Market outlook: Refinancing will drive chemicals consolidation

15 November 2013 10:00  [Source: ICB]

The next five years should see a wave of global consolidation activity as large blocks of debt come due and US shale gas dynamics change the landscape

The next five years will be crucial for the development of the global chemicals industry. Which companies will have the strength to emerge as leaders when the dust settles?

Measured against the early 2000s, the restructuring and debt buildup that occurred in the chemicals industry from 2006 to 2008 was extraordinary. The industry conducted deals worth more than $330bn (€239bn) over that period, with the majority of deals valued at more than $5bn.

By contrast, almost two-thirds of the deals made in 2012 were worth less than $1bn, none were worth more than $5bn, and the industry’s deals as a whole were worth only $49bn, the lowest level since 2003.

One result of the debt build-up from all the mergers and acquisitions (M&A) activity will arrive soon – a wave of repayments that will come due between 2013 and 2016.

At the same time, borrowing is expected to increase, thanks to a resurgent US industry seeking project financing for up to 10 new worldscale cracker and derivative plants.

The original lenders in this sector have suffered through painful write-downs with several major industry players. As a result, industry consolidation is inevitable as lenders and the industry move to strengthen companies prior to refinancing.

Overall, these developments are opening up an opportunity for new entrants and companies from Asia and the Middle East to acquire or merge with established Western chemical companies.

According to our analysis, the bulk of the debt repayment is concentrated over the next few years, with levels of $22bn-26bn through 2015 leading to a peak of $33bn due in 2016.

This comes at a time when US project activity is increasing because of shale gas, drawing funds into the industry to add significant amounts of new capacity.

Looking ahead, any potential oversupply that new capacity causes will depress margins and present significant challenges for those seeking to refinance their existing assets.

To gain an understanding of the debt situation in the global chemicals industry, we analysed 227 companies, both public and private, spanning different industry sectors in all regions with revenue of more than $1bn.

Of the companies, 119 are based in Asia, 52 in North America, 44 in Europe, and the balance in the rest of the world. About half are focused on commodity products and half are diversified or specialty product players. These companies have collective debt of roughly $380bn and the top 27 most indebted companies have debt of roughly $170bn.

Companies have used a combination of debt to fund their ventures, including inventory finance, revolving credit for working capital, securitisation, bullet bonds and normal interest-bearing instruments.

Lenders look at total debt capacity, and we anticipate demands for standby equity, debt for equity swaps, further equity injections, and even pension fund top-ups where the limits or loan covenants have been reached.

In Europe’s refining sector, Petroplus collapsed, and there are likely to be parallels for the commodity chemical players. Debt refinancing is likely to be a major driver for M&A and divestment activity in all regions.

A look at the debt-to-equity ratio and earnings before interest, tax, depreciation and amortisation (EBITDA) margins compared with available credit ratings shows that the chemical industry’s investment-grade companies have debt-to-equity ratios below 90% and EBITDA margins of greater than 10%.

About half have Standard & Poor’s credit ratings of BBB or above and should be able to maintain and increase their debt relatively comfortably to become potential leaders during the industry’s inevitable restructuring.

The remaining companies will need to restructure quickly, but some will inevitably find this difficult and fall prey to bankruptcy or takeovers.

To add to this picture of large-scale refinancing, there will be a major pull on project finances, which may be followed by a cyclical low in the commodity markets based on overbuilding in the US.

The availability of natural gas liquids (NGLs) from US shale developments has resuscitated the US chemical industry, and a new round of investments is underway via expansions and new construction.

Companies in the Americas have higher debt-to-equity ratios than other regions, which would generally make them vulnerable to takeovers.

But the shale gas revolution has handed many of them an unexpected lifeline, with the market now expecting improved profits and a long-term cost advantage.

However, this development will not benefit everyone. Cracker owners will likely keep the lion’s share of the value, reinforced by a recent ruling by the US Internal Revenue Service that extends the use of master limited partnership (MLP) structures for building gas crackers.

US commodity companies without a feedstock advantage will either need to buy into a “condo cracker” – a term for crackers built in partnership by several companies – or find a partner that can finance a new build to stay independent.

Cracker owners will look to acquire such companies to secure their olefins sales, which will also drive consolidation. The US will become a major product exporter, reversing a trend of growing imports and driving companies in the country to secure market access, especially in Europe.

We expect cross-border transactions between chemical companies in the US and Europe, driven by a need for US exporters to access the largest available market option for exports.

What would a bubble in America’s ethylene supply mean for the rest of the world? If America experiences a bubble in its supply of ethylene – one of the industry’s most important chemicals – then Europe will 
become less attractive for debt in the chemical sector.

Europe is likely to come under significant pressure as exports from North America and the Middle East focus increasingly on this market. Large-scale naphtha crackers in Europe, which provide the building blocks of many derivative chains, will face financial pressures, and significant closures are inevitable with the potential for five to 10 crackers to close.

Refinancing will need to take place in the context of oversupply and asset rationalisation for holders of the $76bn in debt of European chemical companies. The knock-on effect for cracker derivatives will also put pressure on the industry to restructure.

Naptha based producers in Asia, and in particular in South Korea, are also likely to come under pressure in this scenario.

From a transaction perspective, Asian acquirers are the most active in the chemicals industry, having made more than 40% of all deals globally since 2006.

In 2013, financial buyers have been 
very active, as have buyers motivated by regional expansion, portfolio expansion or backward integration. Overall, the companies with the strongest balance sheets will be the active buyers, and they will lead the industry’s consolidation.

The credibility of their management teams and the coherence of their long-term strategies will be crucial for attracting funds for any M&A.

We may also see the return of inorganic chemicals to the acquisition trail as they look to monetise shale deposits after a decade of deconsolidation and divestment in this sector.

Although there are no hard-and-fast rules that define an acceptable debt service ratio, and each company will be covered by its banking covenants, the players whose ratios are low will struggle, especially when they drop below 2-to-1 for an extended period of time.

Companies in this zone with access to low-cost feedstock, strong market positions or the leading technologies will prove the most attractive targets to acquirers with the means to make purchases.

The landscape for deals in the chemicals industry is shifting. As the industry’s debt situation reaches an important stretch with a wave of repayments due, financing capability will become an important M&A driver both for sellers and buyers.

That trend, combined with shale-gas-driven investments and strategies, will create new catalysts for deals in the chemicals sector in the coming years. Those companies in the best financial shape will be able to take advantage of the conditions and pursue a long-term advantage.

Andy Walberer is a partner with A.T. Kearney and leads the firm’s Chemicals Practice in the Americas. He can be reached at Richard Forrest is an A.T. Kearney partner and Chemical Practice leader for Europe and the Middle East, and is based in London. The authors would like to acknowledge the contributions of their colleagues on this study – Philip Dunne, partner based in London; and Joachim von Hoyningen-Huene, principal based in Munich.

Author: Andy Walberer

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