Consolidation Continued in 2003

In many ways, the mergers and acquisitions (M&A) market resembles a yard sale.

At a yard sale, homeowners put out their unwanted, but often serviceable, goods. Friends, neighbors, and complete strangers all wander through the sale looking for something that will fit into their own houses--an appliance or tool that can make them more productive, a little-used piece of clothing that they can wear, or that vase selling for $1.00 but that they recognize as an antique that can be resold for a lot more. And whatever they want to buy, they try to beat down the price.

So it is in mergers and acquisitions. It is wrong to think that companies or units that are on the sales block are bad businesses. They may be there because they don't fit in with the parent company's plans, they may require different management to perform better, or the parent company may need to use the proceeds from the sale to reduce debt.

Buyers may see an opportunity to extend the reach of their existing businesses, to add to their product lines, or to enter new businesses. And then, like the buyer of the vase at the yard sale, there are the financial buyers. These are investment firms that acquire companies and businesses, fix them up by cutting costs and improving management, then sell them after five to seven years, either to other companies or through an initial public offering.

According to Peter Young, president of Young & Partners--an investment banking firm providing merger, acquisition, divestiture, and other services to chemical and life sciences industries--financial buyers accounted for three of the 10 largest acquisitions in the chemical industry in 2003.

These include the largest deal--the $4.35 billion purchase of Ondeo Nalco by a group made up of the Blackstone Group, Apollo Management, and Goldman Sachs Capital Partners. The other two were Bain Capital's $982 million acquisition of Total's SigmaKalon paints and coatings business and Texas Pacific Group's $770 million buy of the Kraton styrenic block copolymers business from Ripplewood Holdings, another financial buyer that in 2001 bought the business from Shell.

Financial buyers, according to Young & Partners' annual survey of chemical mergers and acquisitions, also increased their relative share of the acquisitions and of the total value of them. Financial buyers accounted for 38% of all transactions in 2003, up from 20% the year before, and 42% of the total value of the deals, up from just 16% in 2002.

According to Young, the increase in financial buyer purchases is aided by readily available private equity money, low interest rates, the continued conservatism of industrial buyers, availability of debt financing, and low chemical M&A valuations.

He notes, however, that there is a large pool of chemical companies, already owned by financial buyers, that were purchased at the peak or just after the peak of the M&A market in 1998 and 1999. These companies have been held for five or six years now, and Young believes that buyers will be testing the M&A waters with these businesses, especially if the market for initial public offerings remains difficult.

OVERALL M&A ACTIVITY slowed in 2003 in the worldwide chemical industry, according to the Young & Partners survey. The number of transactions greater than $25 million declined to 67 from 74 in 2002, while the total value of these transactions fell to $21 billion from $23 billion. This was the third straight year that the number of transactions declined and the second year of falling valuation.

Young points out, however, that the number of transactions and their value have held up well during the current economic downturn. He notes that the value of total M&A activity is still four times that of the previous dollar volume trough in 1991 and 1992, while the number of transactions remains double that of 1991 and 1992.

Of the current trend, Young says, "when you talk about the M&A market, you have to take into account the business of the industry. Things are driven by profits, cash flows, and business trends."

There is no question that over the past six years the industry has experienced difficult business conditions and weak profit margins. "This is in spite of 12 years of vigorous cost cutting, revamping their portfolios, globalization, and focusing on shareholder value creation," Young says. "They've worked very hard, but even with all that work, it's been very challenging."

Because of external factors, some of the restructuring turned out to be "false victories," according to Young. Many companies decided to form joint ventures or sell or buy businesses. In some cases, these actions were beneficial, but in others, the advantages were offset by new competitors from the same region or from someplace overseas, like China. "It's very sad," Young says, "because chemical companies have worked very hard in this area, but not all of the effort has resulted in improved profitability."

There have also been structural impediments to M&A activity in the chemical industry in the past few years. These include overcapacity, weak demand, raw material cost pressures, and increasing competition from new entrants. Emerging problems include profit-crimping consolidation of upstream suppliers and downstream customers, as well as slower new product innovation. Thus, few companies have been able to achieve acceptable profit margins and growth, Young says.

High levels of debt have played a part in M&A activity in the past few years, according to Young. In the current low-profit climate, highly leveraged firms are unable to make enough money to pay down debt. This has caused distressed sales of assets among companies such as ICI, Solutia, and Rhodia; debt restructuring at Huntsman and Rhodia; and, unfortunately, bankruptcies at Borden Chemicals & Plastics, Farmland Industries, Penn Specialties, Solutia, Sterling Chemicals, and Texas Petrochemicals.

On the buy side, however, the chemical industry continues to have easy access to the debt market to make acquisitions and has little use for equity financing--in which the acquiring company issues stock to finance the purchase or trades its own stock for the target company's stock.

On top of easy access to debt, there is another reason that companies don't use equity: The stock market doesn't like it. Besides diluting earnings, stock-for-stock swaps follow a short-term pattern. The target company's stock increases above the value of the offer, while the acquiring company's stock declines as the market foresees diluted earnings, integration problems, and other costs of the proposed takeover, lowering the value of the deal to investors.

The most recent example of this pattern was not in the chemical industry but in broadcasting and telecommunications, where Comcast bid 0.78 shares of its stock for each Disney share. On the day of the offer, this would have given Disney stockholders a premium of about $2.00 per share. However, just three weeks later, the per-share premium to holders of Disney stock had swung to a loss of $3.17.

There is a growing body of financial research on this subject. For instance, according to a working paper by a group of academic researchers led by Sara B. Moeller, assistant professor of finance at Southern Methodist University's Cox School of Business, shareholders in acquiring firms lost 12 cents at the announcement of acquisitions for every dollar spent on the acquisitions, for a total loss of $240 billion from 1998 through 2001.

THE PAPER, titled "Wealth destruction on a massive scale? A study of acquiring-firm return in the recent merger wave," notes that, in that period, the losses of bidders exceed the gains of target companies by $134 billion. The study covered more than 12,000 acquisitions between 1980 and 2001.

Moeller and her colleagues note that "the large losses are consistent with the existence of negative synergies from the acquisitions, but the size of the losses in relation to the consideration paid for the acquisitions is large enough that part of the losses most likely result from investors reassessing the stand-alone value of the bidders. Firms that announce acquisitions with large dollar losses perform poorly afterward."

Research such as this will not stop chemical industry consolidation, however, since M&A is driven by economic and business conditions. Young expects that the global economic recovery that started last year will finally improve economic conditions for the industry this year. Rising demand will ease some of the excess global capacity in both specialty and commodity chemicals, and higher demand is expected in Asia. However, he warns that oil and natural gas prices will continue to cause raw material and energy cost pressures.

Chemical mergers, Young says, are in a valuation trough but a very active period in deal volumes, and this should continue through 2004. The volume of activity will remain strong as the main drivers of M&A activity continue. These drivers include ongoing industrial restructuring, business portfolio rearrangement, and consolidation. This dynamic is decidedly different than during the trough in 1991 and 1992, when volume collapsed.

He sees the flurry of deals announced in late 2003 and early 2004 as a sign of pickup in the market. These deals include large pending acquisitions such as Koch Industries' $4.4 billion purchase of DuPont's Invista fibers unit, Blackstone Group's $3.8 billion acquisition of Celanese, Henkel's $2.9 billion buy of Dial Corp., and Air Liquide's $3.3 billion offer for Messer Griesheim's industrial gas business.

And Young believes that the 2004 dollar value will be materially higher than that of 2003, while the year will be very active regarding the number of deals completed.