WLK + AXLL: A Deal Makes Sense – WLK Attractive Regardless

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 25th, 2016

WLK + AXLL: A Deal Makes Sense – WLK Attractive Regardless

  • There are likely consolidation benefits to a WLK/AXLL deal:
    • Chlor alkali – on the heels of PPG-AXLL and DOW-OLN, and at the cycle trough
    • Vinyls – combined entity would have a similar market share in the Americas/West Europe markets as in chlor alkali (~17%) – similar to both Ineos and Shin-Etsu
  • Portfolio integration and optionality would be much improved
    • WLK would be able to meet some of AXLL’s current spot ethylene purchases and in the event of a deal would be the logical buyer of EMN’s excess ethylene capacity. WLK only balanced on ethylene if derivatives run at 100% (unlikely)
    • Combination of the downstream vinyl portfolios could solve AXLL’s announced strategic review of its Building Products business – WLK would want the business in our view
  • The respective capital structures are well suited
    • WLK has net cash, putting the company in good position to absorb debt from AXLL, which itself deleverages without handcuffing its acquirer.
    • Strong combined EBITDA would easily fund the Axiall ethylene project and keep dry powder for possible future moves
  • Stock component of the deal allows AXLL shareholders to participate in upside of a company (WLK) currently trading at a lower multiple and with a better business model
  • WLK looks compelling even in the absence of a deal
    • Lowest EV/EBITDA multiple in our Chemicals group – Exhibit 1
    • Discounting a 20% EBITDA reduction to the commodity group average
    • FCF yield (5.6%) is three points higher than AXLL’s and compares favorably in the space
  • The main risk is the deterioration of polyethylene margins beyond what we already expect
    • We would be incrementally less positive on the deal (and the stocks) if a second bidder emerges and WLK is forced to pay up, though we see this scenario as unlikely

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

While WLK’s stock reacted very negatively to the Q4 earnings news, we have suggested in prior research that we think the price already reflects the expectation of negative revisions for 2016 and that sentiment driven weakness provides for an interesting entry point. Notwithstanding the emotional gyrations caused by the swings in oil prices, we think that the entry point is now.

However, the expectation of a weaker polyethylene market suggests that WLK’s bid for AXLL is not only opportunistic (as AXLL is suggesting) but also highly strategic. WLK would likely be buying PVC and chlor-alkali at a trough and buying AXLL assets for less than replacement cost, but at the same time it would be dramatically expanding its exposure to PVC and might well be of the belief that as polyethylene weakens, PVC might start to recover. One thing that WLK would achieve through the AXLL deal is the ability to run its ethylene plants flat out regardless of any possible weakness in polyethylene volumes. To us this looks more like a smart strategic move rather than something opportunistic. The trough in chlor-alkali and PVC, combined with AXLL’s poor operating record have created a very attractive entry point for WLK, but it is likely that value can be added on several fronts:

  • Synergies – likely a lot more than WLK is suggesting – perhaps as much as $200 million.
  • Operating improvement at the AXLL facilities – WLK is a good operator, AXLL has improved from the lows of 2014 and early 2015, but still has some ground to cover
  • Possible PVC or Chlor-Alkali rationalization – the US market for PVC is oversupplied as are the export caustic and PVC market
  • Ethylene loading – AXLL has a significant spot market exposure for ethylene and WLK will be able to use that to its advantage – if the deal is confirmed, WLK then probably becomes the only logical bidder for EMN’s ethylene capacity – at a good price for WLK and low price for EMN
  • Increased and very low cost exposure to a business at the bottom of the cycle which could offset potential weakness in polyethylene

All this suggests that WLK could pay a lot more for AXLL (probably 50% more than offered before the opportunity might begin to look more marginal). The question is whether it will need to. If AXLL can find a “white knight” it is almost inevitable that WLK will increase its bid – which of course makes it harder for AXLL to find a “white knight”. It will be interesting to see how this plays out, but if WLK can get AXLL at or around the current asking price we would be buyers of the stock today and on any further revision related weakness. WLK has screened as the most attractive small/midcap stock in our multifactor selection model for most of the last year.

Aside from the AXLL deal, WLK is very inexpensive, and likely already discounts more of a reduction in 2016 EBITDA than is likely. WLK has the lowest EV/EBITDA value in the group today – Exhibit 1 – and if you assume that the share price is discounting a move to the average of the commodity group, then it is discounting a 20% decline in 2016 EBITDA versus current consensus.

Chlorovinyls Consolidation: PPG-AXLL, DOW-OLN…WLK-AXLL?

A Westlake/Axiall combination would be the next in a series of consolidating moves in the North American chlor alkali market that started with AXLL itself (still Georgia Gulf then) acquiring PPG’s business. As industry leaders, DOW and now OLN have reduced capacity in an oversupplied market, giving the same major players a slightly smaller share of the overall capacity pie, but concentrated in fewer hands thus increasing a simple, sum of squared market shares, HHI. Given the very global nature of both PVC and caustic soda we do not believe that an AXLL/WLK combination would hit any serious regulatory hurdles.

Exhibit 2

Source: IHS, SSR Analysis

Consolidates the Vinyls Market As Well

The combined AXLL-WLK entity would have a similar competitive position in PVC as in chlor alkali, when we look at a combination of the Americas and West European market. Globally the market remains very fragmented with dozens of producers – many of them new – in Asia. A deal would bulk up the downstream portfolio and provide an answer for AXLL in reviewing its Building Products business as WLK would likely want to keep the businesses and combine with its own downstream business, which is dominated by pipe.

Exhibit 3

Source: IHS, SSR Analysis

Ethylene Flexibility

AXLL’s joint venture with Lotte gives the company substantial flexibility from an ethylene perspective, with the option to escalate its ownership percentage from 10% to 50% and the right of first refusal for any excess ethylene not consumed by Lotte itself. WLK has opted for capacity expansions rather than greenfield projects – acquiring AXLL would be a low risk way to participate here. Further optionality and additional ethylene could come from EMN – with the increased ethylene need from AXLL, WLK would become the most logical buyer of EMN’s excess ethylene capacity.

Capital Structures Well Matched

From a capital structure perspective this is a good match – WLK’s net cash balance puts it in position to assume AXLL’s debt and AXLL will not hamstring its acquirer with its obligations – Exhibit 4. The implied pro forma net debt to EBITDA ratio (assuming no synergies) is 0.5 on a trailing basis, which would be the lowest in the Chemical space.

Exhibit 4

Source: Capital IQ, SSR Analysis

Benefits to AXLL Shareholders

By virtue of receiving roughly .2 WLK shares for every share of AXLL owned, shareholders would gain potential upside in a company that trades at a lower EV/EBITDA multiple and has arguably a better business model. The market, at least, has placed more value on a dollar of WLK earnings compared to AXLL, particularly over the past three years – Exhibit 5.

Exhibit 5

Source: Capital IQ, SSR Analysis

WLK Looks Interesting Regardless

We noted in Exhibit 1 that WLK has the lowest EBITDA multiple in our Chemicals group. Current estimates would have to fall 20% to equate WLK’s multiple with the commodity group average. On a free cash flow basis, WLK does not look as strong as LYB but compares favorably otherwise – Exhibit 6.

Exhibit 6

Source: Capital IQ, SSR Analysis

Risks

The major risk here is that polyethylene margins deteriorate further and/or quicker than we already anticipate – see recent research. The emergence of a second bidder would also present a risk, as WLK might be inclined to pay up, but we do not see this as likely – we ran through several possible scenarios in a recent note.

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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