If there ever was a right time to make predictions, now would be about the time. Since Q4 of last year, the global economy has come back from the brink, demand has stabilized, and stock prices have made a huge comeback, anticipating a further improvement in business. So what’s next? Are we well on our way to a V-shaped recovery, or could we be on the brink of another downturn – the second leg down in a W-shaped recovery? Does it even matter? Interesting to note that the debate is definitely about a recovery – just in what form.
In Bob’s presentation, we’ve already seen some of the V-shaped recoveries in key indicators like industrial production. Here’s a chart of the ICIS Petrochemical Index, or IPEX, showing a V-shaped recovery in petrochemical prices worldwide – from North America to Europe to Asia. Here you can see the absolute collapse in Q4 2008 as demand fell off a cliff and inventory destocking happened on a massive scale. Starting in March, the IPEX posted 7 consecutive quarters of gains, before falling a bit in October as ethylene, propylene and benzene prices dropped in Asia.
Now I had thought I may have coined a clever phrase with “Volkswagen Syndrome” describing the debate about a V- or W-shaped recovery. But some of you might have heard this term before. Upon further research… here’s what I found. Now bear with me guys! The term “Yellow Volkswagen Syndrome” describes the phenomenon of when bringing something to mind seems to bring it into your field of vision, and often. So say if you’re driving on the road and look out for Yellow Volkswagens, you’ll notice there are a lot more of them. And the “Volkswagen Syndrome” is apparently a dated metaphor for “when scientists make assumptions about similarity based only on appearance.” This stems from the Volkswagen Beetle coming out with the same shape year after year from the 1940s to 1970s, despite significant changes under the hood. Looks the same, but it’s different! Isn’t Google wonderful? You may have noticed I got this second one from something called “Intimate Strangers” – it’s not what you think. It’s actually a book about microbes. Now I think both metaphors can be applied to the debate about today’s economy. In the first instance – the “Yellow Volkswagen Syndrome” - because we’re looking for signs of recovery, and the recovery is the number one topic on Wall Street as well as Main Street, we notice they are everywhere – or at least more apparent. Not that there’s isn’t real fundamental improvement in the economy, but we’re going to notice it more. That’s part of what’s driven the stock market.
In the second instance – the “Volkswagen Syndrome” – where things might look the same but are fundamentally different, people today are also making assumptions about the recovery, especially in stock prices, based on similarities to earlier patterns. The sharp rise in the Dow Jones Industrial Average from its March low had mirrored that of 1929-1930 when it recovered half the losses from the crash before falling again to new lows by 1932. When the Dow recovered 50% of its losses earlier this year, you heard comparisons to 1930. But the Dow kept on rising to regain about 60% of its losses today. So now you might hear comparisons to 1938, when the Dow also recovered about 60% before falling again and zigzagging to a 1942 low. Things have been very volatile lately, with 100-200 point daily swings in the market – it feels like the market is trying to decide which direction the next major leg will take.
Now let’s look at stock prices in the chemical industry – they’ve had a massive rebound off their March lows. For 2009, the S&P Chemical Index is up 40% as of mid-October, doubling the overall broader market S&P 500’s rise of 20%. From its low in early March, the S&P Chemical Index is up about 70% versus 63% for the S&P 500. Many chemical stocks have doubled, tripled or more off their lows. Dow Chemical at about $26 has more than quadrupled from its low of below $6, while DuPont has had a more modest doubling to about $34. We know stock prices have gone up and the market is enjoying some stability with sequential gains in sales and profits through 2009 – not just in chemicals but throughout other sectors as well. But there is now widespread concern about the general economy, unemployment in the US in particular, the weak US dollar, persistent weak auto and housing markets, and looming defaults in commercial real estate. So many expect the economy and stock market to turn down sharply as it has several times in the past. But as with the Volkswagen Beetle, let’s now look under the hood.
There are several factors pointing to a sustainable recovery for the chemical industry. Major economies are coming back, with growth being led by the BRIC countries once again – mainly China, India and Brazil. Industrial production is on the upswing worldwide. In the US, the weak dollar is providing a boon to exports as well as the profitability of US multinationals that have significant sales abroad. An encouraging sign was third quarter earnings, where companies continued to report sequential profit improvement and CEOs were mostly optimistic on business conditions going forward. Also, the stock market overall has improved dramatically, signaling confidence. On the negative side, unemployment is high and continues to grow, and will hit double-digits soon. That’s important because consumer spending accounts for around 70% of US GDP. Plus there are still worries about housing prices, foreclosures and now, looming commercial real estate and consumer credit defaults. But if you’re looking at leading and lagging economic indicators, note that the stock market typically leads a recovery, while employment lags.
Here’s a chart from American Chemistry Council chief economist Kevin Swift – looking at Global Industrial Production, as well as something called the OECD CLI + 6. What is the OECD CLI + 6? Well the OECD CLI is a composite leading indicator for developed nations. But the OECD has also developed CLIs for a group of 6 OECD non-member countries such as Brazil, China, India, Russia, Indonesia and South Africa. These leading indicators are focused on industrial activity and designed to provide early signals of major turning points between expansions and slowdowns. You can see that the OECD+6 is flagging a strong V-shaped recovery for global industrial activity.
Let’s look at earnings forecasts for 2010. Here is a list of projected earnings per share for the publicly-traded US chemical companies from Wall Street analysts. Just about across the board analysts expect earnings to recover strongly in 2010 over 2009 levels. The industry has been subject to volatile swings as 2009 profits will fall dramatically from 2008 levels. Profits will rebound sharply in 2010, but we won’t be back to 2008 levels yet. Stock prices have rallied sharply off their March lows. If you look at the valuations based on expected 2010 earnings, the sector looks pretty fairly valued at a P/E ratio of about 15x. It’s the same 15x multiple as the S&P 500. There could be further upside, but there fewer screaming bargains. Investors have to be increasingly selective.
Even though the earnings outlook is on the up and up, there is another important theme to highlight. And that is, there is a real dichotomy in the chemical industry today – you have one group of companies that have unprecedented opportunities and another that is facing limited options. On the one hand, you have companies that overleveraged themselves through the heyday of M&A and LBOs and are now under water, having declared bankruptcy or being forced to renegotiate terms with their lenders. On the other hand, you have companies that have come through the downturn with strong cash flows and solid balance sheets, and are fully prepared to capitalize in a time of turmoil.
From the late 1990s up to early 2008, there was a building frenzy of LBOs, record M&A activity and stock buybacks. Private equity really emerged as a major force in chemical M&A in 1999 and continued to be a big player through early 2008. Activity peaked in 2006 with private equity buyers accounting for 36% of the total M&A dollar volume, according to investment bank Young & Partners. Plus M&A activity had been strong for a number of years and peaked in 2007 with $55bn in deals. Debt financing was plentiful, loose and cheap – and banks were taking on almost all the risk – big risk for little reward. And lastly, public companies continued to buy back billions of dollars in stock, often financed with debt.
So as a result, today there are many more highly leveraged companies than in the past. According to John Rogers, the head of the chemical group at credit ratings agency Moody’s, out of 70 North American chemical companies under coverage, a full 2/3rds are in the high-yield (or junk) category – this compares to less than 1/3 at the end of 2001. There were even more junk-rated companies earlier this year, but as they went bankrupt, the ratings were removed. Standard & Poor’s downgraded the credit ratings of 28 companies year-to-date versus only 6 upgrades. Most happened in the first half of the year. Today, there are 30 companies in the B or CCC categories – this indicates very high leverage. Much of the chemical universe is still drowning in debt. Highly leveraged companies with debt coming due have 3 escape options – 1. declare bankruptcy, like LyondellBasell, Chemtura, Tronox and Arclin, 2. sell out, as NOVA did to the Abu Dhabi investment fund, or 3. Strike a deal with lenders to swap debt for equity or renegotiate terms. Georgia Gulf did a debt-for-equity swap, while INEOS renegotiated debt terms.
Here’s a list of chemical companies that have gone through LBOs in past years. These companies are all highly leveraged. And for a company to be considered highly leveraged, it typically has a debt/EBITDA ratio of about 4.5x or above. Many chemical companies that went through LBOs had debt/EBITDA levels up to the 10x range – and that was back in 2008! These stats are from 2008 – couldn’t get an update from S&P – but you can be sure these leverage ratios are much, much higher today. Many of these companies have their hands tied behind their backs when it comes to making investments – whether it’s capital investments, R&D, or acquisitions.
So there are a lot of bad apples out there. But it looks a lot better for a select group of companies. Here are the ones with the A-rated balance sheets. Companies that are in great financial shape with low debt levels include DuPont, Air Products, Monsanto, PotashCorp, PPG Industries, Praxair, Sherwin-Willimans and Sigma-Aldrich. These companies have weathered the storm and will have the pick of the litter when it comes to acquisition opportunities.
Credit ratings are good to look at, but so is another important measure – and that’s Free Cash Flow, or FCF. Free Cash Flow is defined as cash flow from operations minus capital spending minus dividends. Laurence Alexander, chemical analyst at Jefferies & Co., recently did a comprehensive 126-page analysis on free cash flow in the industry. Why is free cash flow so important? As Alexander puts it: “Free cash flow is the best measurement of management’s freedom of action. A firm with negative FCF will have difficulty maintaining current operations without selling assets, issuing debt or issuing equity. A firm with positive FCF can invest in future growth, reward shareholders, reduce liquidity risk or preemptively fund pension plans.”
Here are some of the results for estimated 2010 FCF from Jefferies & Co. Note that these are only of the publicly-traded companies – not the private companies, many of which are saddled with high debt. Notice that some of the names at the top with higher-than-average projected free cash flows are also the same ones with the A-rated balance sheets – DuPont, Monsanto, and Air Products. The companies with positive free cash flow are going to have the financial flexibility to take advantage of opportunities – doesn’t guarantee success, but at least they’ll have a shot. But to be fair, this absolute measure is more favorable to the larger companies. You could be a good mid-size company and never be able to generate the $500m in FCF of a DuPont.
So here’s a look at Free Cash Flow as a percentage of sales, measuring the efficiency of companies when it comes to generating free cash. At the top we have smaller companies like Lubrizol, Solutia and Albemarle as well.
Let’s get back to the dichotomy. Nowhere has this been more apparent than in the financing market. The investment-grade companies with strong balance sheets are able to borrow money where most junk-rated companies are not. You’d think that would be a no-brainer – but it simply has not always been the case. In past downcycles, even leveraged companies were able to refinance and have access to credit, despite deterioration in credit quality. But it’s been different this time around. The industry faced the double whammy of falling profits AND a frozen financing market.
Let’s look at debt issuance through the first 3 quarters of 2009. In January, after a months-long silence in the financing market, kicked off by issuing $500m in debt, but at a much higher rate – it will pay a coupon of almost 9% versus its previous rate of 4.625%. Then Cytec Industries in July raised $250m, paying 8.9% - some of the proceeds were used to repay its 5.5% notes. In August, Dow Chemical, Olin, Air Products and Praxair came to market. September saw more offerings at low rates. Last month, NOVA Chemicals issued $700m in debt. The commonality between all these debt issuers? Every single one is rated investment-grade.
But now, we are at a critical juncture in the financing market. After more than a year, we are finally seeing the high yield (or junk) market starting to come back! In October, NOVA raised $700m in debt. Now that was an exceptional case because it’s owned and supported by the Abu Dhabi government fund IPIC. But a few weeks earlier, Solutia issued $400m in debt, becoming the first high-yield chemical company in North America to do so in well over a year. And now on tap are other high-yield offerings, including $250m in debt from coatings company RPM. Significantly, there is the proposed $330m debt offering from private equity firm American Securities, to fund its $411m acquisition of specialty chemical firm GenTek. If successful, this will be the first public bond offering by private equity to finance a chemical acquisition since Carlyle’s buyout of PQ Corp in 1997.
So, that takes us to the outlook for mergers and acquisitions. For 2009, M&A activity will no doubt be significantly down from last year as the world fell apart – scaring would-be buyers and knocking out private equity firms who couldn’t get financing. But now that business conditions have at least stabilized, players are coming back to the table. The M&A cycle has likely bottomed, and there should be increased activity in 2010.
Through the first half of 2009, there were $21.1bn in deals completed in the global chemical industry versus $40bn for all of 2008. But a big chunk of the 2009 figures were companies that completed large deals signed in 2008 – including Dow’s $15bn buyout of Rohm and Haas, and BASF’s $4.7bn acquisition of Ciba. But these were legacy deals – the types of which we won’t see again this year. We won’t get anywhere near $40bn in deals for 2009. In terms of volume, there were only 11 deals over $25m in size completed in the first half – well off the pace of 55 for all of 2008. With the financial and economic crisis in full swing earlier this year, companies just froze – they didn’t know where the economy or their businesses were headed. Plus, nobody could get financing for deals, especially private equity, which relies on debt financing to get deals done.
But lately, we’ve seen a bit of a revival in M&A – not the huge billion-dollar deals, but smaller ones, typically well below $500m in size. Surprisingly, even private equity has gotten back in the game. Here’s a list of some of the latest announced deals. You can see private equity players are active once again – but in smaller deals. They have to have a lot more skin in the game these days – putting up lots of equity. Years ago, they could put up 10-20% equity and finance the rest. Today, it is almost reverse that in some cases, where they have to put up more than half if not all of the purchase price up front. In August, PE firm GenNx360 Capital Partners announced the acquisition of Clariant’s silicones business – a business with $20m in sales. Managing partner Art Harper said the firm put up significant equity in the deal, and is committing to put another $50-100m in equity for specialty chemical deals. Most recently, PE firm American Securities agreed to buy GenTek for $411m. GenTek makes inorganic chemicals, but also valves and auto parts. Also, you have chemical companies selectively doing deals. Evonik recently announced a deal to buy pharma company Eli Lilly’s big API plant in Indiana, and Huntsman is looking to buy TiO2 producer Tronox’s assets out of bankruptcy.
But big deals are not completely dead. There are several rumored blockbuster deals. In Japan, Mitsubishi Chemical is said to be looking to buy Mitsubishi Rayon, and In Brazil, there’s talk about Braskem and Quattor merging to become the largest plastics firm in Latin America. And rumors swirl around India’s Reliance looking at LyondellBasell’s assets. Plus, Dow continues to talk to several parties about its commodity chemicals and plastics businesses after its failed venture with PIC of Kuwait. So there’s a definite pick-up in activity – if companies aren’t doing deals, they’re at least talking about them.
DCAT Sourcing Summit 2009
Chemical Industry Outlook for 2010 + M&A and Financing Trends Joseph Chang Global Editor DCAT/ISM Strategic Sourcing Summit ’09 New Brunswick, New Jersey November 4, 2009
V- or W-shaped Recovery? The New Volkswagen (VW) Syndrome
“ Volkswagen Syndrome” *Communicatrix **Intimate Strangers – unseen life on earth by Cynthia Needham (about microbes) <ul><li>“ Yellow Volkswagen Syndrome” = bringing something to mind all of a sudden brings it into your field of vision* </li></ul><ul><li>“ Volkswagen Syndrome” = when scientists make assumptions about similarity based only on appearance** </li></ul>1946 1971
Economic Outlook – Most Signs Point to Up <ul><li>Pros </li></ul><ul><li>Global economic recovery, led by BRIC countries </li></ul><ul><li>Global industrial production turning up </li></ul><ul><li>Low interest rates, recovering financing market </li></ul><ul><li>Climbing global equity markets </li></ul><ul><li>Q3 earnings show sequential improvement + encouraging guidance </li></ul><ul><li>Cons </li></ul><ul><li>High unemployment rate approaching 10%+ in US </li></ul><ul><li>Housing prices still searching for bottom in some regions </li></ul><ul><li>Potential looming commercial real estate and consumer credit defaults </li></ul>
The OECD CLI + 6 and Global Industrial Production % Y/Y Change (3MMA) Source: OECD, various national statistical agencies, ACC analysis
A Tale of Two Cities This aerial photograph of the ‘Paradise City’ area of San Paulo, Brazil, illustrates the division between rich and poor in the world in a way rarely seen so starkly in photographs – compare the sizes, shades and textures of what you see – could anything be more different? Click here for even more incredible rich/poor divides .
Sources: Young & Partners, ICIS Chemical Business <ul><li>Private equity leveraged buyouts (LBOs) of chemical companies rise in 1999 and peak in 2005 at 36% of total M&A dollar volume. H1 2007 also hits 28% of deals and 36% of dollar volume. </li></ul><ul><li>Chemical M&A peaks in 2007 at $55bn in deals </li></ul><ul><li>Loose lending practices with covenant-lite loans </li></ul><ul><li>High leverage became more accepted </li></ul><ul><li>Stock buybacks liberally used as a tool to boost shareholder value </li></ul>Recipe for Disaster Wall Street and Management
<ul><li>Out of 70 North American companies under coverage by Moody’s, 2/3rds are in the high-yield (junk) category (under BBB-). This compares to <1/3 at the end of 2001 </li></ul><ul><li>S&P ratings downgrades outnumber upgrades 28-6 YTD </li></ul><ul><li>30 companies rated “B and CCC” – highly leveraged! </li></ul>North American chemical industry credit quality A Heavier Debt Load
Source: Standard & Poor’s Pole Position Company Rating DuPont A, Stable Air Products A, Stable Monsanto A+, Stable PotashCorp A-, Stable PPG Industries A-, Negative Praxair A, Stable Sherwin-Williams A-, Negative Sigma-Aldrich A, Stable
“ Free” Cash is King “ Free cash flow (FCF) is the best measurement of management’s freedom of action . A firm with negative FCF will have difficulty maintaining current operations without selling assets, issuing debt or issuing equity. A firm with positive FCF can invest in future growth, reward shareholders, reduce liquidity risk or preemptively fund pension plans.” Source: Laurence Alexander, Jefferies & Co.
Haves and Have-nots <ul><li>Investment-grade firms: </li></ul><ul><li>Can raise money on bond market at decent rates </li></ul><ul><li>Junk-rated firms: </li></ul><ul><li>Mostly frozen out of bond market. Refinancing requires renegotiating with lenders </li></ul>
Financing market thawing Debt issuance 2009 through Q3 <ul><li>January </li></ul><ul><li>Lubrizol issues $500m in 10-year notes with 8.875% coupon – replaces 4.625% notes </li></ul><ul><li>July </li></ul><ul><li>Cytec issues $250m of notes due 2017 at 8.95% – some proceeds used to repay 5.5% notes </li></ul><ul><li>August </li></ul><ul><li>Olin issues $150m in notes at 8.875% </li></ul><ul><li>Air Products issues $400m in notes at 4.375% </li></ul><ul><li>Praxair issues $450m in notes at 4.5% </li></ul><ul><li>Dow Chemical issues $2.7bn in various debt instruments </li></ul><ul><li>September </li></ul><ul><li>Cabot issues $250m in notes at 5% </li></ul><ul><li>Airgas issues $400m in notes at 4.5% </li></ul><ul><li>PotashCorp issues $1bn in notes at 3.75% to 4.875% </li></ul><ul><li>Common denominator – all investment-grade companies! </li></ul>
Junk Rising? <ul><li>October: </li></ul><ul><li>NOVA (owned by IPIC) issues $700m in notes at 8.375% to 8.625% </li></ul><ul><li>Solutia issues $400m in notes at 8.75% </li></ul><ul><li>On tap: </li></ul><ul><li>RPM International $250m in notes </li></ul><ul><li>ASP GT Acquisition Corp. $330m in notes (1st debt offering by PE buyout since PQ Corp. in 2007) </li></ul>
Mergers and Acquisitions – Back to the table in 2010
Global Chemical M&A Trends *Deals over $25m in size Source: Young & Partners $ billions Number of deals completed* 2008 40 2008 55 H1 2009 21.1 H1 2009 11
An M&A Comeback Date Buyer Target Price 8/31/2009 Huntsman Tronox $415m 8/31/2009 GenNx360 Capital Clariant’s silicones (now SiVance) N/A 9/8/2009 Solvay SGI soda ash plant in Russia $229m 9/9/2009 Merck KGaA Suzhou Taizu (effects pigments) N/A 9/15/2009 Unigel BASF’s Brazil PS business N/A 9/23/2009 Kemira AkzoNobel iron coagulant unit N/A 9/28/2009 American Securities GenTek (chems, auto parts, valves) $411m 10/14/2009 Evonik Industries Eli Lilly’s Indiana API plant N/A 10/19/2009 Coim Air Products’ PU pre-polymers N/A Source: Compiled by ICIS
In the works? <ul><li>Mitsubishi Chemical/Mitsubishi Rayon </li></ul><ul><li>Braskem/Quattor </li></ul><ul><li>Reliance/LyondellBasell </li></ul><ul><li>Dow’s commodity chemical and plastics assets </li></ul><ul><li>Chemtura’s PVC additives business </li></ul>
Joseph Chang Global Editor 360 Park Avenue South New York, NY 10010 (212) 791-4224 [email_address] Thank you!