Analysis: Chem industry credit quality to improve in 2005

18 February 2005 17:00  [Source: ICIS news]

NEW YORK (CNI)--After years of crushing credit ratings downgrades and a slew of bankruptcies, the North American chemical industry is finally turning the corner in terms of credit quality.


The outlook for chemical company credit ratings in 2005 is bright as firms focus on slashing debt further with robust cash flows.


"The momentum is building, suggesting a robust turnaround in 2005," says Kyle Loughlin, team leader for the North American chemicals group at Standard & Poor’s. "You’re seeing strong earnings across most categories - especially in commodities where you’ve got tremendous operating leverage to higher pricing and volumes."


"It’s nice to see the light at the end of the tunnel. We expect 2005 to be a better-than-average year for the vast majority of companies in the industry due to continued growth in the US and global economies," says John Rogers, lead chemicals analyst at Moody’s Investors Service, who in January upgraded his rating outlook on the chemical industry from "negative" to "stable." "However, we are less bullish than the consensus after 2006 as potential capacity comes on."


The fourth quarter of 2004 marked an inflection point in credit quality after years of deterioration. For the first time in five years, S&P chemical ratings upgrades and downgrades came into balance with four upgrades (Ashland, NewMarket Corp., Airgas and IMC Global) and four downgrades (Kraton Polymers, Millennium Chemicals, Omnova Solutions and Resolution Performance Products).


"All of these actions resulted from operating gains, end market improvement or tighter supply-demand fundamentals that aided volumes, pricing and margin expansion," says Loughlin. "While debt levels remain high compared to historical standards, many chemical companies finally appear poised to improve their capital structures following a period of overcapacity, heightened M&A activity, an extended decline in the industrial economy and unforeseen challenges on the raw materials front."


So far this year, Huntsman and its related affiliates have been upgraded from B to BB- following Huntsman’s $1.45bn initial public offering (IPO), while Innophos (the former Rhodia phosphates business sold to Bain Capital) has been downgraded from B+ to B because of a large debt offering, and Omnova Solutions was downgraded yet again from B+ to B on operational difficulties.


Positive outlook revisions outpaced negative outlook revisions six to five in the fourth quarter. So far in 2005, there have been three positive outlook changes (Celanese, Eastman and PPG Industries). The percentage of negative outlooks in S&P’s North American chemicals coverage list is down to just 32% versus 45% in March 2004.


"This improvement bodes well for the diminishing risk of further downgrades for many issuers as industry conditions continue to improve," notes Loughlin.


Commodity chemical companies stand to benefit the most in 2005 from a credit perspective. "We see the potential for more stable ratings, especially on the commodity side because of the escalation of polymer prices," notes Moody’s Rogers. "Some of the lower-rated companies such as Huntsman and Lyondell will certainly see some positive ratings pressure."


Specialty sector waits price increases


While large commodity chemical producers are benefiting from strong cash flows, some mid-sized producers of more specialized chemicals are still having a rough time.


"The downgrades of Kraton Polymers, Omnova and Resolution Performance Products highlight another important theme," notes S&P’s Loughlin. "Players that have tried to avoid linking prices directly to raw materials or that have been later to the game in trying to get pricing up have struggled."


However, all specialty chemical companies are trying to increase prices and 2005 should offer favourable year-over-year comparisons.


"While 2005 should be a good year for specialty chemical companies assuming economic growth remains in line with expectations, we note that the ability of some niche companies to offset increased raw material pressure will be a key determinate of credit quality," Loughlin says.


"While dollar profits will increase, margins will likely remain under pressure," says Moody’s Rogers. "It will still be a better year for almost everyone in the industry."


Moody’s has the ratings of Ferro, Great Lakes Chemical and Cytec Industries under review for possible downgrade. Ferro, which is rated Baa3 (equivalent to a BBB- S&P rating), has yet to issue financial statements for two quarters, while Great Lakes, rated A3 (equivalent to A-), is having volatile cash flows and is struggling in its water treatment business. Cytec, which will be moved to Baa3 (BBB-) following the acquisition of UCB Surface Specialties, will remain under review for possible downgrade because of high debt levels.


However, there are bright spots within the group. The outlook is especially strong for electronic materials, coatings and adhesives, due to a recovery in industrial demand and continuing growth in consumer demand, according to Rogers.


"We have already seen a sizeable recovery in electronics and would expect 2005 results to be significantly better for companies that sell into this industry such as Rohm and Haas, Ferro, Degussa, Resolution Performance Products, and DuPont," says the analyst. "In the coatings segment, companies that will benefit will be Rohm and Haas, RPM, Valspar, PPG, ICI, Akzo and DuPont."


CAPX on the rise


With the profit recovery in 2004, many companies are boosting capital expenditures in 2005. However, they still remain fairly disciplined with spending generally flat to below depreciation levels. Highly leveraged companies such as Lyondell Chemical plan to use cash flow primarily to reduce debt.


"Capital spending will be higher in 2005, but I’m still hearing cautious comments from most major companies, and they are trying to be selective about where to deploy capital," observes S&P’s Loughlin. "The wounds from the last downturn are still fresh. But we are already starting to see announcements of debottlenecking activity and selective capacity additions, and that will begin to accelerate. Cycles have not gone away, but I think we’re in for a pretty good ride for the next year or two."


"People aren’t going nuts [with spending] yet," says Moody’s Rogers. "Other than Shintech, no one has announced large capacity expansions in North America. There’s relative calm across the board - we aren’t seeing the wholesale activity of the late 1990s. The vast majority of the industry is trying to reduce debt."


M&A activity bodes well for credit quality


Mergers and acquisitions activity picked up strongly in 2004 and should continue into this year with relatively high transaction multiples. The implications for credit quality appear favorable as large companies divest non-core holdings at good prices.


"The number of companies that have non-core assets remains large, but we are now in the part of the cycle where sellers can obtain a more reasonable price for assets," says Rogers. "Companies that may divest assets in 2005 include Dow, Lubrizol, Crompton, Eastman, Air Products and possibly Ferro."


In January, Eastman Chemical agreed to sell its stake in Genencor International to Danisco for $419m. Eastman will use the proceeds to reduce debt.


Moody’s revised the outlook for Eastman’s Baa2-rated (BBB) long-term debt from "negative" to "developing," while S&P revised its outlook on Eastman from "negative" to "stable" and raised its short-term corporate credit rating from A-3 to A-2.


Despite the downgrades of Celanese, Lubrizol and the placement of Cytec under review for possible downgrade following M&A activity in 2004, Rogers believes M&A activity in 2005 will result in new entities issuing debt rather than downgrades of existing issuers.


"Given the recent success of financial buyers in flipping assets or raising cash through IPOs, we believe there is substantial capital available to pursue transactions in this industry," Rogers notes. "In our opinion, the majority of these transactions will result in new issuers."

By: Joseph Chang
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