M&A in Chemicals – More to Come and Other Sectors to Follow

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 6th, 2016

M&A in Chemicals – More to Come and Other Sectors to Follow

  • In March we wrote about the likelihood of further consolidation across Industrials and Materials – driven mostly by a need for “something to do” in a slow growth world
    • So far we have not been disappointed – SHW/VAL, APD (performance materials)/Evonik, WLK/AXLL… and Bayer/MON, PX/Linde, POT/AGU in the works
    • We do not think we are done for the year
  • For the most part, deals have been driven by a desire to consolidate industries with significant overcapacity and have largely focused on the earnings growth, or offsets to commodity declines that come from operational synergies
    • In most cases the deals are likely worth only some fraction of the capitalized value of the synergies to investors, as in most cases market structures remain little changed
    • BASF can probably create more value from Chemetall and we think there is plenty of upside in the Dow/DuPont deal, but most other stocks already price in the upside in our view and for some of the speculative deals there could be downside depending on structure
  • With no or slow industrial growth, companies are looking at deals that are either hard or expensive to do because the synergy potentials offer more upside than they can see in organic growth
    • PX/Linde is the best example in our view but Bayer/MON and POT/AGU are similar
    • We would expect more of these types of deals rather than creative moves like DOW/DD
  • But there is risk for those that do nothing, especially if they are not in a niche/protected business, as combinations lower costs, can bring together complementary skills, both technical and marketing and can lead to share gains
    • Not acting while all around you get bigger may be a “frog in warming water” event
  • Weakness in the ethylene market in 2017 could result in needed and interesting big deals
    • This might be a place to invest for the longer term given demand growth
      • LYB and WLK (as well as DOW) could look interesting once 2017 earnings expectations are realistic

Exhibit 1 – This, combined with SHLM’s miss should encourage more M&A discussions

Source: ISM, SSR Analysis

Overview

The last 24 months have been all about Chemicals within Industrials and Materials, with completed, announced and in-discussion deals potentially consuming as many as 14 large companies around the world. In the past 20 years other sectors have seen similar waves of activity, all of which have changed market structure significantly (rails, metals, E&C and packaging), but few have generated any real pricing power and meaningful outperformance – rails being the more obvious exception. Packaging looked like it was on a better track for a while, but the outperformance in the sector post the wave of mergers has retraced its steps.

The primary questions we would raise at this point are:

  1. Are we done with the Chemical deals?
    1. No, we think ethylene will be next
  2. Should investors think differently about the sector because of the activity?
    1. Not really as these are all global markets and remain fragmented – with the exception of Industrial Gases and seeds, both of which are currently suffering from significant oversupply and consequently an improved market structure will be overwhelmed by fundamentals for a while
  3. Which sectors are next?
    1. Electrical Equipment, some Metals and Capital Goods

Within Chemicals we have seen meaningful consolidation in the Coatings space and we expect this to continue; we have seen and are seeing attempts at consolidation in the Industrial Gas space and in Agriculture, which if completed may result in limited further opportunities in these segments. Some of the deals on the list in Exhibit 2 are in the specialty segment, but we would expect many more, particularly rolling out of the DOW/DD merger. Where we have not seen activity is in ethylene and we think this will be the next wave, particularly if we get the weaker margin environment that stock prices are discounting for in 2017. The competition is in polyethylene rather than ethylene but the two go together. The World has more than 25 credible competitors making High Density Polyethylene, excluding China, Russia and Iran. China alone has more than 20 suppliers. We could see some large consolidation moves in this sub-segment.

Exhibit 2

Source: Capital IQ and SSR Analysis

Many of the deals listed in Exhibit 2 have been driven by problems and not by opportunity. Slow growth has resulted in cost reduction initiatives such that top line growth has been negative while earnings have for the most part grown. In industries where cost cutting is finished, the next step is to combine to find more costs – lack of growth is driving the Agriculture and Industrial Gas deals and we believe it will start to drive more Coatings deals (outside auto OEM) going forward (see recent research). In many sub-sectors you should pay for the synergies, but the stocks will not really work until fundamentals are tight, and polyethylene and possibly the styrenics chain is the only place where we see that today.

  • Industrial Gas companies need general industrial growth – this is limited all over the globe. A good infrastructure program in the US would help – we are not holding our breath and clearly neither is Praxair – getting a deal done with Linde might be both hard and expensive, but it could generate years of bottom line growth
    • Pay for the deal synergies but this is not earnings growth that justifies a meaningful P/E expansion
  • Agriculture is suffering from oversupply – both of crops because of seed technology productivity gains, and of fertilizer because of overbuilding. Urea will likely grow its way out of trouble first
    • Same as for Industrial Gases – pay for the synergies
  • Coatings growth is slowing in the West – automotive and housing – though it is growing more quickly in China where the consumer driver of the economy is robust
    • Technology gains and marketing gains might suggest paying for more than just synergies
  • Other diverse/specialty companies should probably be looking for some alternative to waiting for the world to recover
    • We still see value in EMN but we do not see a likely buyer unless BASF became very creative or the right sized and shaped entity emerges from DOW/DD
    • MOS and CF could combine in response to POT/AGU
    • We could probably see one more merger in TiO2 given the dominance of Chinese producers
  • Ethylene is different – we think! Notwithstanding the likelihood that we do get a period of global oversupply, starting later this year, we think that the sector is perhaps investable for the longer-term once this negative is fully priced in:
    • Demand is much more driven by the consumer than anything else these days with food and other goods packaging dominating the end market
    • Capacity additions appear limited and well-spaced after the imminent US wave in 2017/18
    • Consolidation is likely in 2017 and could further reduce the build rate

Outside Chemicals we would look for consolidation to pick up in sectors with slow growth and increasing global competition.

  • Capital Goods is a more obvious space as is Electrical Equipment – in both cases we think consolidation is more likely at the lower end of the value chain than the high end
  • In both sectors we think you could also see deals that are complimentary rather than direct overlap
    • We still like the idea of a CAT/DE merger
  • We believe that as for TiO2, there is room to maneuver in Aluminum and also in other metals, including Steel. Alcoa, once separated from Arconic, should look for a consolidation opportunity in our view
  • Over time we would expect the pressure from China oversupply to move downstream from basic materials and their first order derivatives and drive further consolidation across all industries

We will discuss opportunities in other sectors in more detail in separate future research

Chemicals – Big Moves But More To Do

The chemical industry is not in bad shape and margins are approaching historic highs – Exhibit 3 – so one might reasonably question the significant wave of mergers that we have seen over the last 2 years and why we expect many more. Dissecting the margin index gives you the answer; most of the uptick has been relative energy price and ethylene margin related (this is a US company index so it is biased towards US production), and the rest of the increase has been cost related – there is little to no volume growth and pricing pressure results in negative revenue growth, and the dollar has been strong and is likely to remain so – depressing earnings, though not necessarily margins, from business outside the US.

Exhibit 3

Source: Capital IQ and SSR Analysis

The ethylene margins are real and in the near-term expanding, but stock prices reflect a view we share, which is that oversupply (albeit short-term) is around the corner, just delayed by an unusual number of production problems. More on this subject to follow.

Cost cutting initiatives have been a constant in this industry and “productivity” gains have driven earnings growth while revenues have slowed or declined. Real growth engines like China industrial growth, autos globally and housing in the US and China have peaked in our view and we only see and expect real growth in the Chinese consumer – packaged goods, durables (including autos) and home decoration – so paint.

M&A activity is a reaction to the slower growth (PX/Linde, Air Liquide/ARG, Ag, SHW/VAL), in some cases a necessary look at what in the portfolio makes sense and what might make more sense to someone else (BASF, DOW/DD, ALB, APD) and aggressive competition and oversupply from China (WLK/AXLL, deals in Korea, OLN/Dow Chlorine Products, POT/AGU).

Companies sitting on the sidelines today may wake up in 24 months and find their competitive landscape very different – fewer competitors (which you might think of as a good thing). However, not few enough to create any real global pricing power, but larger and lower cost competitors, pushing others to the uncomfortable top end of the cost curve.

Exhibit 4 shows the universe of chemical companies for which we have long histories of data or for which we can find easy proxies – the stocks are ranked by attractiveness on our “Normal” valuation metric.

Companies on the sidelines in our view include: CF, EMN, MOS, HUN, LYB, FUL, RPM, and we would add TROX, TSE and CC for whom we do not have the history to add to the chart.

  • Given the excessive competition from China in TiO2, we think a case can be made for one more consolidation move in the West – if PX/Linde think they have a shot and so does Bayer/MON, then TiO2 producers can make a case also
  • CF/MOS is an obvious response to POT/AGU
  • EMN, RPM and FUL look a bit out in the cold, the big difference being that the market has all but given up on EMN as either a stand-alone story or an M&A play
  • Ethylene requires its own section – see below

Exhibit 4

Source: Capital IQ and SSR Analysis

Ethylene – The Next Big Consolidation Wave?

Ethylene producers around the world are making a killing this year, especially those selling polyethylene and styrenics. Markets are tight and product is short, in part because of strong demand growth (polyethylene), in part because of years of underinvestment (styrenics) and in part because ethylene producers seem less able to run their facilities as well as they did in the past.

US ethylene pricing is up almost 30% over the last 2 months, despite the market dealing with a new competitor in Mexico and looking down the barrel of a gun loaded with millions of tons of new capacity due on stream between now and the end of 2017. We had predicted the market to fall apart months ago, and it began to in Q2, but we have been surprised by demand growth for polyethylene (hopefully not an inventory build ahead of expected increases in crude oil prices) and production issues. Production issues have become a much more significant problem for the industry than in the past and we will focus on this in separate research.

The ethylene and polyethylene market has not suffered from China oversupply – demand growth in China, mainly for packaging, is greater than the country can keep pace with, despite significant local investment over the last 20 years. That said, ethylene and polyethylene remain cyclical businesses and the 2017 wave of US investment, plus the new Braskem/Idesa Mexico plant, plus Sadara, is too much supply in too short a space of time. LYB, WLK and DOW are pricing in an expected drop in profitability for the ethylene/polyethylene chain, however stubborn that drop is being in the near-term.

No company wants to talk consolidation at the top of the cycle – profits and cash flows are high, but so are perceived valuations. Lyondell is trading at an EV/EBITDA multiple of 5.9 and even looks cheap on our “normal” framework, but the company would have no interest in selling at these multiples and is instead an aggressive buyer of its own stock.

Excluding China, Russia and Iran, there are more than 25 independent sellers of High Density Polyethylene in the world and China adds another 20 plus. This is a very fragmented market, despite quite a bit of consolidation in Asia (excluding China) – as well as some in the US and Europe. We believe that some larger deals are likely as profits fall, so most likely in 2017 and 2018.

Those involved could include: LYB, the new DOW, CP Chem, Shell, Total, Sasol and Ineos. We think that Exxon Chemical will stay clear (preferring organic growth), but not if Exxon decides to make another combination move at the oil company level. While the mechanics may be a bit tricky, we would expect to see a more formal tie-up between Nova and Borealis, and if the current owners were looking for an exit strategy and cash they should move quickly with a combination and an IPO.

Chemicals M&A: Not Really A Long-Term Investable Trend

In general, we do not believe that the wave of M&A we see in Chemicals, and that we expect to continue, is an investable theme on its own. Unlike the US Rail industry or Steel industry (in the past, not this cycle!) we do not see market structures changing to create any sort of sustained pricing power in any sub-sector. Despite concerns that regulators have, farmers will continue to buy from the lowest priced/best value supplier as will Industrial Gas customers and there are enough producers left – even with all the proposed mergers to keep competition alive. There may be some limited product areas or geographies where some pricing may be possible but not enough to move the needle for any of the large companies. In our opinion you are investing in the announced deals for two things:

  1. The capitalized value of whatever proportion of synergies is not passed on to customers – so not 100% of the announced synergies anywhere, but higher in Ag and Industrial Gas than in commodities
    1. You would pay more if you felt that the synergy targets or cost opportunities were understated at the time of the deal
      1. Dow/DuPont
      2. WLK/Axiall
  2. The potential revenue benefits of increased volumes stemming from better innovation, novel product combinations or a more effective sales and marketing platform
    1. We may get some of this in the Ag deals and more broadly for Dow/DuPont – we continue to see this as the most interesting opportunity
    2. BASF will likely get more from Chemetall
    3. There may be some technology and marketing gains in the Coatings deals

Chemicals and plastics are not just fungible products and consequently can be traded globally, but to make things worse often they provide a value in use that can be substituted by another chemistry or another product. For example a car fender (bumper) can be made from steel, aluminum, some blend of polycarbonate, polypropylene and other plastics.

What we saw happen to Rails in the US since 2000 – Exhibit 5 – was a direct result of consolidation which allowed the industry to reverse destructive price trends and it was an investable turning point for the sector. We do not see this happening in Chemicals.

Exhibit 5

Source: Capital IQ and SSR Analysis

Is Ethylene Some Sort Of Exception?

The short answer is no from a market structure perspective, but we do think that ethylene may have a brighter future – perhaps helped by further consolidation. This is not a sub-sector which can consolidate to a point whereby the market structure can outweigh supply/demand fundamentals, but we believe there is a case to be made for sustained good fundamentals for ethylene longer-term.

Ethylene operating rates around the world are not the highest they have been in the past, but every plant that has access to the global market – through trade of derivatives – and can run – is running flat out today. At the same time apparent derivative demand growth is strong – dominated by polyethylene and dominated by packaging – food and consumer goods. The market is now so large that the world needs three to four new world scale facilities a year to keep up – these are expensive to build and feedstock security at the right price limits who can build and where. Near term we have a couple of issues:

  • A wave on new capacity that is coming on faster than is needed – now through 2018
  • The risk that some of the recent very strong demand for polyethylene is in part an inventory build against the risk of rising oil prices

These risks ae why LYB is trading at 5.9 EV/EBITDA and PE of 8.6 and they are holding back WLK and DOW. Should we get a dip in profits it will likely be quite sharp, but we do not think it will last that long – perhaps long enough to promote some consolidation as suggested above. On any drop in profits, which are probably at least 60-75% reflected in current values, we see this sector as a longer-term investment as we struggle to see where the necessary new capacity gets built after this round in the US – see earlier research. Exhibit 4 shows that LYB and WLK are cheap today, but probably not cheap enough to discount the risk of possible further weakness on negative revisions. LYB’s consensus estimates for 2017 do not reflect any weakness in ethylene/polyethylene – we believe that there could be as much as 30% downside to estimates as the capacity comes on stream – more if the world is holding an unusual amount of polyethylene inventory. In Exhibit 6 we show a chart updated from the work we did earlier in the year. We have adjusted the capacity data by pushing timing out for Sasol and Westlake/Lotte projects in the US as well as some of the more speculative plans – we think many will go ahead, just on a delayed timetable, which should tighten the ethylene market from 2018.

Exhibit 6

Source: IHS, Company Reports, and SSR Analysis

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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