Consolidation in the Chemical Industry
Through careful, consistent observation of the businesses we follow and the environments in which they compete, the Diamond Hill research team strives to build a cumulative knowledge base over time. This knowledge, coupled with our intrinsic value philosophy, enables us to uncover attractive investment opportunities. Within the chemical industry, a key theme over the past several years has been industry consolidation. Against this backdrop, we believe our chemical investments are well-positioned and we are prepared for opportunities that may arise from the recent Dow and DuPont merger.
Over the last few years, nearly all of the largest chemical companies have been involved in very large, global merger or acquisition transactions (see table below). Why did these businesses pursue these deals? For many of these companies, organic growth has been stubbornly low since the financial crisis (volume growth in the 1-2% range), which prevented them from achieving earnings growth at rates they had been accustomed to in the past. In addition, the 2015/2016 time frame was especially challenging for chemical companies with industrial and/or agriculture end-market exposure, given the cyclical headwinds from lower commodity prices and slower global economic growth. Thus, these firms sought greater certainty of earnings growth by combining with other large chemical firms and aiming to extract significant potential cost savings (on average 3-4% of combined revenues).
In the case of Dow and DuPont, activist shareholders of both companies advocated for aggressive cost reductions and portfolio optimization/rationalization, which resulted in the combination of the two companies (which will subsequently be broken up into at least three businesses, as discussed further below). Finally, several acquisitions (Bayer/Monsanto, PPG/Akzo Nobel, Sherwin Williams/Valspar) were at least in part aided by the low cost of debt financing available in the capital markets.
Top-10 Chemical Companies by 2016 Market Capitalization
|Company||2016 Market Cap||2016 Revenue||Major Deals||Deal Size||Projected Cost Synergies||Cost Synergies as a % of Revenues|
|1||Dow Chemical Co.||$56B||$48B||Merger of equals with Dupont||$130B||$3B||4%|
|2||E.I. DuPont de Nemours & Co.||$56B||$25B||Merger of equals with Dow Chemical||$130B||$3B||4%|
|3||Monsanto Co.||$44B||$14B||To be acquired by Bayer AG pending antitrust||$66B||$1.2B||4%|
|5||Praxair, Inc.||$31B||$11B||Merger of equals with Linde AG||$73B||$0.8B||3%|
|6||LyondellBasell Industries NV||$30B||$29B|
|7||Air Products & Chemicals, Inc.||$29B||$10B|
|8||PPG Industries, Inc.||$26B||$15B||Proposed acquisition of AkzoNobel rejected; could be revisited in 2018||$30B||$0.8B||3%|
|9||Sherwin Williams Co.||$26B||$12B||Acquired Valspar||$11B||$0.8B||5%|
|10||International Paper Co.||$16B||$21B||Acquired Weyerhauser’s pulp business||$2B||$0.2B||1%|
Impact of Industry Consolidation
We believe our current holdings are well-positioned to benefit from industry consolidation in the chemicals sector.
Axalta Coatings Systems Ltd. (AXTA) has already been a direct beneficiary of the Valspar/Sherwin Williams transaction, acquiring Valspar’s attractive North American industrial wood coatings business at a reasonable price in order for the merger to pass antitrust review. Should Akzo Nobel eventually decide to sell its paints and coatings business to PPG (it spurned several PPG offers earlier this year, but PPG can re-engage beginning December 2017), Axalta would be in a similar position to acquire attractive assets. Management is returns-focused with regards to capital allocation decisions, so I believe they will continue to act rationally with respect to price paid for acquisitions. As I mentioned in my February 2016 Industry Perspective, Axalta generally competes in consolidated industries where leaders such as Sherwin Williams and PPG have historically acted rationally from a pricing standpoint. Thus, any transactions that further consolidates market share in the hands of these competitors should be a net positive to Axalta, all else equal. Finally, we believe Axalta is a unique coatings company that generates industry-leading margins and returns. And while it could be an attractive acquisition target, we own Axalta because it trades at a discount to what we believe the business is worth on a standalone basis.
Praxair, Inc. (PX) has signed a definitive agreement to merge with German company Linde AG in a $73 billion transaction expected to close in late 2018, which will create the largest industrial gas
supplier in the world. The industrial gas industry is even more consolidated than the coatings industry and, similar to coatings, these companies generally enjoy pricing power and earn above average returns on invested capital. Although expected cost synergies from the merger are fairly low at ~2.5% of combined revenues, I believe there could be upside to these estimates driven by Praxair management running the Linde plants more efficiently than Linde has operated them historically. Praxair and Air Products lead the industry in operational efficiency and generate operating margins which are approximately 500 basis points higher than Linde’s. With Praxair management in control, we believe the combined Linde/Praxair business will earn industry-leading margins and returns on invested capital and will be poised to continue to compound earnings over the long term.
Potential Future Investment Opportunities
Dow and DuPont completed their $130 billion merger on September 1, 2017. Within 18-24 months, the new DowDuPont intends to realize $3 billion in annualized cost savings and split into three separate, publicly traded companies: an agriculture company, a materials science company, and a specialty products company. We currently do not own shares of the combined entity as we believe the benefits of the acquisition are fully priced into the shares and the business is fairly valued. However, we think the combination could create future investment opportunities. There is speculation that DowDuPont CEO Ed Breen could follow a similar playbook to the one he used as CEO of Tyco International to further break up the specialty products company into numerous smaller, independent public companies. Occasionally, very good investment opportunities can present themselves when there is forced selling by certain shareholders in spinoff situations. Thus, we will be monitoring this situation closely.
In summary, we believe the chemical companies we own are well-positioned in the long run to benefit from any number of scenarios as chemical industry consolidation continues. In addition, we will be prepared to act should future opportunities present themselves.
As of September 30, 2017, Diamond Hill owned shares of AXTA and PX.
Originally published on October 17, 2017.
The views expressed are those of the research analyst as of October 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.