Chemical M&A Outlook
OUTLOOK ‘19: Caution signals flash for chemical M&A amid downdraft
Source: ICIS News
NEW YORK (ICIS)–Coming off a long stretch of strong chemical mergers and acquisitions (M&A) activity, the sector could cool off markedly in 2019, depending on the depth and length of the downturn in financial markets, which reflects expectations of slowing economic growth.
“There are negative and positive factors at work. There are concerns about whether there could be a global recession and the US credit markets have significantly tightened,” said Federico Mennella, head of Chemicals and Materials, North America for investment bank Rothschild & Co.
“China is up in the air because of US tariffs, there’s a general slowdown in Europe, and certain industrial sectors such as automotive are slowing,” he added.
The risks are grouped into three categories – political risks, trade tensions and general economic growth, all of which are intertwined, he noted.
“In general, leveraged finance markets weakened further in December with macro concerns and market volatility resulting in a broad-based sell-off in both the loan and bond markets. Investors are largely in risk-off mode for lower-rated new issues,” said Mennella.
“There are a number of uncertainties out there. Higher interest rates could slow down the US economy, Brexit is still not solved, and there is already a slowdown in China and Europe. Plus, the shift to electric mobility is causing changes in the automotive sector,” said Bernd Schneider, managing director at Germany-based investment bank Alantra.
“2019 probably won’t be a record year for chemical M&A when it comes to cumulated value, but it should still be a healthy year,” he added.
The pace of global chemical M&A activity has actually been declining for the last two years and should continue to fall in 2019, according to Peter Young, president of investment bank Young & Partners.
“Separate from one or two mega deals, the dollar volume and number of deals has been declining for the last two years and will continue to decline in 2019,” said Young.
“Although there are strategic buyers who want to add synergistic businesses, particularly in specialties, there are other forces that are pushing M&A volume in the other direction,” he added.
In terms of the number of deals over $25m in size, the first three quarters of 2018 saw 42 deals completed (56 deals on an annualised basis) compared to 89 deals for all of 2017, according to Young & Partners.
In terms of size, the first three quarters of 2018 saw $89.6bn worth of deals closed. However, just two deals dominated and represented $69.7bn of the total – the Bayer/Monsanto and PotashCorp/Agrium deals. All of the rest was only $19.9bn, noted Young.
“The industry faces many uncertainties that are impacting M&A. Slowing economies worldwide, difficulties in the very large Chinese economy, higher interest rates, the slumping stock market, the unknown trajectory of the US/China trade disputes and tariffs, and the high levels of geopolitical strife are all factors that will drive a slower M&A market and potentially, a severe downturn in activity and valuations,” said Young.
“There is still a window to sell at solid valuations for certain assets, but that window will not stay open for all of 2019,” he added.
EQUITY MARKETS TUMBLE
Chemical equity prices have tumbled since early October along with the broader markets, denting public valuations as well as management confidence. Stock prices are considered a leading indicator. The stock market looks forward, and it doesn’t like what it sees.
“The level of volatility is not instilling confidence in the M&A market. That being said, we are not aware of any [sale] processes that have been pulled,” said Leland Harrs, managing director at investment bank Houlihan Lokey.
“It is serving as a wake-up call that we are in the late innings of the economic cycle, and that it might be a good time to sell,” he added.
Interestingly, earnings estimates for 2019 have not yet been slashed to the extent stock prices would suggest. Consensus estimates as of mid-December show chemical company profits largely rising in 2019 versus 2018.
“Equity volatility could cause some pause for those looking for deals, but M&A is a long-term investment and companies take a long-term view,” said Sean Gallagher, managing director at investment bank Janney Montgomery Scott.
“Most companies look at long-term trends and see if the support is there – sales synergies, cost synergies, and the need to add to the team to achieve higher growth, especially with tightness in the labour market. In the end, the deals that make sense will still get done,” he added.
US-focused chemical companies in particular have more cash available from the tax reform to make acquisitions, said the banker.
“And the range of financing sources keep on increasing, branching out from traditional banks. There are PE funds focused on debt that are looking to put capital to work, and BDCs (business development companies) can now take on more leverage,” said Gallagher.
With the March 2018 “Omnibus” bill that was passed to avert a US government shutdown, one provision allowed for BDCs to borrow more money to lend out. Specifically, BDCs can borrow $2 for every $1 in equity versus a 1:1 ratio previously.
PUBLIC COMPANIES IN PLAY
The carnage in equity prices could make publicly traded companies more attractive, putting them “on the radar screen” for potential acquisitions, said Telly Zachariades, co-founder and managing director of investment bank The Valence Group.
“Stocks had gotten ahead of themselves and thus there were less buyouts of public chemical companies. The field has now returned to normality,” he added.
However, buyers won’t necessarily be able to offer takeout premiums for stock prices going back to October 2018 highs and expect to find a willing seller just yet, warns the banker.
“You need stock prices to stay down longer – to have 3-6 months of ‘seasoning’. If stock prices stay where they are or fall lower, then public companies will be in play,” said Zachariades.
Lower stock prices could also spur divestitures.
“When equity markets soften a bit, corporates are more willing to pursue smaller, non-core divestitures because they are less dilutive to earnings per share,” said Chris Cerimele, founder and managing director of investment bank Balmoral Advisors.
“Many companies have been on the sidelines because their public trading multiples have been so strong,” he added.
With a high public trading EV/EBITDA multiple, management would be hesitant to divest earnings generating assets, as they are getting a higher valuation on the consolidation of those profits than if they sold them.
CEO CONFIDENCE IS KEY
And what about public chemical companies as buyers? Managements seeing their own stock prices decline precipitously would arguably hesitate paying high multiples for deals.
However, Zachariades noted that deal multiples have typically been higher than public valuations.
Recent deal valuations have indeed been solid, highlighting the demand for good assets of size.
Germany-based Evonik’s planned acquisition of US-based hydrogen peroxide and peracetic acid producer PeroxyChem from One Equity Partners announced in November for $625m was at a multiple of 10.4x expected 2018 EBITDA of around $60m and over 2x expected sales of $300m.
Zachariades pointed to US-based Ingevity, which despite a recent decline in its stock price, announced on 10 December the acquisition of Perstorp’s caprolactone business for €590m, representing a robust 11.8x expected 2018 EBITDA of €50m.
“It all comes down to whether the CEO is confident in prospects for his own company. It’s not about what the market is valuing it at, but what the outlook is for 2019,” said Zachariades.
“If CEOs start to get nervous, then that will have an impact on how they approach M&A,” he added.
Using capital expenditures (capex) as a proxy for business confidence, the banker points out that around 75-80% of chemical companies reporting capex plans for 2019 have them at similar levels as 2018 or higher.
Yet a consistently declining stock price can impact management confidence.
From a public company perspective, it’s a lot easier for boards to approve deals when their stock price is up. It’s a matter of confidence,” said Omar Diaz, managing director at investment bank Seaport Global Securities.
In general, chemical companies’ “balance sheets are fantastic as they have not borrowed like drunken sailors, and they are generating strong cash flows. Portfolio realignment is still the name of the game”, he added.
Yet “volatility is not the friend of M&A”, said Diaz. “China is a wild card. All this uncertainty on the US-China trade front is putting a damper on sentiment, along with worries about a slowing global economy.”
CREDIT TRENDS WEAKENING
While leading indicators are “flashing warning signs” and the market seem to be “on edge”, “as long as credit is available on acceptable terms, and trade and oil aren’t disruptive, US chemical M&A should continue at a good pace,” said Rothschild & Co’s Mennella.
“The availability and pricing of credit have a more direct tie to M&A. We’ve seen some widening of credit spreads and choppiness but it’s too early to say if it will impact activity. Everyone’s antennas are up,” said Houlihan Lokey’s Harrs.
“The debt capital markets are becoming an increasing concern. It’s gotten harder to borrow as institutional investors are looking for higher Libor floors and overall pricing. This may also put a damper on activity in 2019 and beyond,” said Seaport Global’s Diaz.
“The first quarter of 2019 may be on the slow side, but if there’s any indication that volatility may lessen, M&A market growth should accelerate from there. We’re cautiously optimistic for 2019,” he added.
“Buyers might use this as an opportunity to slow things down or lower their price if this volatility persists. However, if you do nothing, you are losing that growth lever. Most chemical companies are still longing to do M&A,” he added.
“There is still more demand than supply of assets for sale. If there’s a downturn, deal multiples may soften. But for now, multiples are still strong and still drawing sellers out,” said Cerimele from Balmoral Advisors.
“The chemical M&A market is still strong. Everyone’s looking at it and wondering how long it can last. How many times does the coin flip come up heads? That’s the mentality today,” he added.
On the positive side, profitability, as measured by earnings before interest, tax, depreciation and amortisation (EBITDA) is expected to continue improving in 2019 for specialty chemical companies, said Mennella from Rothschild & Co.
“While we see certain commodity chemical companies weakening, many specialty chemical margins are expanding on lower commodity prices,” said Mennella.
Profit margins are often a driving force for corporate acquisition interest, noted Cerimele from Balmoral.
“Corporate buyers are often more focused on gross margin improvement (accretion) with acquisitions rather than the dollar size of earnings. If a deal is likely to result in profit margin accretion of the combined business, it will get more attention,” said Cerimele.
However, the US-China trade war could become problematic for M&A if it escalates, causing havoc across global economies and financial markets.
“A key factor is valuations. If you cannot properly value a business because of all the uncertainty, you’re going to be at a disadvantage in terms of M&A,” said Mennella from Rothschild.
And for crossborder M&A between the US and China, the trade war is already taking its toll.
“In the past year and a half, there’s been a significant slowdown in Chinese companies seeking to acquire US assets. The Chinese government has also cracked down on outflows of capital,” said Harrs from Houlihan Lokey.
PRIVATE EQUITY OUTLOOK
Private equity (PE) firms continue to express high interest in the chemical sector, and have been active on both the buy and sell side.
Through November 2018, PE firms were involved on the buy or sell side in 38.9% of total chemical transactions announced in the year, up from 25.7% for all of 2017, according to Rothschild & Co.
On the buy side, PE firms and strategics continued to pay full prices for chemical assets.
Sponsor deal multiples rose to 10.4x earnings before interest, tax, depreciation and amortization (EBITDA) year-to-date through November 2018, compared to 13.6x for strategic deals. Those figures were up from 10.0x for sponsor deals and 10.4x for strategic deals in 2017, according to Edgewater Capital Partners.
“Credit markets are currently supportive of defensive industries and credits with reasonable leverage and terms. Risk has been repriced higher – so sponsors are still getting deals done, but in more expensive and conservative terms. More private equity groups are getting involved in chemicals while valuations are not crazy,” said Mennella.
Rothschild & Co together with Mennella, then at his previous firm Lincoln International, advised Bain Capital on its acquisition of specialty chemical additives producer Italmatch from PE firm Ardian in July 2018.
Italmatch reportedly generated around €400m in sales in 2017. Then in December 2018, Bain Capital and Italmatch, again advised by Mennella, announced the acquisition of US-based BWA Water Additives.
“There’s been a flood of PE firms with interest in the chemicals market with huge amounts of raised capital,” said Alantra’s Schneider.
“And now we see more former bankers joining PE firms. The competition between PE firms is so fierce that they must ramp up every asset they have to win deals, and that includes bringing in expertise to differentiate themselves,” he added.
Mario Toukan, former managing director and head of chemicals at KeyBanc Capital Markets, joined SK Capital Partners as a managing director in December 2018. Earlier in 2017, SK Capital brought on Simon Dowker, formerly an investment banker focused on chemicals with PJT Partners and Jefferies.
Expect PE firms to be opportunistic in 2019, especially if corporates step back from M&A.
“In 2018, deals involving private equity have moved at an extremely accelerated pace. PE firms have massive amounts of capital, and speed in closing a transaction is their primary differentiator,” said Diaz.
FAILED MERGERS, ACTIVISTS
Even failed mergers can lead to M&A activity as the companies take their next steps, noted Mennella.
Switzerland-based Clariant, after its planned merger with US-based Huntsman was scuttled by activist investor White Tail, gained Saudi Arabia’s SABIC as a partner through the activist’s sale of its nearly 25% stake in Clariant to SABIC.
While this was a not a change-in-control acquisition, it brought in new management. The new Clariant CEO Ernesto Occhiello had been heading up SABIC’s specialty chemicals business.
Netherlands-based AkzoNobel, which had to deal with activist investor Elliott Management along with a hostile takeover bid by US-based coatings rival PPG, in October 2018 sold off its specialty chemicals business to PE firm The Carlyle Group and Singapore sovereign investment fund GIC for €10.1bn.
“Failed mergers and activists can either drive direct M&A, or indirect M&A as they raise the flag and essentially clamor for another investor to come in,” said Mennella.
“Once management is exposed, they usually decide to do something,” he added.
Elliott Management also targeted US-based coatings company RPM International, which in June 2018 agreed to appoint two new independent directors to the board and form an “Operating Improvement Committee” to conduct a comprehensive business review.
“Activism typically results in divestitures as the targeted companies refocus their efforts,” said Harrs from Houlihan Lokey.
New CEOs can also often lead to M&A activity, as they seek to make their mark on the company through acquisitions, divestitures or a combination of both.
Chemical companies or those with chemical operations with relatively new CEOs include Clariant, Nouryon (former AkzoNobel Specialties) and Milliken & Co. Coming up in 2019, Solvay will have a new CEO. Plus, the DowDuPont spinoffs Dow, DuPont and Corteva set for 2019 will all have their own new CEOs.
AGE OF MEGA DEALS OVER
The age of the chemical mega deal is likely over, at least for 2019, as it is getting harder to find the strategic rationale for these kinds of transactions. Yet one potential big deal we could see in the New Year is LyondellBasell/Braskem.
“Any planned mega deal might take longer than expected because of all the uncertainty,” said Schneider from Alantra.
“The period of mega deals could take a pause, but we could see even more mid-size and smaller deals as new companies like Nouryon seek to grow certain divisions and also dispose of assets to deleverage. The companies spun off from DowDuPont should also see consequential deals,” he added.
Certain subsectors will be in high demand. Compounding and even more composites are up there on the attractiveness scale.
“Composites in the age of lightweighting and electric mobility are the name of the game. It’s a hot industry and good assets are commanding high multiples,” said Schneider.
“With increasing environmental awareness and potential decrease in the consumption of basic plastics – for example in packaging – resins makers are afraid of losing demand. They are taking the necessary steps downstream,” he added.
Companies such as LyondellBasell, Covestro, Celanese and Ascend Performance Materials have been acquiring such compounding/composite assets to gain access to new applications and improve their long-term margins.
US-based integrated nylon producer Ascend Performance Materials in August 2018 acquired Netherlands-based engineering plastics compounder and customer Britannia Techno Polymers (BTP) – it’s first such acquisition. It is seeking additional acquisitions to broaden its compounding footprint.
The “hunger for composites” stems from companies’ need to find new applications where resins will replace metals, to compensate for a potential loss in classical uses such as packaging, and to achieve better margins and pricing power, noted Schneider.
“Resins companies have to get out of that strategic trap and composites is the answer,” he added.
Along the electric mobility mega trend, there is renewed interest in electronic chemicals, including electronic coatings and battery materials, said Schneider.
While the overall automotive sector faces challenges of slowing growth, certain subsectors continue to show strength.
“Even within automotive, it depends on what you’re supplying. Commodity materials will see a slowdown. But if you produce higher-end materials for lightweighting – certain plastics, adhesives and sound insulation – you may not have witnessed any slowdown at all,” said The Valence Group’s Zachariades.
Focus article by Joseph Chang