Searching for return: Investors, cycles, and capital

21:34 PM | December 18, 2017 | Vincent Valk

Global chemical industry capital spending looks set for a decline in the next few years, despite continued strong spending in the United States, as M&A activity remains at a high level. Companies are looking for consistent returns on capital and growth investments—and investor pressure is rising.

It’s safe to say that 2017 has been another banner year for chemicals M&A. Some 276 transactions worth a total of $62.2 billion were announced in 2017 through 11 December, according to deals tracked by CW. While that value figure is off by about two-thirds from 2016’s record pace, the number of deals has held steady. Indeed, it’s possible to argue that activity below the megadeal level is increasing. Excluding deals with an announced value above $5 billion, values rose by 6.5% in 2017 through 11 December, to $41.6 billion.

At the same time, capital spending is expected to fall to levels comparable to the 1990s in real dollar terms, according to IHS Markit data. Capital spending is still increasing in the United States, due to low feedstock costs. US chemicals capital spending is expected to total $33.8 billion in 2017, and rise by another 6.3% next year, according to ACC. But in other regions capital investment is declining. New capacity in Asia outside China is expected to fall by more than half from 2017 to 2018, and remain low for the next few years, according to IHS Markit. In China, measured by capacity, investment will fall only slightly in 2018, but decline steadily thereafter. European investment may see a slight boost, but is likely to remain trivial in comparison to other regions.

Yet, for publicly-traded companies, at least in the United States and Europe, the pressure is on to generate quarterly growth. M&A continues to look like a preferred route for this, despite persistently high EBITDA multiples. Companies also prioritize giving cash back to shareholders via dividends and buybacks, although the latter appears to be on the decline. Share buybacks in the overall market are expected to fall by 21% in 2017, according to Bloomberg. Still, investors are asking management teams to put money to work or give it back, and activists are growing increasingly vocal about strategy. “The activists have really pushed down the number of companies that have really high cash balances,” says John Rogers, senior VP with Moody’s Investors Service (New York).

Industry executives know what’s at stake, and know that the future of their companies —and the satisfaction of their investor bases —depends largely on decisions about how to allocate capital. “Capital allocation is one of the most important things any of us does in business,” says Howard Ungerleider, CFO of DowDuPont and vice chairman and CFO of Dow.

Finding the balance

UNGERLEIDER: Balance is key in allocating

Good capital allocation is in no small part a matter of balance, according to Ungerleider. “We try to be balanced,” he says. “You have to look at all stakeholders. We have stockholders and bondholders, we try to have a target credit rating in mind.” In Dow’s case that rating is in the ‘BBB’ or ‘BBB+’ range, which qualifies as investment-grade. Dow and DuPont continue to have separate credit ratings, as their debt capital structures are different. It also remains unclear what the capital structures of the three spin-offs that will result from DowDuPont will look like.

Historically, Dow Chemical adopted a fairly straightforward metrics-based approach to making capital allocation decisions, Ungerleider says. The company targeted a return on invested capital (ROIC) of 13%, assuming a 10% weighted average cost of capital. “In Dow our focus has been to maximize our spread over the cost of capital in the long run,” Ungerleider says. The company has stuck to a 10% benchmark for the cost of capital despite low interest rates that have persisted for years. “We don’t want to be lulled into thinking that there will be a low interest-rate environment all the time,” Ungerleider says. “So we use 10% as a benchmark and the goal is to get a 300 basis point [or 3%] spread above that.”

That spread, however, can vary depending upon the risk of the investment. “A 13% return might be good for a low-risk investment” such as one in a product or market with which Dow is familiar, or one in a developed economy, Ungerleider says. “But for a higher risk project you want a higher possible return. And I’d say what the financial crisis taught me is that you can’t just do discrete planning. You need to run scenarios. Before the financial crisis, we’d look at the base case, but now we look at the base case, the worst case, and the best case. So we try to weight those and we look at the ROIC for an investment relative to other choices.”

Those choices include giving money back to shareholders in the form of share buybacks or dividends. “Over the past five years [Dow] has generated about $30 billion in operating cash flow,” Ungerleider says. “We’ve used half of it to invest in the business, and the other half was returned to shareholders.” DowDuPont announced a $4 billion share buyback program, along with a quarterly dividend of 38 cents/share, on 2 November. These figures represent Dow and DuPont’s combined pre-merger buyback programs and dividends, respectively. Moody’s says the company has ample liquidity and cash generation capacity to fund buyback and the dividend.

M&A ascendant

HARRS: Strong track records for acquisitions are rewarded.

DuPont merger aside, Dow Chemical has been quite active on the capital investment front in the 2010s. The company has invested in several new plants and capacity expansions on the US Gulf Coast, as well as 26 new units related to the Sadara joint venture with Aramco in Saudi Arabia.

Indeed, a wave of capital spending in the chemical industry has built over the past several years. The single biggest driver was the North American shale gas boom, but that was hardly the only factor. In terms of capacity added, the biggest investments have been in Asia throughout the 2010s, according to IHS Markit.

That wave, however, appears to have crested. “As decisions to build new capacity were delayed or cancelled during [2014 to 2016], chemical industry capital spending shifted toward mergers and acquisitions,” says Mark Eramo, global VP/energy and chemical markets at IHS Markit. Reduced spending in China and the rest of Asia is particularly notable, IHS Markit adds.

This even holds true for Dow. While the DuPont merger did not involve a cash consideration, it has been far more consequential than any individual cracker project. When the three spin-offs from the merger are complete, Dow Chemical will look considerably different than it did prior to the deal—especially after $8 billion in assets were transferred away from the materials science spin-off, the future Dow Chemical, in September.

Low demand growth and cheap debt has made M&A seem like a good bet for growth. “Low-cost access to debt, strong equity pricing, and weak earnings resulting from falling commodity prices in 2014 and 2015 have also been key factors behind the surge in M&A activity,” Eramo says. Bankers expect this situation to continue—a forecast borne out by 2017 deal numbers—although demand growth is improving and M&A valuations continue to climb.

M&A is currently seen as the key risk to industry credit ratings, as well. “We anticipate M&A to remain an important credit factor for the global chemical industry as companies try to look for growth through acquisitions fueled by the availability of cheap financing and a prevailing trend for chemical industry consolidation,” Standard & Poor’s (S&P; New York) said in a report last month. “There’s an increased likelihood of mounting debt leverage to finance these transactions [and] a general increase in integration or transaction risk.”

Moody’s agrees that M&A is driving down credit ratings. “We’ve seen a lot of ‘A’-rated companies drop down to ‘B’ or ‘AA’ over the past six or seven years,” Rogers says. “I would not be very surprised to see very few ‘A’-rated companies at the end of this spate of M&A activity.”

The best way to mitigate this risk is to plan for contingencies, according to Rogers. “It’s always important, from a ratings standpoint, to have a plan B that is credible,” he says. Many companies will sell assets to offset an acquisition that does not generate initially anticipated cash flows—Rogers uses Albemarle’s sale of Chemetall and FMC’s sale of its soda ash business as examples. “Selling a soda ash business in North America was a credible plan B,” he says. “But in Asia, maybe not so much, because of the cost structure. You need to have the deleveraging plan after the acquisition, and if things don’t go as planned have an idea of your next move to fix the balance sheet.”

Equity markets, meanwhile, increasingly view acquisitions as necessary components of any growth strategy. Some recent deals, such as FMC’s asset swap with DuPont or Quaker Chemicals’ acquisition of rival lubricants maker Houghton International, have seen companies’ share prices rise after the announcements. Others, such as Sherwin-Williams’ acquisition of Valspar, have entailed quick share-price rebounds after a brief dip. “It feels like there has been an impatience with organic growth, and companies who have taken on transactions have been regarded favorably,” says Mukta Sharma, managing director/chemicals consulting with IHS Markit. Investors frequently ask about M&A during earnings calls, and executives say it is a major topic of discussion at investor meetings.

It does, however, pay to have a reputation for strong execution on acquisition plans. “There is a case to be made that companies get rewarded for being seen as acquisition machines and growth engines and many companies appreciate that,” says Lee Harrs, managing director and head of chemicals with Houlihan Lokey (New York), an investment bank. “In today’s market, there is little doubt that this gets rewarded.”

Investor pressures

On the other hand, if investors, particularly activists, don’t like an M&A deal, that can be dangerous. For example, activist White Tale Holdings­­—an vehicle created by hedge fund Corvex and investment fund 40 North—successfully scuttled the Huntsman-Clariant merger. As the largest shareholder in Clariant, White Tale appears likely to continue to have an important say in the company’s strategic direction, and rumors have emerged that private equity firm CVC Capital Partners (New York) may seek to break up the company. While activists did not derail the Dow-DuPont merger, the changes to the spin-offs announced in September—which move a number of businesses from performance materials to specialty products—appear to have been designed in response to pressure from Third Point, another activist hedge fund. The moves bear a resemblance to proposals put forth by Third Point earlier this year. Trian Partners (New York), which mounted a proxy fight against DuPont in 2015, also had a hand in negotiating the original deal, though the extent of the fund’s influence is unclear.

Led by activists, investors in general have become more vocal about strategic concerns. In many instances, activists echo the concerns of institutional shareholders, who have a less confrontational approach. Indeed, White Tale had buy up a 20% stake in Clariant to kill the merger with Huntsman, strongly suggesting that other shareholders shared its view of the merger.

Activist investors have been vocal about other strategic considerations, as well—including capital allocation. “In the past few years, we have observed activist investors increasingly taking a bigger role to drive management teams and boards decisions regarding allocating capital among M&A, reinvestment in core businesses, or share buybacks,” says Craig Kocak, partner with PricewaterhouseCoopers (PwC; New York). This influence can serve to push things in particular directions. “When times are good, activist investors want…to minimize cash on balance sheets,” Rogers says. “They don’t want companies to take really large bets on new capacity unless it obviously entails some advantage, such as lower feedstock costs.”

And while demand growth is not expected to substantially exceed GDP growth, and some uncertainty remains around oil prices, times are good at the moment. ACC and Cefic are both forecasting increases in chemicals output for 2017 and 2018. The CW75 index has risen by over 20% so far this year, and price-to-earning ratios for publicly-traded chemical companies are high. IHS Markit expects global GDP growth to be steady next year, at 3.2%.

Investors see this and expect companies to react accordingly. “Companies and investors alike need to continually be in tune with the market and cyclical dynamics of the industry and the economy,” Kocak says. There is an element of cyclicality to capital spending and M&A, and to equity and debt markets. For example, interest rates have been low for several years now, helping to boost corporate borrowing and, thus, M&A activity. But most observers expect the US Federal Reserve to raise interest rates steadily over the course of the next year, in response to an improving economy. A quarter-point rate increase was approved by the Fed on 13 December, and reiterated its projection for three additional rate hikes in 2018. The rate increases appear likely to be modest—and are not a significant concern for industry executives and bankers—but could, in the long term, change the capital allocation calculus. A new cycle is certain to begin at some point.

Considering this, communication with investors is critical for ensuring that they understand a company’s strategy and its views on markets, cycles, and capital allocation. Ungerleider says he talks to shareholders every month, and ratings agencies two or three times per year. “You may get lots of different opinions, but you have to listen and make them comfortable about your strategy,” he says. “You don’t want to surprise anyone. [Your decisions] should be consistent with what you’ve communicated to investors over time.”