Description
Celanese (Bloomberg: CZZ GY) is a German commodity chemical company that is the subject of a tender offer from Blackstone closing on March 12th. This is one of the rare merger arbitrage ideas that get posted on VIC, but the Company’s upside, valuation, and liquidity make it a great long opportunity. I will review the situation and recent trading, the misunderstandings surrounding the Company, the Company’s valuation, the upside to the business, and the potential scenarios that could occur. While there is a substantial risk of near-term losses due to the potential for a failed tender, I believe that the time to buy is now so that the upside from a successful tender / increase in price is not missed.
Situation Overview and Recent Trading:
Blackstone has reached an agreement with the Management of Celanese to tender for the Company’s shares at EUR 32.50 in an effort to take the Company private. The tender offer is conditional on 85% acceptance and the Company’s largest shareholder, the Kuwaiti Petroleum Company, has agreed to tender. The purchase price represents a premium of 11.3% to the prior day’s purchase price or about EUR 170mm.
The Company has two major institutional shareholders, Fidelity (10%) and First Pacific (6%). On the conference call, First Pacific indicated that they are dissatisfied with the bid. Fidelity has been known to refuse to tender into low bids in Europe (see Pizza Express). We believe that a decision by either Fidelity or First Pacific puts meaningful risk into the deal being completed.
In the fourth quarter, the Company reported poor earnings and gave a very cautious outlook statement. We believe that management purposely positioned the Company in this light to try to increase the probability of the bid succeeding. As part of the bid, management will be granted options for 10% of the equity of the Company (tender document). Based on a 25% IRR over 5 years, this is EUR 140mm of value to the management team; based on what we think will be at least a 30% IRR, this is EUR 190mm of value to the management team. Not only is this an absurd amount of compensation to a management team, but it could easily be in excess of the premium paid to shareholders! Clearly, management has motivation to do whatever necessary to insure that this tender succeeds.
So how did management depress earnings? The majority of the poor earnings can be accounted for by new provisions taken and the change in pension assumptions. For instance, the Company took an additional EUR 22mm in COGS related to termination benefit expenses. The Company also decreased its discount rate on its pension to both increase the underfunding and the net periodic benefit cost. We believe that this could have decreased EBIT by an additional EUR 10mm. Lastly, the Company took an extraordinary depreciation charge of EUR 7mm related to potential asset retirement obligations. Adding these non-recurring charges back gives us a much more reasonable EBITDA of EUR 104mm.
Misunderstandings Surrounding the Company:
1) It appears that most analysts have failed to include the equity income from affiliates and the dividends from cost investments in their valuation of Celanese. Importantly, these divisions have real value and overlooking them will cause investors to miss significant value. In 2003, Celanese received EUR 52mm of dividends from investments accounted for by the cost method and EUR 31mm of income from equity in affiliates. The dividends from cost investments are depressed because the Chinese Acetate operations have chosen not to pay dividends this year so that they can reinvest the cash flow in growing the business. I believe that a conservative valuation would consider these earnings as EBIT. Valuing these entities at 8x our “EBIT” produces a value of EUR 664mm (EUR 12.94 / Share). By way of reference, if we assume a similar ratio of EBITDA to EBIT as the core business has, the EUR 664mm of value equates to 3.2x EBITDA. To be incredibly conservative, we will lump these earnings into EBITDA in our valuation.
2) Significant non-operational cash flows to come: The Company will realize over EUR 200mm in cash-flows that are not related to its business over the next 12 months related to asset sale proceeds (EUR 48mm), insurance benefits to be received (EUR 150mm), and a reduction in pulp inventories due to a 1-time buildup. These cash flows are clearly recognized in Blackstone’s bid when on p. 65 of the tender document they detail their sources and uses for the transaction. In the sources and uses, Blackstone reveals that they expect to refinance only EUR 164mm of debt vs. net debt of EUR 387mm at year-end.
3) Pensions: Most people add the pension expense back to Enterprise Value without making two necessary adjustments. First, Pension contributions are tax deductible, so you should add back the after-tax value of the pension under funding. Second, EBITDA needs to be adjusted for the change in the net periodic benefit cost needs due to the higher value of the pension (and hence the higher assumed return on plan assets).
4) Captive Insurance Companies. Celanese owns several insurance companies with a book value I estimate at EUR 95mm. They produced EUR 23mm of income in 2003. I believe that it is conservative to value these at 1x book value.
Valuation:
Tender Price: EUR 32.50
Basic Shares: 49.32
Shares from Options: 1.98
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Diluted Market Cap: 1,667
Net Debt: 387
Pension Underfunding: 696
Pension Underfunding Tax Benefit: (209)
Non-Operational Cash Flows: (200)
Book Value of Insurance Subsidiary: (95)
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Adjusted Enterprise Value: 2,246
2003 Operating Income: 106
Special Charges: 12
Other Non-Recurring Charges: 29
Asset Disposition Gain: (5)
Foreign Exchange Loss: 3
Stock Appreciation Rights: 50
Insurance Subsidiary Income: (23)
Stock Option Expense: 4
Benefit Cost Adjustment for Pensions: 62
Dividends from Cost Investments: 52
Equity in Net Earnings of Affiliates: 31
Depreciation & Amortization: 253
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2003 Adjusted EBITDA 574
2003 Adj EV / Adj EBITDA: 3.9x
Clearly, if you do the math (and read reams of public documents), it becomes obvious that Blackstone is getting a great deal. Why then do none of the equity analysts talk about it? Simple: they are either conflicted or lazy. The only analyst I have spoken with who understands it is Campbell Gilles at DB but he is restricted (numerous buy side analysts, however, understand the valuation). To quote another sell-side analyst who will remain anonymous “It’s the smallest company I cover and it’s just not worth my time.”
Upside:
1) Cyclical Recovery: While it should be clear that Blackstone is getting a great deal based on 2003 results, it is even better when you consider that this is a cyclical company. 2003 was the second lowest EBITDA of the past seven years. Here is a review of EBITDA and margins in the core business over time (EBITDA defined as Operating Profit + Special Charges + Stock Rights + Depreciation + Amortization):
1997 1998 1999 2000 2001 2002 2003
Sales 4,951 4,344 4,318 5,207 5,097 4,065 4,075
EBITDA 660 580 377 500 420 468 409
Margin 13.3% 13.3% 8.7% 9.6% 8.2% 11.5% 10.0%
2) New Methanol Sourcing Agreement: The Company has recently entered into a new methanol sourcing agreement with Southern Methanol. Southern Methanol will build a plant in Trinidad & Tobago to process stranded natural gas into methanol and will then ship the methanol to the Company’s gulf coast factories. This method will produce significant cost savings relative to the Company’s current method of making methanol because of the cost differential in natural gas (about $1/mmbtu in Trinidad & Tobago vs. $5/mmbtu in the gulf coast). Based on company guidance, this should produce cost savings of at least EUR 85mm / year. The PV10 at 4x EBITDA equates to about EUR 280mm or EUR 5.5 / share.
3) Fuel Cells, DHActive, and Caromax: Celanese has three interesting new products, each of which provides significant earnings upside to the Company and none of which are currently producing EBITDA. The most important of these products is Membrane Electrode Assemblies for Fuel Cells. Celanese is the leading manufacturing business for these assemblies and the sole supplier for these assemblies for use in high-temperature environments. The fuel cell activities represent substantially all of the EBITDA in the Other Activities segment after backing out the contribution from the captive insurance companies. This was a breakeven business over the past 12 months. The other new products that have significant upside, DHActive and Caromax, are both food additives being produced by the Nutrinova subsidiary. Neither of these products has appreciable sales but both have upside as nutritional supplements. The Company’s annual report suggests that each of these products is novel and has nutritional benefits. While it is difficult to put a value on these products, the current bid incorporates no value for investors.
Scenario Analysis:
As I see it, there are several possible scenarios. The most likely is that Blackstone increases their bid. While Blackstone has categorically ruled-out increasing their bid, I believe that if they face the choice of losing the asset or increasing the bid, they will choose to increase the bid. A review of their likely 5-year IRRs makes this obvious:
IRR sensitivity of Purchase Price per Share vs EBITDA Exit Multiple:
32.50 34.50 36.50 38.50 40.50
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4.0x | 29.5% 27.8% 26.1% 24.4% 22.8%
4.5x | 32.2% 30.5% 28.9% 27.3% 25.8%
5.0x | 34.7% 33.0% 31.4% 29.9% 28.4%
5.5x | 36.9% 35.3% 33.7% 32.2% 30.8%
6.0x | 39.0% 37.4% 35.9% 34.4% 32.9%
6.5x | 40.9% 39.3% 37.8% 36.4% 34.9%
7.0x | 42.7% 41.2% 39.7% 38.2% 36.8%
This LBO model does not assume a cyclical recovery and has very modest sales growth. It does include the effect of the new Methanol sourcing agreement that the Company has signed. Excluding the agreement decreases IRRs by about 4%.
Clearly, the easiest scenario is if Blackstone increases their tender price. If Blackstone does not increase their tender price, I suggest not tendering your shares. If you do not tender your shares and the tender achieves at least 85%, you will have a second tender period, during which I suggest you still not tender. By doing so, Blackstone will have to force you out of the Company and you will quickly receive your EUR 32.50 per share. After you are forced out of the Company, you will have a free option on a higher valuation from a court-appointed appraiser. The court appointed appraiser and your legal fees will be paid by Celanese and there is a long history in Germany of people receiving values from a court appointed appraiser that are substantially higher than the bid value. In essence, you have gotten a 1% spread, a quick return of your capital, and a free upside call option.
The last possibility is that the tender fails. In this case, I think that the shares will probably trade down in the near-term if the tender fails by a slim margin. If the tender fails by a wide margin, this would mean that the bid price is widely viewed as unsatisfactory and the share price would be unlikely to trade off. I believe that their current valuation is easily supported by the current price (3.9x trailing EBITDA). I also believe that the supervisory board can be convinced to hold an auction for the Company, in which case EUR 32.50 becomes a de facto floor on the valuation. We have spoken with several other large Private Equity firms and they have all expressed an interest in the asset and that Blackstone is getting a great deal. I would anticipate an active and highly contested auction.
Catalyst
Conclusion of the tender leading to either:
1) Increased Price
2) Ability to get call option from German squeeze-out law
3) Failed auction and own cheap asset (3.9x trailing EBITDA) that is likely to get auctioned