Chemical Deal Mania – When to Hold Them and When to Show Them

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 3rd, 2016

Chemical Deal Mania – When to Hold Them and When to Show Them

  • Last week saw another large chemical deal, with Lanxess’ acquisition of Chemtura also Praxair made it clear to investors that it was still interested in a deal with Linde.
    • In 2016 those involved in deals – completed, announced and rumored (like PX/Linde) have outperformed the group that appears to have sat on the sidelines so far – Exhibit 1.
    • Of course, we have no idea whether constituents in this group have been in discussions that have either gone no-where or are yet to be announced.
  • But it must be a bit frustrating sitting in that second group – everyone around you appears to have new “bling” to show off and you don’t.
    • You are probably under pressure from shareholders to come up with something.
    • And you are probably looking over your shoulder almost daily to see whether an activist has taken interest, particularly if you are underperforming.
  • There are lots of different drivers of the M&A that we have seen so far but the underlying message is that CEOs see a business landscape that is evolving in a less friendly direction.
    • Slower growth, lower returns than expected on R&D, greater global competition.
    • Going it alone for many does not provide the value creation opportunities that most companies saw a decade ago.
  • Unlike other cycles – most of what we are seeing is strategic, calculated and not driven by cyclical low based desperation.
    • The Axiall sale was in the latter category as have been the Chemours divestments and we perhaps see Olin falling into the same trap – forced to divest assets to pay bills.
  • Today only the ethylene players are playing their cards close to their chests and given current cash flow implied deal valuations that no-one would agree to, we are not surprised by this.
    • We expect more activity in Industrial Gas, Specialty Chems and Coatings this year.
    • Ethylene will likely be 2017 – companies need to be patient or risk paying peak values.
    • Ag may evolve because of regulatory concerns with BASF likely well placed to pick off forced divestments. FMC may also be in the mix, but could just as easily buy as sell.
    • We would own Akzo, Axalta, Linde, Air Liquide, Mosaic, Dow, DuPont and PPG.

Exhibit 1

Source: Capital IQ, SSR Analysis

Top Line Constrained

Some very experienced and very smart senior chemical industry executives are making strategic decisions today that send an implicit message that the world is evolving in a way that will make it harder for companies to create value without adapting – in some instances dramatically:

  • Monsanto would not be selling itself to Bayer if it felt that what had driven value creation at the company over the last 10 years could be repeated.
  • Praxair would not be contemplating a complex deal with Linde, likely involving significant divestments if it could find other drivers of value growth. Praxair management apparently does not have much faith in consensus estimates for 2017 and 2018!
  • Dow Chemical is on record with the view that the company could find no other strategic path that looked like it created more shareholder value than the multistage merger and split with DuPont.

In Exhibit 2 we try to frame the top line issue. Consumer strength is driving growth – innovation is a mild positive and everything else is negative. The top line drivers summarized below for Chemicals are no different for other Industrials and Materials sectors and the same slowing trend is evident – Exhibit 3. Also like Chemicals there are winners and losers depending on focus – in both Electrical Equipment and Capital Goods there are pockets of focused consumer exposure and some of those companies are doing better than the pack. If you look at the worst and best performers for the year so far – Exhibit 4 (taken from our industrials monthly), the left side is dominated by commodity chemicals and then industrial growth exposed companies – the right side is very influenced by the bounce off the bottom that the metals space has seen this year – without a pick-up in industrial and infrastructure spending we see this as a very fragile recovery.

Exhibit 2

Source: SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Options Are Limited But Obvious

In Exhibit 5 we attempt to show the options open to a management that is either unhappy with its prospects or under pressure from shareholders. It also represents a simplistic formula for any activist looking at a possible investment.

While the companies in the group on the left side of Exhibit 1 may be working on strategies and may not be “waiting for a recovery”, they are being valued as such.

The cost cutting story has worked at APD and it will work at Dow/DuPont. Others have similar opportunities and we think this is an immediate path that EMN and Akzo should follow – while also looking at the portfolio alignment option. However, PX, LYB and shortly APD confirm/will confirm that cost cutting has a limited lifespan – there is only so far that you can cut – PPG will likely reach this point within 18 months, absent another large acquisition, as will Axalta and Westlake in our view. Olin has more runway here, but does not appear to have the focus and if it remains in the “wait” group, it should continue to disappoint.

The missing arrow is the one that runs from cost cutting to large scale M&A as this is the path that PX is contemplating. Dow has done some cost cutting, some portfolio alignment and is now working on large scale M&A which will lead to more cost cutting and more portfolio management. To this extent Dow and DuPont continue to evolve – necessary as the world evolves. Only Bayer/Monsanto, some of the coatings companies and the industrial gas companies are trying to get on the same path.

The big gaps in our view are:

  • Ethylene – we think this will come
  • Aluminum – we think this will come also – post the Alcoa split
  • Fertilizers – started with POT/AGU, but we need more
  • Machinery – The consolidation opportunity is in construction, but portfolio breadth could also be a driver
  • Those subsectors of electrical equipment and capital goods where industrial demand dominates and China continues to add capacity – low end electrical – wire and cable for example
  • Engineering and construction as we come off this wave of US Gulf investment
  • Conglomerates – but we think the first move is portfolio focus in this group through divestments – as GE has done – perhaps then followed by consolation in some sub groups

Exhibit 5

Source: SSR Analysis

Chemicals Well Ahead of the Pack in Terms of Activity

Chemical deals overshadow activity in the other Industrial and Materials sectors over the last two years – Exhibit 6. In some cases the industries are already quite consolidated and this is part of the reason for the lead that chemicals has recently – E&C, Transports and Paper and Packaging have seen some major periods of consolidation in the last 15 years and Metals cannot really do much more without large cross border deals. However, many of the chemicals deals are cross border – Bayer/Monsanto, Lanxess/Chemtura, ChemChina/Syngenta, and APD’s materials sale to Clariant for example.

Exhibit 6

Source: Capital IQ, SSR Analysis

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