- Despite a rash of negative rating actions in 2020, there were no fallen angels (companies downgraded from investment grade to speculative grade) in the U.S. Chemicals sector.
- A record level of U.S. chemical companies are rated 'BB+' or 'BBB-', indicating crossover potential.
- S&P Global Ratings believes there is more potential for rising stars over the next year than there is for fallen angels.
The COVID-19 pandemic wreaked havoc on nearly all industries, leading to an overwhelmingly negative bias on rating actions across global corporate ratings. Fallen angels (companies downgraded from investment grade to speculative grade) outpaced rising stars (companies upgraded from speculative grade to investment grade) by a 49-to-7 count across global corporate ratings in 2020. The seven rising stars were a record low in a given year since S&P Global Ratings Research began tracking the data in 1987.
How did the U.S. Chemicals sector weather the 2020 downturn? The U.S. Chemicals sector was battered by negative rating actions in 2020, with negative rating actions (both downgrades and downward revisions in the outlook) outpacing positive rating actions by a 55-to-5 count. Despite this, the industry did not witness any crossover credits. This was due in large part to the ratings distribution prior to the pandemic, more conservative financial policies during the downturn, as well as some financial cushion at the rating among investment-grade companies in the sector. Heading into March 2020 when the pandemic really started affecting the U.S., only two companies (roughly 3% of the U.S. Chemicals portfolio) were at the lowest rung of the investment-grade spectrum, 'BBB-'. FMC Corp. and The Mosaic Co. both cater to the agriculture sector, with portfolios of agricultural chemicals and fertilizers, respectively. This subsector was less affected than the broader chemicals sector, as demand tends to be driven by population growth, demand for food, and farmers income, as opposed to exposure to more cyclical industries such as housing and automotive. As a result, these companies withstood the COVID-19 pandemic with no impact to their ratings and instead just outlook revisions. We revised our outlook on FMC to stable from positive, and on Mosaic to negative from stable. While we downgraded several companies from 'BBB' to 'BBB-' in the midst of the pandemic, there were no multinotch downgrades from 'BBB' to 'BB+'. These companies had the cushion at their investment-grade rating, and undertook financial policy decisions to preserve cash flows, which allowed them to ward off multinotch downgrades.
What are some of the benefits of an investment-grade rating?
- Investment-grade companies tend to have an easier time accessing capital, including during downturns as we saw in 2020.
- Many investment-grade companies can tap the commercial paper markets to manage day-to-day cash needs and working capital fluctuations.
- These companies are typically not required to pledge collateral, and thus can issue unsecured debt. Secured debt issuances are much more common for speculative-grade issuers.
- Investment-grade companies have access to a broader investor base. Certain longer-term investors, namely pension funds, endowments, and insurance companies, may have mandates requiring them to only hold investment-grade debt.
- An investment-grade rating tends to coincide with lower debt leverage. This provides more flexibility to pursue financial policies, which could include growth initiatives and shareholder rewards.
How does S&P Global Ratings weigh a combination of business and financial risk factors for an investment-grade rating? When assessing our issuer credit rating on a company, we take into account many factors, including a company's business risk profile and financial risk profile. A company's business risk profile weighs our view of country risk, industry risk, market position, scale, scope and diversity, operating efficiency, and profitability. As depicted below, all of the current investment-grade companies in the U.S. Chemicals sector have business risk profiles of satisfactory or higher. Companies with a fair or lower business risk profile have the potential to achieve investment-grade ratings, although they would need to maintain even stronger credit ratios to get there (more discussed below).
When we analyze a company's financial risk profile, we take into account a variety of leverage, cash flow, and coverage ratios (see Table 1). Funds from operations (FFO) to debt and debt to EBITDA are the two main ratios, and thus you will see one or both of those ratios quoted in our publications in terms of expectation at the current rating, and in upside and downside scenarios.
|Cash Flow/Leverage Analysis Ratios--Standard Volatility|
|--Core ratios--||--Supplementary coverage ratios--||--Supplementary payback ratios--|
|FFO/debt (%)||Debt/EBITDA (x)||FFO/cash interest(x)||EBITDA/interest (x)||CFO/debt (%)||FOCF/debt (%)||DCF/debt (%)|
|Minimal||60||Less than 1.5||More than 13||More than 15||More than 50||40||25|
|Highly leveraged||Less than 12||Greater than 5||Less than 2||Less than 2||Less than 10||Less than 5||Less than 2|
|FFO--Funds from operations. CFO--Cash flow from operating activities. FOCF--Free operating cash flow. DCF--Discretionary cash flow.|
In addition, financial policies are a key driver in assessing management's commitment to not only obtaining appropriate credit measures for an investment-grade rating, but maintaining those metrics after factoring in potential downturns, and balancing debt leverage targets with growth initiatives and shareholder rewards. This is particularly important to consider for commodity chemical companies, as their credit measures tend to have material swings given the higher volatility in earnings and cash flows than that of specialty chemical industry peers.
Table 2 shows how we get to an anchor score, with various modifiers (such as financial policies) that we can use to fine-tune the outcome to arrive at the issuer credit rating. This table depicts that while there is no set formula to get to an investment-grade rating, at a high level, the lower our assessment is of a company's business risk profile, the higher the bar would be on the financial risk side to get to a given rating.
|Combining The Business And Financial Risk Profiles To Determine The Anchor|
|--Financial risk profile--|
|Business risk profile||1 (minimal)||2 (modest)||3 (intermediate)||4 (significant)||5 (aggressive)||6 (highly leveraged)|
Who are some potential crossover candidates over the next one to two years? As discussed, absent unexpectedly aggressive financial policy decisions or a significantly weaker operating environment than currently forecast, we currently view the risk of a fallen angel over the next year or two as limited. In January 2021, we revised the outlook on The Mosaic Co. back to stable from negative, to reflect an improvement in phosphate prices that we believed were sustainable, leading to credit measures above our previous expectations. As a result, there are currently no U.S. chemical companies rated 'BBB-' with a negative outlook or on CreditWatch with negative implications. Conversely, we believe there is potential upside for some 'BB' and 'BB+' rated peers over the next one to two years.
INVISTA Equities LLC (BB+/Watch Pos./--)
INVISTA could be the nearest potential crossover credit, given our 'BB+' rating on the company. We placed all ratings on CreditWatch with positive implications in April, reflecting upside within the next few months after we have had further discussions with management and ownership on financial policies, including their commitment to maintaining investment-grade metrics, as well as get further updates on the progress of INVISTA's world-scale ADN plant in China. Our ratings on the company benefit from a one-notch uplift based on parent support, as we consider INVISTA to be moderately strategic to its higher-rated parent Koch Industries. Koch has provided substantial support to INVISTA in the past, including about $2.6 billion of equity and other payments between 2008 and 2011.
CF Industries Inc. (BB+/Stable/--)
CF Industries was a fallen angel in 2016 following a period of weak operating results in the nitrogen fertilizer sector, along with increased capital spending, which depressed the company's credit measures. In our May 26 full analysis on CF, we said we could consider a positive rating action (including an upgrade to investment grade) in the next few weeks or months. This could be driven by CF Industries establishing a record of strong earnings leading to FFO to debt sustained above 40%, even after factoring in potential volatility in pricing. Before considering raising CF to investment grade, we would also need to believe that management would remain committed to maintaining these credit measures during both periods of earnings strength and weakness.
Huntsman Corp. (BB+/Stable/--)
One company that draws a lot of investor interest and questions is Huntsman. For Huntsman, there are two potential paths to improving the rating and achieving rising star status. One would be on the financial risk side, if weighted-average FFO to debt were to improve sustainably above 45%, even after factoring in expectations for acquisitions and share repurchases. We believe that as Huntsman balances shareholder rewards, growth initiatives, and target debt leverage, this may not ultimately support maintaining credit measures at these levels. Instead, we believe the more likely path to an investment-grade rating would come from an improved business risk profile. Through a series of divestitures and acquisitions over the past few years, Huntsman has transitioned toward a specialty chemicals-focused company. Still, the company's EBITDA margins remain below that of many rated specialty chemical investment-grade peers. A potential upgrade could be the result of the company's efforts to increase its value-added and specialty components, helping to strengthen earnings. We would need to view an increase in margins as a fundamental strengthening of the company's business, and not a reflection of a cyclical upturn in some product lines. This improvement could lead to a sustained increase in the company's adjusted EBITDA margins to the mid-teens percent area.
Univar Solutions Inc. (BB+/Stable/--)
We upgraded Univar to 'BB+' in April 2021, as the company continued to make solid progress on the integration of the Nexeo acquisition, improving EBITDA margins to near top in class for a chemical distributor, and strengthening credit measures. Univar's No. 2 global position as a global chemicals distributor, as well as continued focus on improving operating efficiency are key factors in the company's satisfactory business risk profile, and could eventually be supportive of an investment-grade rating. To consider an upgrade, we would likely need to see a sustained improvement in EBITDA and cash flows exceeding our base-case scenario, such that Univar maintains weighted-average FFO to debt above 30%. The chemicals distribution sector is a very highly fragmented industry, and lends itself to growth through acquisitions, as evidenced by Univar's $2 billion acquisition of Nexeo. In order to consider Univar to be a potential rising star, we would need to gain confidence that the company's financial policies reflect a commitment to maintaining credit measures appropriate for a 'BBB-' rating (including FFO to debt above 30%), even after factoring in its appetite for acquisitions.
J.M. Huber Corp. (BB+/Stable/--)
Given Huber's meaningful exposure to cyclical end markets, such as housing and construction (reflected in the company's business risk profile assessment as fair), ratings upside is more likely to come by an improvement in our assessment of the company's financial risk profile. Given the very strong U.S. housing market, we expect 2021 to be a record earnings year for the company. Still, to consider an upgrade we would need to believe that 2022 EBITDA and credit measures would not drop as much as we have forecast, such that the company is able to maintain weighted-average FFO to debt above 45% (pro forma for acquisitions). Equally important, we would need to have confidence that the company's financial policies, growth initiatives, and business mix would support maintaining these credit measures, even after factoring in potential transformational transactions.
Olin Corp. (BB/Stable/--)
Despite Olin currently being two notches away from investment grade, we wanted to highlight this credit as a potential crossover for a few reasons. First, the company's business risk profile of satisfactory is among the strongest in the speculative-grade U.S. chemicals space, with leading market positions across the chlor-alkali chain and improved diversity following the 2015 acquisition of the Dow Chlorine Products business. Second, we expect a substantial increase in 2021 EBITDA and credit measures, in part due to the success of Olin's relatively new strategy to focus on maximizing the Electrochemical Unit value by matching output to demand, as opposed to chasing volumes at the expense of price. In addition, there is limited announced new supply coming on in the industry, which we believe bodes well for pricing and operating rates over the next few years. Lastly, we believe management is committed to reducing debt in 2021 in an effort to improve credit quality.
Trends That Bear Watching
Financial policies are going to remain a key focus as we consider potential crossover credits in the sector. The merger and acquisition environment has heated up in recent months, as companies gain greater confidence in the strength of the recovery and their improving balance sheets. We expect interest rates to remain low for the time being, and more assets could become available with a rebound in earnings, as sellers were reluctant to divest assets based on weak 2020 results. Additionally, many companies pulled back on share repurchases in 2020 to preserve cash flows, and that could become a bigger use of cash in 2021 and beyond. One additional risk factor is the expectation that key commodity chemical prices could come under pressure over the next year as we enter a period of large-capacity expansions, particularly in China. We believe the current investment-grade companies will continue to adhere to financial policies commensurate with ratings of 'BBB-' or above, based on our discussions with the companies and public statements about the importance of maintaining investment-grade ratings. Before considering any company to be a potential rising star, we would need to believe it could maintain appropriate financial policies and credit measures, even after factoring in a potential downturn from oversupply in the industry, while balancing its priorities for growth initiatives and shareholder rewards.
Note: Aaron Dalal contributed to this report.
This report does not constitute a rating action.
|Primary Credit Analyst:||Daniel S Krauss, CFA, New York + 1 (212) 438 2641;|
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