Thank you for the invitation once again. It’s a pleasure to be speaking with Rob and Peter – always interesting to get different perspectives, especially during these very interesting times. A year ago today, it was a very chaotic situation. The global financial system was on the verge of collapse and bankruptcies abounded. The chemical industry was getting hit hard, and companies were scrambling to refinance their debt.
But since then, the global economy has come back from the brink, demand has stabilized, and stock prices have made a 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? Interesting to note that the debate is definitely about a recovery – just in what form. The latest comes from Dow Chemical CEO Andrew Liveris, an Australian native who’s now coined the term “Lazy-V” in describing the current economic recovery. What’s a Lazy V? Kudos to BB&T analyst Frank Mitsch for the translation – It’s “Aussie for moderate growth” – or slow, steady progress.
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 in the 2 nd instance, 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 major 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” – but it’s not what you think. It’s actually a scientific 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, we notice they are everywhere – or at least more apparent. Not that there’s isn’t real fundamental improvement, but we’re going to notice it more. That’s part of what’s driven the stock market off its lows. In the second instance – the “Volkswagen Syndrome” – where things might look the same but are fundamentally different, that also applies. How different will this recovery be? Still open to debate, but let’s take look under the hood.
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 there was massive inventory destocking. But starting in March 2009, the IPEX posted 7 consecutive quarters of gains, before falling a bit in October. The latest February figures show a gain of 7.8%, bringing the index to 275.63, within 13 points of pre-recession levels in November 2008. The February gain was led by benzene worldwide, and butadiene in Asia.
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 it’s a composite leading indicator for developed nations, plus a group of 6 developing countries, including Brazil, China, India and Russia. This leading indicators is 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.
There are several other 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. In the US, the still weak dollar is providing a boon to exports as well as the profitability of US multinationals that have significant sales abroad. On the negative side, unemployment is high in Western nations. In the US we’re at 9.7% with little signs of relief. Plus there are lingering concerns about commercial real estate defaults. The latest worries today revolve around the sovereign debt crisis in Greece, and whether this could spread to other European countries. Plus we have probably the most talked about question – Will the Chinese government’s efforts to put the brakes on credit expansion hurt the global recovery? It has already prompted banks to curb lending, and it could also raise interest rates.
Now let’s take a look at the latest Q4 2009 earnings results for some major US chemical companies. Most reversed losses from a devastating Q4 2008 - very easy comps. Most beat Wall Street expectations, but CEOs were still cautious on earnings prospects going forward. DuPont posted profits on 10% higher sales and volumes, driven by Asia. Volumes were up 34 in Asia-Pacific, and exceeded pre-recession levels. Sequentially versus Q3, volumes gained 8%. DuPont also raised its 2010 earnings guidance. Dow Chemical also posted a profit, and volumes were also up 10% year over year. Reflecting similar trends, emerging markets volumes surged 33% with China up 57%. Sequential volumes gained in all geographic areas except North America, where they were down 1%. Dow CEO Liveris expects the US and Europe to lag the recovery as high unemployment persists. Eastman had a blowout Q4, and the CEO expects 2010 earnings to come in 20% ahead of 2009. PPG Industries and Celanese also did well. While year-over-year volumes were up in Q4, they still have not recovered to pre-recession levels. Last year, Q4 volumes were off 20% or more across the board.
Now let’s look at earnings forecasts for 2010. Here is a list of projected EPS 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 14x. There could be further upside, especially as 2010 is not considered mid-cycle, but there fewer screaming bargains.
Even though the earnings outlook is on the up and up for everyone, there is a real dichotomy in the chemical industry today – it is truly a Tale of Two Cities. On the one hand, you have companies that overleveraged themselves through the heyday of M&A and LBOs. Some declared bankruptcy and are restructuring, and others were forced to renegotiate with their lenders, potentially kicking the problem down the road. On the other hand, you have companies that have come through the downturn with solid cash flows and strong balance sheets. This group is fully prepared to capitalize on growth opportunities.
Because we’ve had such a frenzy of LBOs in the past decade, 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 junk category – this compares to less than 1/3 at the end of 2001. And Standard & Poor’s downgraded the credit ratings of around 28 companies in 2009 versus only 6 upgrades. Most happened in the first half of the year. Today, there are 30 companies out of 65 in the single B or CCC categories – this indicates very high leverage. Last year leveraged companies with debt coming due had 3 escape options – 1. declare bankruptcy, like LyondellBasell, Chemtura and Tronox, 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. Last year, Georgia Gulf did a debt-for-equity swap, while INEOS renegotiated debt terms. Hexion also recently refinanced and extended debt terms. These amend-and-extend terms may just be kicking the ball down the road. Companies will eventually have to deal with their overleveraged balance sheets.
Here’s a list of some “Vintage” chemical LBOs. These companies are all highly leveraged. For a company to be considered highly leveraged, it typically has a debt/EBITDA ratio of at least 4.5x. These stats are from S&P back in 2008. Couldn’t get an update from S&P – but you can be sure these leverage ratios are much, much higher today. Interesting to note that Kraton Polymers, owned by Texas Pacific Group, was able to go public through an IPO in December 2009.
But it looks a lot better for a select group of companies. These are the ones with A, and close to A-rated rated balance sheets. Companies like DuPont, Air Products, Praxair, Monsanto, PotashCorp, PPG Industries and FMC have the pick of the litter when it comes to acquisition opportunities. Already we’ve seen Air Products make a $7bn hostile bid for Airgas – and financing for the deal? All arranged by JPMorgan - No problem!
And speaking of financing, let’s take a look at the financing market. In the good ol’ days of 2007, just about anyone could borrow money at decent rates. But no longer. 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 really has not always been the case. In past downcycles, even leveraged companies were able to have access to credit and refinance, even as credit quality went down. But it really has been different this time around.
Let’s take a look back at debt issuance through the first 3 quarters of 2009. The year started off slowly, with Lubrizol kicking things off. But they paid a much higher rate to refinance at that time - almost 9% versus its previous rate of 4.625% on $500m in debt. By August, the financing market had recovered further. Dow, Olin, Air Products and Praxair came to market. September saw more offerings at low rates. The commonality between all these debt issuers? Every single one is was rated investment-grade.
But since the third quarter of 2009, the high yield market has started to come back! In October, Solutia issued $400m in debt, becoming the first high-yield chemical company in North America to do so in well over a year. NOVA Chemicals also raised $700m in debt. Now that could have been considered an exceptional case because it’s owned and supported by the Abu Dhabi government fund IPIC. But in November, Koppers came to market with $300m in notes, and then in December, Georgia Gulf issued $500m in debt.
So an improved financing market has major implications for mergers and acquisitions. I won’t dwell too long on this, as Peter’s presentation will give much more detail. But For 2010, M&A activity is poised to rebound as business conditions have recovered and confidence has returned. Players are coming back to the table.
While in 2009, buyers were predominantly looking for distressed bargains, they are now seeking acquisitions for growth. And where growth opportunities are limited, some companies may force the issue on M&A. Last week you saw Air Products launching a hostile bid to buy Airgas for $60/share, or $5.1bn. With the assumption of debt, the offer is valued at $7bn. Shares of Airgas are trading above the $60 offer, indicating that investors expect Air Products to boost its bid to get the deal done. Plus, you’ve seen a number of buyers in emerging countries looking to buy Western assets. Brazil’s Braskem has agreed to buy Sunoco’s polypropylene business for $350m and says it will look for more deals in the US. Mexichem has agreed to buy INEOS Fluor – the fluorochemical operations of INEOS with plants in North America and Europe. And South Korea’s Lotte Chemical has bought the Artenius PTA and PET assets in the UK from La Seda. And Reliance is still weighing options to buy LyondellBasell after a US bankruptcy court ruled that Lyondell could pursue its own restructuring plan. So no doubt you will see lots more M&A activity in 2010.
After the Crisis: What’s Next? Chemical Market Outlook for 2010 Joseph Chang Global Editor Societe de Chimie Industrielle, New York February 17, 2010
V- or W-shaped Recovery? The New Volkswagen (VW) Syndrome
“ Volkswagen Syndrome” *Communicatrix **Intimate Strangers – unseen life on earth by Cynthia Needham (about microbes)
“ Yellow Volkswagen Syndrome” = bringing something to mind all of a sudden brings it into your field of vision*
“ Volkswagen Syndrome” = when scientists make assumptions about similarity based only on appearance**
*As of the close of February 9, 2010 Source: Yahoo! Finance, ICIS Chemical Business Wall Street Crystal Ball 2010 Majors/Diversified 2009 EPS E2010 EPS % Change Stock price* P/E (2010) Dow Chemical $0.59 $1.48 +151% $27.79 18.8x DuPont $2.02 $2.35 +16% $32.47 13.8x Celanese $1.69 $2.76 +63% $29.94 10.8x Eastman Chemical $2.54 $3.49 +37% $57.86 16.6x Specialties E2009 EPS E2010 EPS % Change Stock price* P/E (2010) Nalco $0.89 $1.36 +53% $21.98 16.2x Cytec Industries $1.32 $2.21 +67% $37.62 17.0x PPG Industries $2.93 $3.86 +32% $59.16 15.8x FMC $4.15 $4.62 +11% $54.91 11.9x Albemarle $1.90 $2.62 +38% $35.32 13.5x Arch Chemical $1.86 $2.00 +8% $27.99 14.0x Lubrizol $7.55 $7.78 +3% $71.62 9.2x AVERAGE 14.3x
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 .
Grade A Credits Source: Standard & Poor’s Company Rating Monsanto A+, Stable Air Products A, Stable Praxair A, Stable Sigma-Aldrich A, Stable Ecolab A, Stable DuPont A, Negative Sherwin-Williams A-, Positive PotashCorp A-, Negative FMC BBB+, Stable Cabot BBB+, Stable PPG Industries BBB+, Negative