BASF – Trapped From the Inside and the Outside?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 19th, 2016

BASF – Trapped From the Inside and the Outside?

  • The Dow/DuPont deal (merging the 3rd and 4th largest chemical companies) could have a significant direct impact on BASF – the largest global chemical player (by market cap)
    • The Ag consolidation creates a formidable competitor, which if run properly could take share from everyone – including BASF
    • Dow/DuPont Auto and Electronics platforms look interesting and could also chip away at some of BASF’s business – same for building products and some packaging lines
  • Like Dow and DuPont, BASF has failed to create meaningful value in its chemical business for decades, spending more on capex, M&A and R&D than it has created in shareholder returns – despite returning its own measure of cost of capital
    • Strength from 2010 was driven by the oil and gas segment – chemical returns on assets and income have been flat despite continued investment
    • Even with oil and gas BASF has not created value over the last 10 years and without oil and gas would look similar to Dow or DuPont
  • Returns on tangible capital are falling and valuation multiples are falling with them
    • Estimates for 2016 suggest a further fall in returns and valuation looks high as a result, by as much as 15% – this would create a peak dividend yield but has happened before
    • Any cyclical benefit from higher oil prices is simply that – investors are likely not looking at BASF as a way to play higher expected oil and European natural prices
  • BASF was rumored to be interested in buying Syngenta as well as having conversations with DuPont; perhaps about Ag, perhaps about electronics or perhaps about the whole thing. It is possible that BASF feels that it needs to do something – potentially something radical
    • Capital investment has not worked in Chemicals – so chasing Iran may not be the best move
    • A large cash based acquisition will likely be taken negatively by shareholders
    • “Verbund” could become a problem as the complexity – site by site – is so great that the company loses transactional flexibility – i.e. cannot separate businesses that are underperforming and dragging down the overall results
  • We see more risk than reward in the story – would rather own DOW/DD or possible US BASF targets: EMN, ALB, FMC, MON

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

BASF looks like a very challenging investment to us over the next few years unless you believe in a sustained recovery in the oil price. The company underperforms relative to investment expectations in its core chemical business just as Dow and DuPont have for decades and is now faced with a much more significant competitor in many of its core businesses because of the Dow/DuPont merger. The Dow/DuPont deal creates potential headaches for BASF in agriculture, electronics and automotive as well as some packaging and construction end markets. For all their many historical faults, Dow and DuPont have plenty of experience integrating acquisitions, and while their track record has not been perfect we are assuming that the institutional knowledge is there and that this deal will yield stronger businesses. Even if they falter, BASF should be planning on the basis that they don’t.

BASF can ill afford to lose a couple of hundred basis points of market share in any of its main industries given the recent trajectory of chemical EBITDA and EBITDA margins which have been relatively flat despite considerable capex and a hefty R&D spend. The company barely earned its cost of capital in 2015, and absent a substantial increase in oil prices in 2016, consensus expects returns to be lower in 2016 than in 2015 – which alone suggests downside for the share price – Exhibit 1.

So faced with the usual options of build, buy, divest or hunker down we are not sure we like any!

  • Build has not worked – it has increased revenues but it has not driven real shareholder value (in our view most of BASF’s shareholder value creation of the last decade has been driven by the energy business). When you add capex to R&D spend the company is spending much more than it is returning in value to shareholders – a problem common to Dow and DuPont, but not common to all, with Industrial Gas and Coatings companies showing more positive trends.
  • Buy – it is reasonable to assume that BASF looked at Syngenta and also had some conversations with DuPont, but the company is not in a strong negotiating position and does not have the merger of equals (MOE) opportunity that Dow and DuPont have. Any deal big enough to move the needle would likely need to be a cash deal and despite the global economic malaise we are not seeing any companies that might be of interest to BASF at anything close to trough valuations. One possible exception is Eastman and while you might be able to construct a very long-term argument about Monsanto, there are some potential short-term risks and the stock would likely get punished for such a move.
  • Divest – does Verbund (strength through large scale site integration) create a roadblock here? We have seen Dow divest two businesses that were completely co-mingled with large Dow facilities – Trinseo and chlorine products – suggesting that such moves would be possible for BASF. However, the company has advertised Verbund as a strength for decades and breaking the company up would come with an admission that the strategy may not work going forward.
  • Hunker-down – this is hardly a strategy, but given the uncertainty of energy prices and the higher risk of some of the other options (such as spending $4bn in Iran), running for cash and buying back stock may create more value than anything suggested above.

We think that BASF, fearful of the likely impact of the Dow/DuPont deal, is far more likely to take one of the first two paths and we struggle with why we would want to own the stock on this basis, especially given that it already looks expensive when factoring in a likely fall in ROTC this year.

It is easier to get comfortable with the possible value creation in Dow/DuPont, although some of the early upside is gone, and we would be more interested in possible BASF targets, which would include EMN and MON, and possibly FMC and ALB, should BASF want to take the lithium route towards strengthening its electronics offering.

Lack of Value Creation – A Theme

Over the last 15 years BASF has failed to return as much to shareholders as it has spent – Exhibit 2. In this analysis we are looking at the cash spend that is controled by management ( R&D, capex, M&A and share buyback) and comparing that to the cash gain to shareholders (share appreciation and dividend). If the spending decisions are good ones, the shareholders should get a return – over the long-term the gains should offset the costs. For BASF they do not, but BASF is in good company. Its profile does however look somehwat better than either Dow or DuPont – Exhibits 3 and 4. But looks can be deceptive when taken at face value, and if we overlay the oil price on the BASF chart (Exhbit 5) we get a strong correlation, suggesting that the share price appreciation component of TSR has come from oil strength not from capex, R&D and net acquisitions. Take out the oil driven share price appreciation and the BASF chart would likely look very similar to the Dow and DuPont charts.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

To show that this is not a ubiquitous problem for the industry we include the equivalent analysis for PPG in Exhibit 6. Some of the industrial gas companies have a more positive profile, as does SHW.

Exhibit 6

Source: Capital IQ, SSR Analysis

While BASF appears to have a positive trend to return on capital over the last 20 years, the oil influence is clearly there pre-2008 and surprisingly absent since then, suggesting bigger problems in the core chemical business – Exhibit 7. When we extract the oil business from published segment data the volatility of the oil price shows up well and EBITDA/assets has declined in the core business since 2010 (flat for the last four years), despite continued high levels of investment in R&D – Exhibit 8.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

The Threat of Dow/DuPont and Others Just Makes Things Worse

In Exhibit 9 we have listed BASF’s business segments (as reported by BASF) and we have then attempted to match where Dow and DuPont compete (qualitatively) and where the merger will likely create a more formidable competitor. There are some geographic differences which will help BASF, but generally we have tried to err on the side of BASF in this table and the competitive threat is probably greater than this table suggests. Dow and DuPont are talking about revenue synergies in Ag, but we would expect them to be looking at possible revenue opportunities in materials and specialties also.

Exhibit 9

Source: Company Reports

Return on Tangible Capital Analysis Suggests the Stock Has Downside

When we look at a basket of global chemical companies and compare valuation with return on tangible capital (ROTC) – so adjusting for M&A driven goodwill and other intangibles – we see a fairly good correlation, with BASF sitting above the global based line of best fit today – Exhibit 10. We include the US chemical companies as a separate series with a separate line of best fit – nearly all have premium valuations relative to the global companies.

Exhibit 10

Source: Capital IQ, SSR Analysis

If we look at BASF’s recent “journey” we see a reasonable trend, but certainly not the nice neat progression that we showed for PPG in recent research. The oil influence and perhaps the overall strategy shows a meandering path for BASF and if we believe that consensus estimates for 2016 are correct and we believe in mean reversion, we could argue as much as 15% downside in BASF from current levels – Exhibit 11. The company has already experienced some significant negative revisions for 2016 – Exhibit 12. EPS growth expectations are well below industry average and free cash flow as a percent of net income is not impressive – Exhibits 13 and 14.

All of this leads us to believe that BASF will likely not make the hard choice of hunkering down and focusing on costs, free cash flow per share and share buyback, and will instead buy something or some things – most likely for cash. It is possible that such deals might make longer-term sense, but we cannot see how they would be viewed positively in the current envirnoment.

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis
Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

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