyethylene production is expected to remain flat in Year 10 and capacity to increase, causing operating rates to fall. The result is increased competition and lower product prices. In the long run you expect use of polyethylene to grow 4% per annum and prices to rise 5% per annum, beginning in Year 12. Company fundamentals. ABEX's operating income depends primarily on two businesses: pipeline distribution of natural gas (gas transmission) and petrochemical production. The gas transmission business is declining due to lower gas production and price constraints, but your outlook is for modest increases in volume and transmission rates. Your summary of key statistics for pipeline operations is included in Exhibit I. The more unpredictable component of ABEX's operating income is the petrochemical operation. Operating income from petrochemicals are sensitive to selling price, production costs, and volume of polyethylene sales. A key to estimating operating income is estimation of future prices and costs, and ABEX's market share. ABEX's management is confident their lower cost structure makes them price competitive and permits a higher capacity operating rate than their competitors. Exhibit I includes a summary of key statistics for polyethylene operations. Stock price evaluation. Some investors value companies using discounted cash flows, but you are increasingly emphasizing the quality of cash flow, earning power, yield, book value, and earnings components. You also assemble financial statements and key financial ratios for ABEX (see Exhibits II–IV). TOTAL U.S. POLYETHYLENE CAPACITY, PRODUCTION, AND PRICES
ABEX CHEMICALS, INC. Selected Key Statistics
Required: a. Identify five ratios from Exhibit IV relevant to at least one of these three areas of analysis. Discuss and interpret both levels and trends in these five key ratios from Year 7 through Year 9. b. Compare and analyze the pipeline and petrochemical divisions using three qualitative measures relevant to ABEX’s credit quality for the period Year 7 through Year 9. c. Using your analysis from (a) and (b) discuss whether ABEX’s credit quality has changed from Year 7 through Year9.