Description

Cyclical, operationally and financially leveraged. These factors led to a >60% share price decline over the past 3 years. Recent developments in these factors suggest a potential IRR >30% over the next 3 years.

Situation until today

Lanxess was written up a few times on VIC, most recently by savvystockguy, so I’ll focus only on the current situation and the outlook from here. This is the situation of a company that probably wasn’t as good as people thought in the past, but likely also not as bad as people think today.

Lanxess is a (self-proclaimed “specialty”) chemicals company with HQ in Germany, but has also a significant business in Europe, Asia and US (almost 2/3 outside of EU). The current CEO, Matthias Zachert took over in 2014 and it seemed that he made all the right moves. He sold highly cyclical and competitively disadvantaged businesses  (e.g. synthetic rubber) and tried to focus on higher value add products. This transformation seemed so successful that even Warren Buffet took a 3% stake in the company and made it one of the very few positions in his personal account. Lanxess came into the COVID crisis in great shape, having just received an €800M cash inflow from the sale of their Currenta (Chempark) business.

In 2021&2022 Lanxess significantly incrased leverage through the acquisition of Emerald Kalama and IFF’s Microbial Control business. Both acquisitions seemed to have a strong industrial logic and should have been high margin, stable, “specialty” chemicals businesses.

Then the issues started. In 2022, after Russia invaded Ukraine, Lanxess was hit by record high gas (and high raw material) prices in Europe. While these higher costs could initially be passed on to customers with only little volume declines, towards the end of 2022 the economic slowdown was so strong that volumes plunged. At the same time  Lanxess was sitting on extremely high-cost inventory (due to high energy and raw material prices). This led to a precipitous decline in EBITDA and Cash Flows. Highly levered from the two most recent acquisitions and with very little cash generation the “stable and progressive” dividend was cut and discussions about necessary equity raises made the round. Extremely strong external headwinds, combined with some internal missteps led to the current predicament. Now it looks like the situation is finally improving.  

Before focusing on the future, let’s have a more detailed look at the company’s past and current issues.

•  Cyclicality: Lanxess was founded in 2004 as spin-off from Bayer, where they dumped all the BU’s they considered non-core. You can think of it as a cyclical “bad bank” in chemicals. Even though Zachert tried to decrease cyclicality through a major portfolio transformation, the company has proven to still be highly cyclical. In Q1, EBITDA margins were 6%. A far cry of the EBITDA margin targets of the three segments Consumer Protection, Specialty Additives and Advanced Intermediates of >20%, up to 20% and 16-18% respectively. Also the targeted EBITDA margin volatility of 2-3% through the cycle seems laughable today. So while cyclicality should be much lower than in the past, the extreme external headwinds (and internal issues) showed very clearly, that business doesn’t have the stability of a real specialty chemicals player.
•  External headwinds: External factors played a major role current misery. Record high gas prices in Europe (>10x increase at peak), high raw materials prices in 2021 and early 2022 and supply chain issues led to a very highly priced inventory and declining demand. Lanxess’ customers, who double and triple ordered in 2022 due to supply chain issues had full stocks when the economic slowdown hit. This led to a major destocking at all of Lanxess’ customers, with dwindling demand at Lanxess.
•  Negative operating leverage: This difficult operating environment (combined with a reduction of Lanxess’ own inventories to focus on FCF) led to a record low utilization below 60% and record low margins.
•  High financial leverage: There were also some self-inflicted wounds. The acquired assets (especially IFF’s Microbial Control business) were of significantly lower quality than anticipated. Three ownership changes in a short time period at IFF left the business in a difficult situation and this “specialty” acquisition was so far a big disappointment. These acquisitions also turned a pristine balance sheet into one of the most levered chemicals companies at a very bad timing. High debt and a plunging EBITDA brought leverage up above 6x Net Debt/EBITDA and investor concerns about necessary capital raises made the round.

The way from here

The good news is that a terrible situation, which should see gradual improvement can make for a very attractive investment. It seems that we passed the trough and that there is gradual improvement from here on the most important dimensions.

•  While demand from many of Lanxess’ end customers (construction, chemicals, agro) is still weak, at least the customer destocking has ended (except for agro) and the demand at Lanxess reflects now the demand seen in the market.
•  The ended customer de-stocking, combined with an end of Lanxess’ own destocking already led to strong profitability improvements in Q2, almost doubling EBITDA margins to 11% from 6% a year ago (or also 6% in Q1 2024).
•  As Europe built sufficient gas importing capacity, a gas shortage (or astronomical prices like in 2022) are off the table.
•  Significant steps to reduce financial leverage are currently underway. As of June 2024 the net debt stood at €2.5B and there are likely cash inflows of €1-1.5B from sales transactions in the next two years.
  Lanxess is currently in discussion about selling its Urethane Systems business unit. Zachert floated in the past a sales price of €500M. In the Q1 2024 earnings call he stated that the sales progress advances well with 5 parties in the second round. In Q2 2024 Zachert stated that the business is performing much better than anticipated at the beginning of the year. He also mentioned a European Union directive that will have additional posivite impact on the Urethanes business from 2026 onwards “In March, the European Commission has taken a firm action, a firm decision on a directive, which is going to ramp up from '26 onwards, and puts the hurdles high to change here certain applications that are being used, where we have market-leading positions and the technology is the best in town. So, this is a game changer. We are looking at it, we are assessing it, because we see that customers are now moving, and therefore this is a clear positive.” Thanks to the much better than anticipated business performance and the regulatory tailwind, the €500M sales price for Urethane systems seems now likely to be on the lower end. 
  Next to the sale of the Urethane Systems business, Lanxess has another asset to monetize. In 2022 Lanxess contributed their High Performance Materials (HPM) business to a JV with Advent, called Envalior. The JV valued the HPM business at €2.5B at the time. Next to €1.1B in cash, Lanxess received a 40% stake in Envalior and can divest their stake at a pre-agreed multiple, starting in 2025. While Envalior had its own issues from weak demand and destocking, the business seems finally to be improving and there should be significant synergies. While Envalior’s financials are not published, the rating agencies publish reports based on the public debt. Fitch assumes a recovery in H2 2024 an estimates a 2024 EBITDA of €343M. This compares with roughly €2.9B debt today. EBITDA should increase to €479M next year. If we assume a 10x multiple (I hope Lanxess did not agree to a much lower pre-defined multiple and Zachert was generally good at selling assets) and constant debt, this values Lanxess’ 40% at ca. €750M. While a far cry from the promoted €1.4B during the transaction, it is still significant value vs. Lanxess’ current market cap of €2B (and this value might increase further with additional EBITDA recovery at Envalior).
  In short, it seems likely that Lanxess gets over €0.5B cash inflows as soon as next year and another €0.75B in the next 2 years or so. Neglecting any internal cash generation, this would bring net debt down to very manageable €1.25B. 

Valuation

In the 2023 Q4 Roadshow presentation, Lanxess management shared an expected achievable EBITDA above €1B if and when demand recovers. This compares to roughly €900M per year for several years prior to 2023 (and 2024 guidance of €550-615). Looking at the assets that Lanxess has today, it should be a higher quality company than a few years ago. They are also fixing the issues at the acquired companies and started a €150M cost savings program, which is on track acc. to management. So while the bull case is dependent on returning volumes, it does not seem completely out of reach.

Bull case: Uses management’s €1B EBITDA as input. Based on a pre-COVID multiple of 7-8x (while being somewhat higher quality), EV should be €7-8B and equity should (post the two transactions) be €5.75B-6.75B. That’s a 2.9x-3.4x increase from today’s €2B (IRR of 46% at midpoint over 3y).

Base case: Even if volumes never fully return and Lanxess does only achieve €800M EBITDA, 7-8x results in 2.2x-2.6x (IRR of 33% at midpoint over 3y).

Bear case: Assuming Lanxess can monetize only one of the assets at €500M and achieves and EBITDA of €700M, the equity should at 7x still be worth €2.9B. That’s 45% above today’s price and would be still an okeyish IRR of 13% over 3y.

A view on FCF: with base case €800M EBITDA, €400M normalized capex (vs. today’s €330M), €40M interests, €30M exceptionals, €50M taxes results in €280M FCF. That would be roughly 7.1x P/FCF based on today’s prices. (At a still rather depressed EBITDA of €800M capex would arguably be lower than the full normalized €400M.)

Risks

•  The lost volumes don’t recover in line with the economy as customers source their products somewhere else. 
  •  This remains always a risk, but should be somewhat mitigated since Lanxess has only part of their production in (high cost) Europe. All acquisitions were made in the US, so that almost 2/3 of revenues are non-European. Also Zachert stated that customers who ordered very little (currently in the Agro industry) indicated that they will come back as soon as their end markets improve.
•  One or both anticipated divestments don’t take place or only at a fraction of the anticipated value.
  •  This seems rather unlikely, since the Urethanes transaction is already underway with high buyer demand. Also the pre-agreed multiple and date for the Envalior sale help to sell this stake as soon as EBITDA recovers.
•  If they can’t sell the BU’s and can’t payback the bonds, refinancing will be at significant higher rates than today’s avg. of 1%! If you assume a €500M tranche (their yearly average) at a 6% refinancing rate, that’s €25M additional interest costs per year.
  •  This is a real risk, but given that they already arranged refinancing of 2025 bonds and that by 2026 they have most likely monetized at least one of the two assets, this is not an issue until end of 2027 (by when they could have monetized the second asset (and hopefully generated some FCF)).  

Additional material

•  Their 2022 Capital Markets Day gives a decent overview about the business units and the two most recent acquisitions

Catalyst

•  A sale of the Urethane business or the Envalior JV stake