INSIGHT: Persistent slow growth will encourage more chemicals M&A

By Al Greenwood

HOUSTON (ICIS)–Chemical companies are likely to continue pursuing mergers and acquisitions (M&A) because the outlook for growth remains lacklustre.

Already, chemical companies have been making a lot of deals during the past several quarters, as shown in recent reports by the consultancies PwC and Deloitte .

More M&A could be on the way, said Vijay Sarathy, a partner with PwC. “We have many innings to play out here.”

Deal-making is the latest strategy for companies to eke out growth, Sarathy said. After World War II, companies discovered new chemicals and molecules and found new markets for these projects.

After building capacity in developed markets, they expanded into emerging ones and those with access to low-cost feedstock, he said.

Once they played out that hand, they focused on specialty chemicals in a move intended to bring them closer to customers, Sarathy said. However, the strategy often resulted in jumbled, incoherent portfolios of products.

Activist investors have pressured companies to make their portfolios more logical and coherent by divesting those businesses that do not match and acquiring those that do.

This pursuit of more coherent portfolios is one of the reasons behind this latest wave of M&A deals, Sarathy said. “What I see happening here is a lot of portfolio realignment.”

For the most part, the result of these deals will not be larger companies, he said. They will be smaller and more coherent.

There are many reasons behind this trend.

It is easier to manage companies that are more coherent, Sarathy said. Also, the combination of similar businesses results in more synergies and consolidation. That, in turn, can provide companies a boost in earnings.

This focus on bottom-line growth has become more urgent because increasing revenue has become much more elusive.

Revenue growth depends on market growth. If markets aren’t growing, increasing revenue will be challenging.

The chart below illustrates the challenges in growing revenues. It shows the GDP growth rates for the US and for the world, according to the International Monetary Fund (IMF).

Figures are in constant prices

Ever since the financial crisis, US annual growth has not broken 3%, according to the IMF. Since 2012, global GDP has not exceeded 4%. Looking forward, the outlook is for more of the same.

In such a slow-growth world, M&A provides chemical companies with the opportunity to achieve growth through synergies. “You will see an industry that gets a little bit of a boost in earnings,” Sarathy said.

This is particularly true for agrochemicals and fertilizers.

In the US, farm income has fallen, and it is the most reliable indicator for agrochemicals demand.

The following chart from the US Department of Agriculture (USDA) shows net farm income in billions of dollars. The years 2016 and 2017 are forecasts.

The slowdown in agriculture has caused a spurt in M&A among the biggest companies in the chemical industry, such as Bayer and Monsanto; China National Chemical Corp (ChemChina) and Syngenta; and Dow Chemical and DuPont. Among fertilizer companies, Agrium is merging with PotashCorp.

Deal-making was by no means limited to the agriculture segment. In industrial gases, Praxair and Linde are merging. Air Liquide has already completed its acquisition of Airgas.

In paints and coatings, Sherwin-Williams is acquiring Valspar, while PPG Industries is in the midst of an acrimonious bid to buy AkzoNobel.

This M&A strategy does not come free of challenges. In a recent report, Moody’s Investors Services expects the credit quality of the North American coatings sector to erode.

Producers are struggling to meet shareholder expectations for organic growth, Moody’s said. They are compensating for the difficult business conditions by making ambitious M&A proposals.

“Lower growth prospects for coatings leave highly rated public chemical companies to choose between maintaining ratings and pursuing M&A transactions that may become increasingly necessary at a time of slower macroeconomic growth,” Moody’s said.

Sherwin-Williams’s purchase of Valspar will be all cash and entirely debt financed, Moody’s said. The multiple of the deal is more than 15 times Valspar’s annual earnings before interest, tax, depreciation and amortisation (EBITDA).

Moody’s estimates that pro-forma net leverage was 4.6x at the end of 2016. Synergies could bring it down to 4.1x. Within two years of closing, Moody’s expects leverage could approach 3.0x, while Sherwin-Williams expects it could reach 2.0x by the end of 2019.

PPG is attempting to acquire AkzoNobel at a lower multiple than the Sherwin-Williams deal, Moody’s said. Moreover, its offer includes a mix of cash and equity. AkzoNobel also has a large specialty-chemicals business, which PPG could divest.

Based on the company’s second offer, Moody’s expects debt-to-EBITDA would range from the high 2x to the mid 4x.

Despite these challenges, Moody’s expects more M&A in the coatings sector. The industry still has a large number of smaller companies, which open up many opportunities for consolidation.

Industry trends are making such consolidation more attractive. Regulators are adopting stricter rules for volatile organic compounds (VOCs), while industrial applications are requiring higher performance specifications, Moody’s said. In this kind of environment, it is becoming more difficult for small and medium-sized companies to compete.

Meanwhile, as the large coatings deals come to fruition, anti-trust regulators will require divestments.

As in the chemical industry as a whole, coatings companies will be making more deals.