M&A Outlook Remains Subdued As Portfolio Shifts Drive Deals

17 February 2003 00:00  [Source: ICB Americas]

Blighted by weak profitability and an uncertain economic outlook, mergers and acquisitions (M&A) activity in dollar terms in the global chemical industry fell off significantly in 2002. Small to mid-size deals are flourishing as industrial buyers avoid large transactions in favor of bolt-on acquisitions. Financial buyers continue to be active in light of historically low valuations. In 2003, portfolio restructuring will continue to drive deals while the chemical M&A cycle remains mired in the trough.

Mergers and acquisitions in the global chemical industry slowed to $23 billion in completed deals last year, a falloff of 34 percent from the $35 billion in deals in 2001, according to New York-based investment bank Young & Partners. However, transaction volume remained healthy with 74 deals over $25 million in size completed in 2002 versus 79 in 2001.

"Although the number of mergers and acquisitions in the chemical industry continue to be quite active, the average size of the deals has fallen," says Peter Young, president of Young & Partners. "Com-panies are becoming more cautious and are less willing to risk major changes to their business portfolios."

One positive sign is that the number of deals steadily climbed in each quarter in 2002 from 13 in the first quarter to 23 in the fourth. "Volume continues to be relatively robust despite trough valuations, Mr. Young points out. "The M&A market has not collapsed. Deals are still getting done because the drivers of M&A are overwhelming the lower valuations from the perspective of the sellers."

"What's interesting about this M&A trough compared to the last 10 years ago is that valuations are almost identical, but the volume of deals being completed is dramatically higher," adds Mr. Young.

Indeed, despite the painful business conditions of the last few years, the falloff in M&A activity pales in comparison to the collapse during the last trough in 1991 and 1992, when the number of deals averaged about 30, leading to just $5 billion to $6 billion in completed deals each year.

Heading up the big deals completed in 2002 were Bayer/Aventis Crop-Science ( 7.25 billion), Sabic/DSM's petrochemicals unit ( 2.25 billion), General Electric/BetzDearborn ($1.8 billion), EQT/Haarmann & Reimer ( 1.66 billion), and Solvay/Ausimont ( 1.3 billion).

Recent large transactions announced in 2002 and expected to close in 2003 include Belgium-based UCB SA's purchase of Solutia Inc.'s resins, additives and adhesives business for $510 million, DSM's acquisition of Roche's vitamins and fine chemicals unit for  2.25 billion, BASF AG's acquisition of Bayer AG's Fipronil insecticide and select fungicide assets for  1.19 billion, and Bain Capital's purchase of paints maker SigmaKalon from Atofina for a reported  1.6 billion.

2003 Outlook

This year, the outlook for chemical M&A appears mixed. High energy and feedstock prices could hamper deals early in the year, but bankers are hopeful that a pickup in the economy and portfolio restructuring will drive deal flow in the second half. Transaction valuations are likely to remain modest.

"For the first half of 2003, I don't see any great improvement in the M&A market at all," says Telly Zachariades, senior managing director and head of global chemicals for Bear Stearns. "Right now, you have a lot of uncertainty in the marketplace with high energy prices and a potential war with Iraq. If there is a war, it might get worse temporarily, but the economy may be set up for an improvement in the second half as energy prices fall."

"I see a binary situation. As the oil and gas spike and feedstock squeeze continues, that will clearly make some of the more commodity-related restructuring more difficult," says Ulrich Geldmacher, global head of chemicals at Deutsche Bank Securities. "On the other hand, if the situation continues, it will really push firms to clean up their portfolios a bit earlier."

Mr. Geldmacher says he is slightly more optimistic than most of his counterparts. "I tend to think deals will get done. Fi-nancing will have its windows, but with months where it might be more difficult to get," he says. "But there are opportunities where chemical companies are divisions of other companies, and where diversified companies wish to narrow their portfolios."

Tim Wilding, managing director and head of the global chemicals practice at CIBC World Markets, sees a pickup in M&A activity through 2003 as the economy improves. "As we move through 2003, we should see acceleration of deal activity," he says. "Sooner or later, the commodity chemical companies will have their day in the sun as we move closer towards the peak."

Mr. Wilding expects non-chemical companies such as Alcoa to continue shedding chemical assets, and small transactions to continue. "But fundamental to seeing large transactions and a pickup in merger activity will be visibility that earnings are growing," he notes. "That's going to give people more confidence to actually go out and do things. It's very difficult to sell anything when the numbers keep moving and there is no real solid sense of the value, particularly in a tough financing environment."

Mr. Young sees tough M&A conditions persisting. "As long as there is uncertainty about earnings on the part of buy-ers, a greater supply of assets than demand, and where financial buyers-the buyers of last resort-are still prevalent, things aren't going to change much," says Mr. Young. For 2003, the banker expects a subdued year in terms of dollar volume of M&A activity, but still fairly active with regard to the number of transactions.

Portfolio Restructuring

The rash of companies still tweaking their portfolios will contribute heavily to the number of assets put on the selling block this year.

"I think over the next 12 months, you will see some of the big corporations make decisions about selling assets that are really non-core," says Paul Collins, managing director and head of global chemicals at Lehman Brothers. "This is typically the time of year when companies go through their portfolios and figure out what to keep and what to sell, and my sense is that there will be a fair amount of selling activity this year."

"There's still a lot of pent up di-vestiture flow," says CIBC's Mr. Wilding. "Com-panies that have been sitting on assets targeted for disposal were hoping that 2003 would be the year to sell them. Now that we've likely seen the bottom and profits are rising a bit, it's going to make the sale process a lot more healthy. When earnings are going the other way, it's almost impossible to sell because buyers don't know when the decline will stop."

In December, Cambrex Corp. put its Rutherford Chemicals division on the selling block to focus on its core life sciences activities.

"Rutherford's results had softened over the last year, but now Cambrex believes that business has stabilized and hopefully turned around, making it a better time to sell," notes CIBC's Mr. Wild-ing. "I think many of the large European companies with diversified portfolios are hoping they see the same dynamic."

"This year should be a lot busier than last from an M&A perspective because I think companies are finally making the hard decisions on the portfolio," says Lehman Brothers' Mr. Collins. "If you're in too many businesses and some are underperforming, at some point you have to make choices about de-emphasizing some and redeploying capital to higher growth, higher return businesses."

Most recently, Dow Chemical an-nounced it has identified non-strategic and underperforming assets with sales of $1.5 billion it has targeted for divestiture.

While the supply of assets for sale is there, demand is sketchy. "The list of assets that haven't been sold continues to grow," says Bear Stearns' Mr. Zachari-ades. "The inventory of busted auctions is certainly not getting any shorter."

For example, Bayer's planned sale of rubber chemicals producer Rhein Chemie for  251 million to private equity firm Advent International fell through in December. Solutia has been looking to sell its 50 percent stake in rubber chemicals joint venture (JV) Flexsys for years, but Flexsys is currently involved in a price-fixing investigation.

UCB is still looking for a buyer for its methylamines business after its deal to sell the unit for  120 million to Morgan Stanley Capital Partners and Sorgenti Investment Partners fell through on delays in financing.

FMC Corp. is believed to be shopping around two businesses, one of which is speculated to be its agricultu-ral chemicals unit with sales of around $650 million. "There's no doubt that we're interested in focusing our portfolio, which can raise the possibility of divestitures," said an FMC official in January. "In the third quarter of last year, we engaged people on the investment banking side to help evaluate some options. We continue to do that."

Financial Pressures to Sell

Along with normal portfolio re-structuring, many companies will be forced to sell assets this year. Chemical companies overleveraged from the acquisition sprees and ambitious capital expansions of yesteryear are now in the process of disgorging businesses in an effort to return to financial stability.

"A lot of companies have staved off divestitures by getting covenant waivers [on their loans], but those waivers are granted on the expectation that business will improve," points out Bear Stearns' Mr. Zachariades. "If business conditions continue to be difficult, companies may be forced to sell off assets."

Following several credit ratings downgrades in 2002, Rhodia made several sales to meet its objective of raising  500 million in cash to pay down debt, including its European intermediate chemicals unit to Bain Capital, its majority stake in PET and fibers producer Rhodia-Ster to Gruppo Mossi & Ghisolfi, its stakes in the Teris waste processing and Latexia paper latex joint ventures, its technical fibers subsidiary, and most recently, its brewing and enzymes business to Genencor International Inc. There is talk that Rhodia may have to make additional disposals this year.

In the US, liquidity and profitability problems have forced OM Group Inc. and PolyOne Corp. to start divesting assets.

After shocking Wall Street with a catastrophic shortfall in earnings and projected profitability in November, OM Group announced a sweeping restructuring program. Under its new credit agreement, the company must sell $425 million in assets before the end of this year or face higher interest rates. Among the businesses on the block are its SCM powdered metals business, tungsten carbide unit, PVC heat stabilizer product line and other assets such as its Microbond solder pastes for the electronics industry. OM Group is also looking for a financial partner for its precious metals business.

PolyOne initiated a massive restructuring effort in December after revealing a large shortfall in fourth quarter earnings. The company plans to reduce debt by $200 million to $300 million, partly through asset sales, and therefore agreed to sell its 51 percent stake in color and additive concentrates company Techmer PM LLC to JV partner TPM Holdings. More divestitures will come.

Given the record number of credit ratings downgrades in the chemical industry in 2002, companies face severe financial pressure. In the North American chemical industry, there were 18 credit ratings downgrades from Standard & Poor's versus just two upgrades in 2002. More than half of the sector stands at below investment grade status, including "fallen angels" Solutia, PolyOne, Wellman and Nova Chemicals.

"There's a whole slew of companies that have gone from investment grade status to junk over the last two years, and some of these companies will continue to be forced to sell assets," says Lehman Brothers' Mr. Collins.

Acquisition via Distressed Debt

One of the more interesting deve-lopments on the M&A front that could start a trend was the acquisition of nearly 50 percent of the privately held Huntsman companies by MatlinPatterson Global Opportunities Partners (MGOP) through the purchase of Huntsman's distressed bonds on the open market.

By June 2002, MGOP had picked up 82 percent of the bonds of Huntsman Corp. and Huntsman Polymer Corp. for a fraction of their face value. In October, it swapped $775 million in Huntsman debt for almost 50 percent of the equity of the Huntsman companies.

"As financial buyers search around for ways to create value, distressed debt appears to be a very interesting asset class," points out CIBC's Mr. Wilding. "A lot of people are looking at that right now. They've seen what David Matlin did with Huntsman Corp., so I think an emerging trend this year is that there may be value in distressed debt land."

Following the Huntsman coup, MGOP has targeted Vantico, the former performance polymers division of Ciba Specialty Chemicals bought out by Morgan Grenfell Private Equity Ltd. back in May 2000 for $1.2 billion. MGOP already has taken control of nonwovens producer Polymer Group Inc. after buying two-thirds of the company's senior bonds.

In December, Vantico defaulted on a loan payment, leading S&P to downgrade its credit rating to "D"-the lowest rating. MGOP has scooped up much of the distressed debt of Vantico and will take a majority stake in the company following its planned financial restructuring. MGOP's stake in Vantico will then be transferred to the Huntsman group of companies.

Financial Buyers Active

Financial buyers, having emerged in 2000, continue to play a major role in chemical industry M&As. In 2002, there were 15 acquisitions by financial buyers, or 20 percent of the total number of deals, according to Young & Partners. The figures were down slightly from 2001's record of 18 transactions, or 23 percent of the deals. "Despite some falloff in the first three quarters of 2002 due to restricted debt availability, financial buyer activity picked up again in the fourth quarter," says Mr. Young.

However, the dollar value of deals completed by financial buyers fell more dramatically to about $3.8 billion in 2002 versus $11 billion in 2001 as they retreated from larger deals. "The financing markets are reasonably healthy, high yield debt is available, and the bank debt market seems to be in good shape, so financial buyers are still a major presence and will continue to play a big role in chemical industry M&A," says Bear Stearns' Mr. Zachariades.

Lehman Brothers' Mr. Collins points out that many financial buyers have plenty of equity capital they want to put to work. "The focus of the big sponsors are large deals, and many won't consider deals unless they can put at least $150 million in equity to work, meaning they would ideally look for transactions $400 million and up in size." Mr. Collins adds that many financial buyers are now very sophisticated after years of experience owning chemical assets. "Now many can be quasi-strategic buyers if they can find businesses that have synergies with their existing chemical portfolio."

"I think we will continue to see large amounts of interest from financial buyers," says Deutsche Bank's Mr. Geldmacher. "Last year we saw Swed-ish private equity firm EQT buying [flavors and fragrances firm] Haar-mann & Reimer from Bayer where most people expected a strategic buyer to prevail." Deutsche Bank advised Bayer on the deal.

Some Financial Buyers Stub Their Toes

CIBC's Mr. Wilding notes that while it is "absolutely the right time" for private equity firms to buy chemical assets, "a number of them have stubbed their toes. For those that were active a few years ago and participated in the more frothy M&A environment, it's going to be tough for them to see a huge return on investment," he says.

The Vantico example clearly stands out. Morgan Grenfell Private Equity bought the assets that comprise Vantico from Ciba Specialty Chemicals for $1.2 billion in May 2000. That price represented a multiple of 10.7x EBITDA (earnings before interest, taxes, depreciation and amortization) at the time. Specialty chemical assets these days ty-pically fetch between 6x to 8x EBITDA.

Another struggling company bought out by financial buyers is Avecia. The former Zeneca Specialties was acquired by Investcorp and Cinven in July 1999 for $2.1 billion, or 1.9x sales-a rich multiple to say the least. In December, credit ratings agency Moody's Investors Service downgraded Avecia's debt from "B3" to "Caa1," citing weak cash flow relative to debt.

Kohlberg Kravis Roberts & Co. (KKR) bought specialty chemical assets from Laporte PLC in November 2000 for $1.2 billion, or about 1.6x sales, creating Rockwood Specialties Inc. "That's another example of a sponsor overpaying for an asset and thus will find it difficult to exit profitably," says Bear Stearns' Mr. Zachariades.

Trough Valuations

While deal activity, especially in the small to mid-size range, continues to flow, transaction valuations remain mired in the trough. In 2002, the average multiple for specialty chemical deals was 8.2x EBITDA, up from 7.6x in 2001 and similar to the average 8.3x multiple at the 1991 trough, according to Young & Partners. Chemical M&A valuations reached their peak in 1991 at an average 13.9x EBITDA. It is worth noting that individual transactions can command considerably higher or lower values than the average, depending on the quality of the assets being sold.

"Overall M&A valuations dropped considerably in 2000 and 2001, and have been moving sideways since early 2001 at the bottom of the M&A trough," notes Mr. Young. "The M&A market is in a trough which will last for some time."

"A 6x to 8x EBITDA multiple for deals is not inconsistent with history," CIBC's Mr. Wilding points out. "It's just that people got used to high single-digit and double-digit multiples. That was an aberration and there were many people passing up deals on those kinds of multiples."

Good Time to Buy?

With valuations near historic lows, it may pay for those with the means to pick up chemical assets on the cheap.

"The current environment for buying chemical businesses is very similar to the 1992 timeframe, which was an excellent time to buy," Mr. Wilding notes. "The strategic players were on the sidelines then, but you had the be-nefit of buying at attractive multiples, and a multiple on what was a low point of cash flow and cash flow potential.

"What's interesting is that if you believe companies have had downward pressure on their EBITDA because of the economy, the multiple to normalized or peak EBITDA is obviously a lot lower," he adds. "This reinforces the point that now is a great time to be buying."

Seller Expectations And Cycle Considerations

While it may be a great time to make acquisitions from a historical perspective, buyers are faced with a number of challenges in today's market, including sellers holding out for more money. However, sellers looking to divest their assets at the next peak in the M&A cycle may have to wait longer than they think.

"The biggest difficulty is still the heightened expectations of the seller," says Lehman Brothers' Mr. Collins. "People tend to look back over the cycle and say: If you normalize my earnings over the cycle, it's worth X. However, the reality is that from cycle to cycle, earnings typically tend to trend down.

"It's very difficult to get a normalized multiple selling at the bottom of the cycle," adds Mr. Collins. "There are some properties that really should have changed hands that haven't, and will likely end up getting sold for less than they would have two years ago. It takes awhile for people to get used to the new environment and lower multiples."

"Sellers are looking for financial returns, and if they don't get that on their investment, there's no reason to sell unless they're in a hurry to get out of the business," notes Alex Markin, chemical M&A specialist for Chicago-based First Analysis. "We're still seeing that as an impediment to deals."

"In many cases, we see private com-panies looking to sell as management seeks to retire, but they're not willing to sell unless they can get a strategic value for their business," Mr. Markin says. "That is not defined anymore in the 12x to 13x EBITDA range, but more in the 7x range. But they won't sell at 5x."

Along with lower multiples hampering sellers, there has been a dearth of large strategic transactions over $500 million in size as well as acquisitions of public companies. DuPont's purchase of ChemFirst Inc. back in November for $408 million marked the first acquisition of a public US chemical company since Dow Chemical completed its acquisition of Union Carbide in February 2001.

"There's no reason why large strategic deals shouldn't get done again," says Bear Stearns' Mr. Zachariades. "These things go through cycles. We've seen periods of unnecessarily high M&A activity and then we've come to the other extreme, but we will eventually reach some sort of equilibrium."

Mr. Zachariades points out that in the late 1990s "there were too many deals at too high prices, and it's tough to make money when you pay too much for a business, no matter how good the fit."

Strategic buyers continue to be cautious and deliberate, says First Analysis' Mr. Markin. "The periods of where egos drove acquisitions are no more. They've watched too many acquisitions hit the dust," he says. "Large deals in the chemical industry have not turned out as well as the acquirers had hoped. For example, Dow Chemical's acquisition of Union Carbide has been hit by a double wham-my of low commodity margins and in-tegration issues."

"Large deals involving public companies are driven by CEO confidence, and that's been hurt by ac-counting scandals and asbestos, as well as the economy," notes Deutsche Bank's Mr. Geld-macher. "Those deals will depend on the re-emergence of CEO confidence."

Mr. Young of Young & Partners says the chemical M&A cycle is about 10 years long from peak to peak (1989, 1999) and trough to trough (1992, 2002). With the last peak in terms of multiples and dollars in 1999, the next one could be some years away. "If you don't want to sell until you get peak multiples, you may have to wait until 2009," he says. "Rebuilding confidence takes time."

Despite the tough market for chemical industry mergers and acquisitions, certain investment banks-such as Bear Stearns & Co. Inc., which rang up over $1.1 billion in chemical deals in 2002-have managed to ramp up their chemical practices in the past year.

Led by senior managing director Telly Zachariades, the Bear Stearns global chemicals group completed five chemical M&A transactions in 2002, advising Rhodia on the sale of its 88.4 percent stake in Brazilian PET and polyester fibers producer Rhodia-Ster to Gruppo Mossi & Ghisolfi for  204 million, Bain Capital on its purchase of Rhodia's intermediate chemicals assets (phenol, hydro-chloric acid, soda ash), UCB on its acquisition of Solutia's resins, additives and adhesives business for $510 million, Clariant on its sale of its hydrosulphite unit to Chemtrade Logistics for $62 million, and Dor Chemicals and Bain Capital on their acquisition of oriented polypropylene films unit Trespaphan from Celanese for over  200 million.

"It was a tough environment to build a brand new M&A practice two and a half years ago when I came on board, but we're finally getting things toge-ther," says Mr. Zachariades. "Interest-ingly, a lot of our competitors seem to be going in the opposite direction."

The Bear Stearns team includes senior managing director Peter Hall, who heads the European group, and vice chairman Ilan Kaufthal. Includ-ing Mr. Zachariades, the three have, combined, around 65 years of experience in the chemical industry. The team comprises four individuals in the US and four in Europe.

"We have great people and are very focused on the companies we've selected to do business with," Mr. Zachari-ades says. "We recognize that we can't be all things to all people, so we're very se-lective in choosing who we work with and what pieces of businesses we pursue."

The chemical deal activity Bear Stearns participated in during 2002 showed a vast improvement over 2001, when the bank helped AT Plastics sell its packaging business to Smurfit-Stone Container for $38.5 million, advised International Specialty Pro-ducts on its purchase of Fine Tech, and advised Cambrex on its acquisition of Bio Science Contract Production Corp. for $120 million.

Aside from M&A activity, Bear Stearns also helped finance the acquisition of Cognis, co-managed a high yield debt issuance for Foamex International and arranged private debt placements for Wellman.

-Joseph Chang

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