Chemicals: A 2019 Wave of M&A is looking Inevitable

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629/203.901.1627

gcopley@/asalzillo@ssrllc.com

January 2nd, 2019

Chemicals: A 2019 Wave of M&A is looking Inevitable

  • A combination of valuation lows, lack of investor engagement, changing dynamics in the energy market and limited other strategic options will likely drive a major wave of M&A in the Chemical Sector in 2019.
    • The valuation gap between smaller and larger cap companies remains high – although off its peaks – offering significant multiple arbitrage opportunities for buyers before synergies.
  • Smaller company valuations are driven as much by lack of investor interest (resource) as they are by earnings performance; with the late cycle concerns keeping investors in the skeptical camp even where there remains resource and interest in buying smaller-cap names.
    • There is an extreme range, with the cheapest smaller cap companies at less than 4x EBITDA and the most expensive large and mid-cap companies above 15x.
  • Earnings warnings from many in all cap ranges – including large caps like BASF, PPG and small caps like ASIX and IPHS – suggest a slowdown in demand and/or demand growth, such that pricing weakness is inevitable – most evident in international ethylene pricing.
    • Investors are unlikely to make anything other than a trading bet in the group until we see a defined economic bottom, something that may happen in 2019 but may be dragged out for several more years.
  • Companies cannot do much to impact PE or EV/EBITDA ratios without clear changes in strategy, aimed at maximizing free cash flow and returning that free cash to shareholders in a predictable manner – note the volatility in LYB since the strategy shift to M&A and capex.
    • For some, a buyback strategy may look like a “take private” strategy and Private Equity must be interested in certain companies today – while recognizing that earnings could slip further.
      • For some, cash for current dividend payments alone could fund a buyout (IPHS).
    • Proactive strategies are needed to outperform and these need M&A to make a difference.
  • The more obvious take out targets are: KRA, OLN (for someone with vision), IPHS, HUN, FUL, RPM and RYAM, but also possibly WLK.
    • Mergers could include: ASIX/OMN, HUN/EMN, or HUN/CE.
    • LYB should buy 1COV rather than Braskem; HUN should buy rather than sell VNTR.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Drivers of M&A in 2019

We believe that 2019 will begin an unprecedented wave of M&A in Global Chemicals in terms of the number of deals (it will be hard to eclipse the values involved in M&A in recent years given the size of the DWDP, Bayer/Monsanto and Linde deals).

The driver is likely to be an evolving willingness from C-Suite executives and boards of directors to explore alternative strategies in the wake of poor valuations and a general lack of interest in the space. Underperforming stock and option-based compensation packages should also be a driver of more “outside the box” thinking, as will shareholder pressure for change.

A meaningful cause is “Late Cycle Inertia” – the never-ending 8th innings of the economic expansion that we appear to be enjoying. Stocks are pricing in an economic slowdown, and in our view, there will be only muted investor interest until there is a pronounced downturn and we can define a bottom. The more likely scenario is that the economy keeps expanding (although maybe not as quickly) in 2019 – extending the (late) cycle and creating an environment where many if not all chemical companies remain at very low values relative to cash flow.

Separately, shrinking buyside and sell-side budgets means less focus on the peripheral stocks – more limited interest in complexity and old industry, and an inclination to ignore or index where alpha generation is expensive (in terms of resources) and not guaranteed. This makes it increasingly difficult for companies to impact PE ratios because of limited latitude within institutions to invest based on “benefit of the doubt”. The closure of hedge funds only adds to the problem as these are the risk takers that are willing to do the work to understand smaller companies. Corporates can only focus on the E side of P/E (which has always been the case) and then how best to use the cash flow.

  • A great example today would be the compelling math behind HUN buying back VNTR (Exhibit 2), despite prior statements about getting out of TiO2. This would be the right cash flow move for the company and would likely be the best use of any free cash today.

Exhibit 2

Source: Capital IQ and SSR Analysis

Another Complicating Factor: Greater Millennial influence in investing decisions – contributing to more focus on ESG and especially E and S. More limited understanding of, and interest in, old industries and more easily influenced by social media.

  • “Plastics waste is a major issue – why would you own another chemical stock” – younger PM.

Industry coverage expertise on the buyside and the sell-side is becoming more marginalized as large firms in both camps “Juniorize” and standardize offerings and methodology to control costs in a lower fee world. The MiFID II goal of creating a tier of lower cost expert sell-side boutiques appears to be failing, as there is simply not enough money to go around – much lower risk and cost tolerance everywhere. The buyside appears to see significantly more value in corporate access than third party opinions.

If you are a small to mid-cap company, what is going on is likely not cyclical, it is secular – sell-side and buy-side budgets are not going up. You need to be more focused on telling your own story – more focused on improving E and using cash in a way that will attract investors, and, most of all, doing whatever it takes to be more relevant – either to get more index inclusion or to appeal to a wider range of investors.

  • You need a good yield.
  • You need to be a consistent grower of your dividend.
  • Focus on return on capital improvement rather than dilution.
  • Think about scale – are you too small to matter – Exhibit 1.

If You are Willing to Sell, there are Buyers

Several chemical sub industries now rely on M&A for earnings and cash flow growth, as end-markets are either showing slow growth or competition and, consolidating customer bases are resulting in either lower demand (because of manufacturing efficiencies) or pricing declines that offset volume gains. Coatings, Industrial Gases, many Commodities and some Specialties have limited organic growth stories. Those with growth tend to be the first companies that get bought. Consolidation brings several levers:

  1. Synergies.
  2. The ability to retain the best in an industry where the talent pool is shrinking (mostly because of retirement).
  3. Operating synergies in like-for-like businesses – plant output rationalization, etc.
  4. Customer synergies if you can bring broader solutions to customer issues – the environment is changing such that you probably want to be the solutions provider rather than a supplier to the solutions provider. More control over value. New Dow probably has the concept right.
  5. Greater investor relevance because of the above and because of size.

M&A should be driven by adding complimentary technology as well as adding scale and synergies. More focus is required on managing market cap also – it may be cheaper to buy for cash, but a stock may do better if the float is increased because you open yourself up to inclusion in indices and larger cap investors. The small cap discount is real and heading to an extreme, where in our view it could remain.

In the table below (Exhibit 3), we show the companies included in the analysis by market cap grouping. When we began the work and set up the analysis VNTR had a market cap above 1bn. Exhibit 4 shows the multiple bands for each group from 2006 through today – using as much history as is available for each company. Note, that the chart excludes large outliers and companies with very limited data. 1>BN does not include VNTR, compared with the time series above for 2018 which does include VNTR.

Exhibit 3

Exhibit 4

Source: Capital IQ and SSR Analysis

Below we show a series of charts (Exhibits 5 through 9) that look at the multiple gap between the various market cap groups over time. We are looking first at the relative attractiveness of the very small cap group versus the larger cap groups (Exhibits 5, 6 and 7) and then the smaller mid-cap group versus its larger cap peer groups. It is likely that any target acquisition companies are in these smaller groups – hence the focus.

Note that the multiple extremes are well off their 2017 highs in all cases, but in general terms they remain above normal. There were some M&A moves in 2017 but the pressure to deal was not that high at the time as all multiples were rising. Exhibit 10 shows that 2017 was a good year for materials.

Today, the Large Cap Group has the multiple arbitrage to buy the smallest cap group (Exhibit 7) as does the smaller of the mid-cap groups (Exhibit 5). The logic is compelling for both, as the smaller cap names could be relatively attractive bolt-ons for the big guys, with minimal risk because of relative size. However, the more compelling argument may be for the smaller companies to be picked off by the group slightly larger than themselves as the deals would move the needle for the buyers far more meaningfully. Note that our market cap breaks are arbitrary in this analysis and plenty of mid-cap companies could look attractive to other mid-cap companies.

The smaller of the mid-cap groups looks more interesting to the group above it (Exhibit 8) rather than to the large cap group (Exhibit 9).

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

The charts that follow (Exhibits 11 to 14) show the data by company – current multiple, high, low, and average. We are forced to use trailing EBITDA in this work for consistency as more and more of the smaller companies either have no forward estimates or estimates that include too few contributors to be reliable. As you would expect there is a wide range of valuations within each market cap grouping.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14

Source: Capital IQ and SSR Analysis

In the somewhat ugly and complicated diagram below (Exhibit 15) we have thrown up a few suggestions with respect to possible acquisitions, mergers, and PE take-out. Some of the M&A is driven by strong industrial logic, and some by valuation – in some of the more compelling strategic ideas, valuation does not work – e.g. UAN is an expensive target for MOS or CF, but a good strategic fit for either. We are not going to discuss every option in this report – happy to do so on a one-off basis, but we tackle a couple of case studies below:

  1. LyondellBasell: There are multiple possible strategic paths for LYB and in our mind the company is probably pursuing one of the hardest today – Braskem.
    1. Lyondell should merge with New Dow, or CPChem or INEOS or several others in the basic chemical space – we do not see a “cycle free” future for this industry and scale is probably the right direction – LYB could buy rather than merge, and in addition to Braskem could look at either Borealis or Nova, or both.
    2. Downstream acquisitions – like the Schulman deal – KRA, HUN, 1COV.
    3. LYB could sell to a large refiner looking at developing a chemical strategy to consume surplus transport fuels over the next decade – see work we have published on this subject.
  1. HB Fuller: Note that any company highlighted in green is a stock we would buy today because we think a takeout is a highly likely scenario.
    1. FUL has a strategy today – integrate a large acquisition – drive synergies – drive top line though a more integrated offering – improve returns on capital. There is execution risk, but the company still has more cards to play than many.
    2. FUL has what others likely want – both EMN and CE could think about moving downstream and FUL would be a good move for either – EMN has more acquisition integration experience than CE.

New Dow is missing an adhesives platform which to us would seem important in its “solutions” based strategy towards packaging, building products, etc. BASF might have the same view. New DuPont could be a consolidator in the adhesives space.

  • We are assuming that there can be no further consolidation in TiO2 – so no strategic buyers for KRO, TROX, CC, or VNTR (except HUN for VNTR).
  • We also see no further moves in Industrial Gases – APD would need to go further “off-piste” to grow through M&A.
  • The color on KRA is supposed to suggest that it is both a strategic acquisition target and a possible PE target.

Exhibit 15