Covestro's Q1 2024 earnings call presented a narrative of cautious optimism. Volume growth is back, indicating recovering demand and the company's successful resolution of internal production issues. However, low margins and negative pricing deltas persist, impacting the company's full-year guidance. While this dominated the analyst discussion, a hidden gem within the transcript may reveal a far more exciting story: Covestro's stockpile of tax loss carryforwards.

During the Q&A, CFO Christian Baier revealed that Covestro has amassed a staggering €3.6 billion in tax loss carryforwards, a figure representing almost 30% of the company's current market capitalization. These carryforwards, Baier explains, do not expire, offering a potent shield against future tax payments as Covestro's German operations return to profitability.

This revelation was met with intrigue, as the sheer size of the carryforwards raises the question: is Covestro's current valuation adequately accounting for this substantial tax advantage?

Potential Impact of Tax Loss Carryforwards

To illustrate the potential impact, let's consider a hypothetical scenario. Assuming Covestro's German operations generate a pre-tax profit of €500 million annually (consistent with mid-cycle performance) and using Germany's current corporate tax rate of roughly 30%, the company would ordinarily face a tax bill of €150 million. However, the tax loss carryforwards effectively negate this liability, boosting after-tax profits by a substantial 30%.

Projecting this impact over a five-year period, Covestro would pay €750 million in taxes on a €2.5 billion cumulative pre-tax profit without the carryforwards. With the carryforwards, the company could effectively retain this entire sum, significantly bolstering free cash flow and potentially supercharging shareholder returns.

Emerging Market Growth vs. Greater China Revenue

The following chart illustrates the potential positive impact of the tax loss carryforwards on Covestro's net income over a five-year period.

A Bullish Outlook?

This potential scenario suggests a more bullish picture than Covestro's current valuation might imply. The market, focused on short-term margin pressures, may be overlooking the long-term value creation potential within these tax loss carryforwards. They represent a substantial call option on a German economic rebound, potentially enabling Covestro not only to recover, but to thrive as profitability returns.

Of course, this scenario depends on several factors, including the speed and strength of the German recovery, Covestro's ability to maintain its cost leadership and market share, and the potential impact of the ongoing discussions with ADNOC. However, the tax loss carryforwards add a new dimension to the investment thesis, potentially accelerating the company's path to its mid-cycle targets and transforming what appears to be a recovery story into a potential growth play.

Adding to the intrigue, Covestro has a track record of strategically deploying cash flow, including a recently completed €200 million share buyback program. The company is also pursuing a strategic shift towards higher-value specialty products, further enhancing its long-term earnings potential.

Conclusion

As investors grapple with uncertainty surrounding the macroeconomic environment and the ADNOC discussions, Covestro's massive tax loss carryforward stockpile may prove to be the wildcard that rewrites the narrative. While the market focuses on short-term turbulence, savvy investors may see an opportunity to capitalize on a company poised for a potentially explosive surge in profitability.

"Fun Fact: Tax loss carryforwards are a valuable tool for companies that have experienced losses. They allow companies to offset future profits with past losses, reducing their tax burden and increasing cash flow. Think of it like a rainy-day fund for businesses, helping them weather economic storms and emerge stronger on the other side."