Financial market turmoil takes its toll on the industry

Why the credit crunch matters

04 April 2008 00:00  [Source: ICB]

Corrections: in the ICIS Chemical Business story headlined "Financial market turmoil takes its toll on the industry," please read from the second sentence in the seventh paragraph as: "This may prove expensive at companies such as Dutch petrochemical manufacturer LyondellBasell, which faces the challenge of rising interest rates on $8bn of interim financing left over from its takeover last year by US industrial group Access Industries. If it fails to replace the financing, it faces a provision that raises the interest rate by 0.5 percentage points over the London interbank offered rate every three months, starting in June. The financing rolls over into permanent financing in December 2008," instead of: "This may prove expensive at companies such as Dutch petrochemical manufacturer LyondellBasell, which faces the task of replacing $8bn of interim financing left over from its takeover last year by US industrial group Access Industries. If it fails, it faces a provision that raises the interest rate by 0.5 percentage points over the London interbank offered rate every three months, starting in May."

And please read the second sentence of the second-to-last paragraph as: "But for many companies, like LyondellBasell, which faces higher interest rates in June on a portion of its financing, the lack of liquidity on financial markets may have an even greater impact on bottom lines," instead of: "But for many companies, like LyondellBasell, which has until May to replace its bridge financing, the lack of liquidity on financial markets may have an even greater impact on bottom lines." A corrected story follows.

The second of our credit crunch series examines how the deterioration of chemical company ratings may be as much a result of illiquidity as of companies' operational woes

Ed Zwirn/New York

AT THE end of the day, the bankers' case smacked of desperation.

Despite the turmoil in the financial market that began late last year, when the extent of the subprime crisis became apparent, it was never very likely that Citigroup Global Markets, Goldman Sachs Credit Partners, Deutsche Bank Securities and Deutsche Bank Trust would be allowed to back out of their October 25 commitment to arrange the $2bn (€1.3bn) of financing needed for US specialty chemicals producer Solutia to climb out of bankruptcy.

The banks had attempted to use the MAC (material adverse change) clause in their deal with the company, which had been bankrupt since 2003, to argue that there had in fact been an adverse change in credit markets since the deal was struck and that fact justified the cancellation of the deal. After Solutia responded with a lawsuit, the banks agreed in late February to come up with the money.

Far from indicating any easing of the credit crunch, the Solutia episode highlights the difficulty chemical companies, like companies in many other sectors of the US economy, increasingly experience when they try to access credit. Solutia got its money only after kicking and screaming, and in all likelihood, the financial institutions involved in this game of chicken, were left holding the ball, required to provide the financing, but unable to spread the risk around via syndication.

"I've never seen a bank exercise a MAC in a deal like this," says John Rogers, an analyst at global credit ratings agency Moody's Investors Service. The banks "committed to doing this and conditions really hadn't changed since October, but they realized that the markets weren't going to allow them to syndicate the loan."

In addition to the difficulty of securing loans was the fact that the corporate bond markets, in particular the market for high-yield debt, has also become illiquid in the wake of the subprime crisis. "Currently, the market for more speculative high-yield issuers is not functioning," he says.

The absence of sources of funding that were plentiful less than a year ago only exacerbates the squeeze in which many companies find themselves, particularly after leveraged buyouts (LBOs) and other debt add-ons. This may prove expensive at companies such as Dutch petrochemical manufacturer LyondellBasell, which faces the challenge of rising interest rates on $8bn of interim financing left over from its takeover last year by US industrial group Access Industries. If it fails to replace the financing, it faces a provision that raises the interest rate by 0.5 percentage points over the London interbank offered rate every three months, starting in June. The financing rolls over into permanent financing in December 2008.

UNDER PRESSURE

In addition, most chemical companies, at least those directly or indirectly dependent upon the housing market in the US, are already feeling the pinch from the economic slowdown and the compression of operating margins brought about by rising energy feedstock costs. The more recent news here is that many of these same companies are finding themselves unable to borrow.

"The combination of constrained liquidity in the capital markets, increased risk aversion and the exposure of a few leveraged issuers to weaker domestic end markets could increase downside ratings pressure," says Kyle Loughlin, analyst at global credit ratings agency Standard & Poor's.

"The companies that are of greatest concern during 2008 are those with businesses affected by the domestic residential construction market."

The specific credit worries associated with chemical companies exist against a backdrop of a broader deterioration in overall creditworthiness, particularly as much of the leveraging involved in the merger and acquisition (M&A) explosion of recent years comes home to roost on companies needing to refinance or otherwise bridge their way through cashflow disruptions.

Moody's predicts that the rate of default among US speculative-grade debt issuers is likely to rise to 5.3% by the end of this year, up from 2007's 0.9%, the lowest rate recorded by the ratings agency since 1981.

Zeroing in on the chemical sector, Rogers says that while 2008 "will be a tougher year for the domestic industry most firms in the chemical industry should escape the brunt of a downturn due to the lower US dollar," which favors exports, "and growth in Asia."

WHO WILL FEEL IT MOST?

Where a particular company fits specifically into this general scenario depends in large part upon the end market being served.

Companies serving agriculture should "demonstrate exceptional strength in 2008" as crop prices rise and global stocks remain low. Industrial gas firms should also "exhibit solid growth due to regulatory-driven demand, as well as continued strong growth in the energy sector and Asia," says Rogers.

"Larger companies with significant international exposure" should also be cushioned from the adverse economic exposure, he adds, naming US chemical groups Dow Chemical, DuPont, PPG Industries, Rohm and Haas and Celanese as examples of members of this group.

On the weaker side, companies with large regional exposure to North America (greater than 60% of sales) will have a "tougher time but should still generate metrics that aren't substantially weaker, providing they supply industrial end-markets," Rogers says.

The companies facing the biggest threats to credit worthiness are those that, like US chlorovinyls producer Georgia Gulf and Canadian bonding and surface materials maker Arclin, face significant exposure to US auto and housing, although there are companies like US firms Westlake Chemical (with much lower debt and more diversified than peer Georgia Gulf) and Hexion Speciality Chemicals (with a larger international presence and more diversified product line) that should hold up better, according to the Moody's analyst.

LBO HANGOVERS

Beyond the macroeconomic factors affecting the operating performance of chemical companies, the state of individual company balance sheets should also play a role in determining financial strength this year, as will challenging credit market conditions. Last month's bankruptcy of US plastic packaging producer Wellman - the fourth default recorded by S&P since January 2004 - was a "response to deteriorating trends in polyethylene terephthalate [PET] and indications that liquidity could weaken into 2008," says Loughlin.

But it is the finance end of the equation that seems to be hurting companies in the sector most. According to Loughlin, in a trend "concurrent with fairly strong operating results," overall ratings are on the decline from the present BB- median, migrating "with each passing quarter downward to the B category." This deterioration, he says, is caused by "a shift in credit quality among some long-standing rated issuers and that the vast majority of new issuers are highly leveraged."

There is enough of a negative impact from the economy and operating fundamentals, as any holder of Georgia Gulf bonds ought to be aware. But for many companies, like LyondellBasell, which faces higher interest rates in June on a portion of its financing, the lack of liquidity on financial markets may have an even greater impact on bottom lines."

"Most chemical companies' balance sheets appear strong enough to weather these issues," says Loughlin. "For some of the more leveraged, speculative-grade issuers, however, the credit outlook could be somewhat less upbeat."

ICIS Copyright © Reed Business Information 2009

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