- Speculative-grade chemical issuers in EMEA, many of them private-equity-owned, have become increasingly indebted, with median leverage rising to about 5.6x in 2019 from 4.7x in 2018. This makes them vulnerable to the softening operating environment.
- Companies serving end markets exposed to the slowdown will be most prone to credit stress, while high-end specialty chemicals and fertilizer producers, and companies with relatively healthy balance sheets should fare better.
- We don't foresee material liquidity issues while interest rates remain low given recent refinancing and maturity extensions, but the synergies and efficiencies expected from LBOs may be more difficult to realize.
- Financial policies and management actions to reduce costs will be key to maintaining credit quality, but in many cases may not be sufficient to mitigate profit declines.
Displacement Reactions In EMEA Chemicals
The past decade has witnessed a steady migration toward speculative-grade ratings among chemical companies S&P Global Ratings covers in Europe, the Middle East, and Africa. In particular, a strong rise in companies rated 'B' has been fueled by an increase in investments in the sector by private equity, reflecting growing expertise of this type of investor in running and adding value, primarily in specialty chemical businesses. These primary LBO targets became available mainly through disposals by large chemical companies, which have recalibrated their portfolios to focus on their core businesses or enhance growth and margins by cherry-picking the most profitable product lines. Private-equity buyers of chemical carveouts are drawn by their attractive value creation opportunities, notwithstanding the cost, know-how, and time needed to establish a stand-alone company.
In general, specialty chemical companies' operating performance is more stable than that of commodity chemicals. In many cases, they offer promising growth, underpinned by long-term fundamentals, such as an expanding middle class, or the need for lightweight products or emission reductions. Typically, their stable and predictable cash flows are underpinned by long-term contracts for products that have been developed in collaboration with end-customers, ensuring loyalty and revenue visibility. Although specialty chemical products represent relatively insignificant of the cost of a final product, they are key to its final properties and functionality. This offers manufacturers strong bargaining power and allows them to pass through higher prices of raw materials, should they arise. These properties have made this subsector of the industry the most appealing to private-equity firms in recent years, resulting in competitive bidding processes and high valuations, supported by low interest rates and availability of financing.
Out of 36 speculative-grade issuers that we rate, that is those with ratings below 'BBB-', we classify about 56% as producers of specialty chemicals, 17% as producers of fertilizers, and 6% as distributors, with the balance being commodity chemicals producers (see chart 3). Within the speculative grade, we rate 22 issuers in our 'B' category, about 90% of which are owned by a private-equity sponsor.
On average, the debt deal size of a typical private-equity buyout in the sector oscillates between €300 million and €400 million according to LCD, although we have seen an appetite for larger deals, too. (LCD or Leveraged Commentary & Data is an offering of S&P Global Market Intelligence, a division of S&P Global, as is S&P Global Ratings.) These included Carlyle's acquisitions of a specialty plating solutions manufacturer Atotech UK Topco Ltd. (a carveout from Total S.A.) for $3.2 billion in 2017, and of a specialty and commodity manufacturer Nouryon Holding B.V. (carveout from Akzo Nobel N.V.) for €10.1 billion in 2018 (the latter acquired together with sovereign wealth fund GIC Private Ltd).
We anticipate that portfolio reshaping activities by large chemical players will continue driving M&A transactions in the sector in 2020. Already in December 2019, BASF announced it will sell its construction chemicals business to private-equity firm Lone Star for €3.17 billion, and Clariant announced that it will sell its Masterbatches business to PolyOne Corp. for about $1.56 billion. Both transactions are subject to regulatory approvals.
Softening Demand Will Raise Credit Pressures
The global economic slowdown and the slower demand for chemicals will test the credit resilience of speculative-grade chemical companies, especially highly leveraged companies with tight headroom. 2019 was a year of two halves in the chemical industry. In the first half, end-market demand and pricing conditions appeared benign and relatively healthy overall. However, the profit warning announced by BASF in July 2019 sent shockwaves across the industry, as the world's leading chemical producer guided the market that it expected EBIT before special items for 2019 to be as much as 30% lower than for 2018 due to weaker-than-expected industrial production.
S&P Global Ratings' latest economic forecast assumes that eurozone GDP will decelerate to 1% in 2020 from an expected 1.2% in 2019, while the slowdown in the U.S. will be more pronounced at 1.9% in 2020, from an expected 2.3% in 2019. We anticipate China's GDP expanding at a still-strong rate of 5.7% in 2020, but slower than the 6.2% we expect for 2019 and an actual 6.6% in 2018.
According to the American Chemistry Council (ACC), an industry body, global chemical production was up only 1.4% year on year to November 2019. This was supported by 1.9% growth in basic chemicals (notably synthetic rubber and manufactured fibers) and a 1.4% rise in specialty chemicals, partly offset by a 2.5% decline in agricultural chemicals. However, this overall growth was led by emerging economies. Chemical output in North America declined by 2%, while Europe contracted by 1.1%. ACC anticipates global chemical production will advance by 2% in 2020, while Cefic, the European Chemical Industry Council, expects no recovery in chemical production in the EU in 2020.
In our base-case scenarios for EMEA chemical issuers, we expect that continued soft demand for chemicals is here to stay in 2020. Of course, given that the sector is not homogeneous, the impact will not be uniformly distributed: certain subsectors or business lines may be more, less affected, or not at all. For example, we anticipate performance of agrochemical and fertilizer issuers will follow the development in crop prices, weather conditions, and supply-and-demand fundamentals in their specific industries, rather than general economic conditions. Also, diversification of EMEA chemical issuers, notably in emerging regions such as Asia, should provide some cushion from the sluggish domestic environment.
Still, many chemical issuers, notably at the lower end of the speculative-grade rating spectrum, will enter the soft environment with relatively highly leveraged capital structures (see chart 4) and therefore with little room to maneuver under stress. As a result, some companies may find it challenging to emerge from the initial post-transaction debt burden, contrary to the investment premise assuming everlasting growth and supportive business conditions. In addition, upside to EBITDA, owing to realization of synergies and other efficiencies that are typically built into the syndication models, may be delayed, not materialize at all, or be offset by weakening underlying profitability. This is not a concern for our leverage metrics, however, because we do not fully factor such items into our forecasts, and as a result, our EBITDA forecast is typically lower than that in management presentations. We also factor in the restructuring costs required to achieve the synergies, which in our view are not always one-off in nature.
We think that the credit quality of speculative-grade chemicals issuers in EMEA may be protected to some extent by the specialty chemical nature of their activities, which is typically more resilient than commodity chemicals. However, it is worth noting that practically all of our specialty chemical producers also have other, more commoditized or intermediate product lines. As a result, they are unlikely to be immune to the limited visibility, customer caution, the U.S.-China and/or Middle East tensions, and the general economic slowdown that we foresee in 2020.
Ratings Could Continue To Slip
With softening demand, we expect negative pressure on the credit quality of chemical issuers in EMEA to continue. Already in 2019, downgrades exceeded upgrades, contrary to 2018 (see chart 5). Out of 60 chemicals companies that we rate publicly and privately in EMEA (both speculative and investment grade), we took three downgrades and two upgrades in 2019, compared with five upgrades and four downgrades in 2018. However, with 14% of speculative-grade EMEA chemical issuers on a negative outlook, the bias in the portfolio is clearly negative and has worsened in comparison with 2018, when only 3% of the issuers were on a negative outlook (see chart 6).
Within our speculative-grade portfolio, the key drivers for downgrades or revisions of outlooks to negative in 2019 were signs of a weaker market environment (notably in the second half of the year), refinancing risks, or company-specific reasons. In September 2019, we lowered the rating on potash producer K+S AG to 'BB-' from 'BB' after it announced that it will reduce its potash production due to the weak market environment. In the same month, we lowered the rating on Flint HoldCo S.a r.l. to 'CCC+' from 'B-' due to our view of its unsustainable capital structure over the long term and refinancing risks.
For the two issuers that we upgraded in the first half of the year, specialty chemicals manufacturer Perstorp Holding AB (publ) (March; to B/Stable/--) and fertilizer maker OCI N.V. (June; to BB/Stable/--), we subsequently revised the outlooks to negative in the second half. This reflected slower-than-anticipated deleveraging due to extensive turnaround and hence lower EBITDA in case of OCI and the challenging market environment in the case of Perstorp.
Decoding The Molecules In The Mixture
EBITDA adjustments and add-backs, which make companies appear more creditworthy, have been a hot topic in the leveraged finance market. As investor demand has increased for loans, this has, arguably, enabled increasingly more aggressive deal structures, reflected in rising overall leverage.
We have compared pro forma and reported EBITDA for 17 chemicals issuers since 2017 (including loan and bond issuance). All issuers, apart from one, are private equity owned. Pro forma adjusted EBITDA includes forward-looking expectations of cost and revenue benefits estimated by management and presented to investors as part of the marketing process for the debt placement.
The data suggests that, on average, pro forma adjustments improve marketing EBITDA by 21% (median 19%). More than one-half of the sample size marketed an EBITDA adjusted by 15%-25%. Six outliers had add-backs to the tune of 10% (Perstorp Holding, Nouryon Holding, Atotech UK Topco) and 30%-35% (Flint HoldCo, European Crops Products 2 Sarl, and one privately rated company).
Cost savings and cost synergies constitute on average nearly 60% of the adjustments to reported EBITDA. Full-year adjustments for acquisitions and divestments contribute on average 17% of pro forma adjustments. The cost benefits and synergies are typically added without taking into account the time and costs necessary to attain them and, by and large, the net benefits can be marginal for secondary LBOs or add-backs and refinancing transactions. However, for primary LBOs (public to private or corporate spin-offs), we observe that, owing to an abundance of "low hanging fruit" savings opportunities in such transactions, the forecast net cost synergies are largely realized and contribute positively to EBITDA in the first three-year horizon post closing.
In our sample, pro forma adjustments led to, on average, a 1.0x improvement (reduction) in overall net leverage ratios (0.8x improvement on net first-lien leverage). The leverage improvements ranged from 1.5x (Flint HoldCo) to a minimum of about 0.5x (Monitchem Holdco 2 S.A., OXEA S.a.r.l., Luxembourg, Perstorp Holding, Specialty Chemicals International B.V., and Atotech UK Topco).
Negative Free Cash Flow Exacerbates Credit Risks
While we are not predicting a recession or a market crash, certain companies are more vulnerable to downside risks. We view companies as more dependent on supportive business conditions to protect their credit quality if we forecast of negative free operating cash flow (FOCF) due to near-term investments or working capital volatility. Similarly, companies with rating headroom only a few percentage points away from our target ratios are at risk of a downgrade. These factors apply to the following companies:
- Flint HoldCo Sarl (CCC+/Negative/--) has been facing weakened market demand for packaging products and a continued decline in the commercial, publication, and sheet-fed (CPS) business. We view the current capital structure as having high refinancing risks, given the company's weak performance and significant debt maturity in 2021.
- Monitchem Holdco 2 S.A. (B-/Stable/--) could deliver an improvement in its EBITDA margin in 2020 given its expected acquisition of Jayhawk from Evonik Industries AG, as well as the launch of more profitable products and favorable pricing incentives. However, we forecast negative FOCF over the near term because significant capital expenditure will burden near-term cash generation, which is likely to hinder the company's deleveraging prospects.
- Perstorp (B/Negative/--) reported EBITDA of 1.3 billion Swedish krona (SEK) in the first nine months to Sept. 30, 2019, down by 11% compared with the equivalent period of 2018 as a result of softer end-market demand and increased competition. Against this background, we anticipate that the company will pursue its strategic capital expenditure of about SEK1.2 billion in 2020, mainly to support the construction of the Penta plant in India. As a result, we anticipate that the company will generate about SEK200 million of negative FOCF in 2020, and that its leverage could be a high 6.7x-6.9x in 2019, declining to below 6.5x in 2020.
- Seqens Group Holding (B/Negative/--) experienced several operational issues at its site in Limay and one-off incidents at production facilities of the Solvent & Phenol Specialties (SPS) division, which resulted in an EBITDA loss of €9 million in 2019. We expect swift recovery in credit metrics owing to higher EBITDA in 2020, while leverage will remain high at about 6.5x-7.0x. We also note that the significant underperformance in EBITDA resulted in a deterioration of the springing net leverage covenant headroom to below 15% in 2019, even though we expect it to recover to more than 15% in 2020.
Conversely, issuers with healthy rating headroom may weather the softening chemical cycle without an impact on their credit quality. These include issuers with ratings with a positive outlook, such as fertilizer producers EuroChem Group AG (BB-/Positive/--) and Uralkali OJSC (BB-/Positive/--), where upside depends on both supportive market conditions and commitment to financial policy in line with a higher rating. We believe that Inovyn Ltd. (BB-/Positive/--), in the INEOS Group, has considerable rating headroom. We anticipate that despite midcycle conditions in its markets, adjusted leverage could reach 1.5x-2.0x, a level that we view as commensurate with a higher rating.
We have seen only one default of a rated chemical issuer in EMEA since 2009--a privately rated entity. We nevertheless remain cautious about the next downturn in light of the persistent high indebtedness of issuers in the portfolio, as reflected by the combined €41.3 billion of speculative-grade debt that we rate on their balance sheets as of Dec. 31, 2019. At the same time, we do not believe that speculative-grade EMEA chemicals companies will face liquidity issues in 2020 given that the vast majority have refinanced or extended their maturities into covenant-lite capital structures over the past few years. Furthermore, the low interest rate environment remains supportive of median EBITDA interest cover ratios for our chemical speculative-grade portfolio in EMEA of 3.9x (3.4x in the 'B' category) that we expect for 2019.
Still, persistent high leverage, in combination with more cautious investor sentiment and/or incidents of market illiquidity, could lead to a rise in defaults after four to five years when the majority of the debt of speculative-grade chemical issuers falls due. Such a rise could happen especially in a scenario of a higher interest rate environment and be caused by issuers' lack of willingness or ability to meet the original promise.
As companies navigate a softer business climate in chemicals, the keys to preserving credit quality and laying the groundwork for future deleveraging will be their ability to adapt their financial policies to the prevalent market conditions, and the speed and robustness of corrective actions from management and shareholders. These actions may include items within managements' control, such as an increased focus on fixed costs and working capital management, refinancing upcoming maturities well ahead of time, and investment plans that carefully balance near-term leverage tolerance with medium-term growth opportunities. In general, they will have to live within their cash flow generation capabilities--notably when it comes to shareholder distributions.
- A Turning Point For U.S. Chemical Credit Quality, Oct. 29, 2019
- Industry Top Trends 2020: Chemicals, Nov. 20, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||Paulina Grabowiec, London (44) 20-7176-7051;|
|Lucas Hoenn, London + 44 20 7176 8597;|
|Marta Stojanova, London + 44 20 7176 0476;|
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