Analysis: Underleveraged specialty chem firms look for deals

11 March 2005 16:56  [Source: ICIS news]

NEW YORK (CNI)--After years of paying down debt, cutting costs and disciplining capital expenditures, the specialty chemical industry finds itself somewhat underleveraged and generating decent amounts of free cash flow.


Some of these companies are now taking advantage of the situation by making acquisitions, buying back stock and boosting dividends.


"The US specialty chemical group is underleveraged, given the relatively strong economy, the strength of company balance sheets and the outlook for solid free-cash generation," said CS First Boston analyst John McNulty. "This leaves the management teams in the group significant firepower in their arsenals for acquisitions, share repurchases and dividends."


Indeed, a number of US specialty chemical companies with clean balance sheets are stepping up to make cash acquisitions. Most recently, Engelhard offered to buy Coletica, a publicly-traded producer of skin care compounds and related technologies for the cosmetic and personal care industries for $88.7m (Euro65.9m).


However, companies can sometimes simply use stock to make acquisitions. For example, Crompton is merging with Great Lakes Chemical in a $1.8bn stock deal.


Other specialty chemical deals over the past year include Cytec Industries/UCB Surface Specialties ($1.8bn), Sigma-Aldrich/JRH Biosciences ($370m), Henkel/Sovereign Specialty Chemicals ($575m), Arch Chemicals/Avecia’s biocides business ($215m), Albemarle/Akzo Nobel’s catalysts unit ($841m) and Lubrizol/Noveon ($1.84bn).


"Those with the cleanest balance sheets seem to be favouring a more aggressive approach toward acquisitions, while the rest are mixed with some favouring share repurchases and others focusing more on dividend increases," McNulty said. "The companies with the most firepower include Engelhard, Ecolab and Valspar, all of which we expect to make acquisitions."


The specialty chemical group has significantly slashed debt over the past four years. From 2000 to 2004, Engelhard has cut its debt/capital ratio from around 45% to just over 20%, facilitating deals.


Cytec’s aggressive debt paydown over the years has allowed it to make a substantial acquisition. Prior to buying UCB Surface Specialties, Cytec had net debt of just $142m in net debt and a debt/capital ratio of 9% versus nearly 60% in 2000. Lubrizol had an A+ rated balance sheet before acquiring Noveon, while Arch cut net debt by 23% in 2003 before picking up Avecia’s biocides business in 2004.


To determine how much excess capital companies have to make acquisitions, buy back stock or hike dividends, McNulty recommends looking at current debt/capital relative to past peak levels "as it shows how much debt they are willing to take on for the right opportunity, which is usually an acquisition."


Based on this analysis, most companies have substantial capital available to make acquisitions. McNulty then looks at available capital as a percentage of equity market capitalization to determine what that leverage means to each company with regard to its size. On this basis, companies with the greatest buying power include Ferro, Valspar, Engelhard, Praxair and Air Products.


Engelhard has around $2bn in potential excess capital, according to McNulty. "We expect acquisitions to remain a top priority for Engelhard," he said.


Taking on $2bn in debt would push Engelhard’s debt/capital from 22% to roughly 60%, taking into account 2005 free cash flow estimate, McNulty said. "Even if Engelhard was not willing to drive its debt to historic peak levels and just pushed debt towards its target level of 40%, the company could take on over $600m of debt."


Engelhard has also used cash for share repurchase, having bought back $110m in stock each year for the past three years, reducing shares outstanding by 7m shares, or about 5%.


Valspar has slashed debt/capital from a high of 77% after the Lilly Industries acquisition in 2001 to around 40% today, McNulty said. "After spending a number of years reducing its debt, Valspar is back in a position to do what it does best - use its capital to make acquisitions," he said. "Management has made no secret as to what it wants to do with its excess capital, having constantly called for consolidation in the coatings industry."


McNulty estimates Valspar has roughly $200m of excess capital if it pushed debt/capital to its target of 45%. However, taking debt/capital back to 77% would yield as much as $2.5bn in excess capital.


"Aside from acquisitions, we expect Valspar to put cash and excess capital toward dividend increases and minimizing share creep," the analyst said. "However, we expect the company to keep most of its powder dry until it finds the right acquisitions."


Specialty chemicals giant Rohm and Haas is also deleveraging. The company cut net debt from $2.39bn at the end of 2003 to $2.02bn by the end of 2004 for a debt/capital level of 35%. In late February, the company retired $400m in debt.


Rohm and Haas continues to buy back stock, having authorized a $1bn share repurchase program last December. The company hiked its quarterly dividend by 14% to 25 cents last May.

By: Joseph Chang
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