Description

We believe an investment today in Rockwood (ROC) provides an asymmetric return profile with limited downside, a 12 – 17% irr on a risk arb spread and a free call option on a price bump or, best case scenario, over-the-top bidder for a strategic lithium asset. 

Business description / Deal announcement

Please see the May 2014 write-up by yarak775 for a detailed history of Rockwood and its major business lines.  Today, Rockwood consists of a market leading lithium products business and a metal surface treatment business.  Rockwood also has a net cash balance from the recent close of the sale of its pigments business to Huntsman (which added $950mm in net cash to ROC).

On July 15, 2014, Albemarle (ALB) announced the cash and stock acquisition of Rockwood for $6.2bn.  Each share of ROC will receive $50.65 cash and 0.4803 shares ALB.  The take-over price was a 13% premium to ROC’s prior day close ($75.70) and an 11.3x multiple of PF EV to 2014E EBITDA (per ALB press release including synergies).  ALB shareholders will own 70% of PF ALB and ALB has committed debt financing in place from BAML in addition to plans to issue ~35mm new shares of common stock.  The deal is not contingent on the successful completion of the sale of ROC’s TiO2 assets to HUN, though that deal recently closed.    

Albemarle is a leading bromine producer (#1 or #2 with Israel Chemicals Ltd.) and a leading catalyst manufacturer serving multiple industries including refiners/drilling, agricultural, pharma and electronics.  ALB’s Performance Chemicals segment generates 60% of the company’s EBITDA, but recent weak demand for brominated flame retardants and clear completion fluids has prevented revenue growth and kept segment EBITDA margins in the mid-20s.  ALB’s Catalyst Solutions segment has seen recent volume growth driven by its Refinery Solutions business after mid-single digit % revenue declines across the segment in the prior year.

A purchase of ROC’s businesses diversifies ALB away from highly cyclical, slow growing markets into higher margin, faster growing markets.  ALB has traded at an average of 9 – 10x forward EBITDA over the past 5 years but presumably hopes the market rewards it with a higher multiple following the additions of the high EBITDA margin (~38%) and fast growing lithium business and the solid surface treatment business with its strong end markets (inc. auto and aerospace).

Merger Process

The key outstanding conditions prior to merger completion include shareholder votes for both ROC and ALB, as well as regulatory approval from the EU and China (MOFCOM).  The parties announced the expiration of the US HSR waiting period on September 8^th.  The EC review has a deadline of November 13^th.  The lack of overlapping businesses suggests that regulatory approvals are expected in due course, however the unpredictable nature of the Chinese anti-trust review is currently driving estimated Q1 timing for close.  

Shareholder votes for both companies are scheduled for November 14^th.  

Current Spread 

Based on current (October 14^th) prices for ROC ($73.21) and ALB ($53.97), we see the following dollar, gross percentage returns and IRR to different closing dates.  Returns are inclusive of expected ROC and ALB dividends (for a hedged position).  To the middle of Q1, the deal currently returns a low/mid teen’s irr which is very high for a strategic deal with no financing or regulatory issues.

Deal Risk

Either ROC or ALB shareholders can prevent this deal from happening if less than a majority vote in favor of the transaction.  The ROC vote requires a majority vote of shares outstanding while the ALB vote requires a majority of shareholders voting in favor of the deal.   

For ROC shareholders, the initial premium of the deal seemed skinny (at 13%), though the EBITDA multiple (pre-synergies) was >14x (assuming full run-rate Talison JV EBITDA and -$650mm adjusted net debt at close) or ~16x (ex-Talison).  Voting against the deal now would mean a drop more in-line with the very weak performance of ROC’s specialty chemical comps ~20 – 25% (e.g. FMC, SQM).  We estimate the break price in the low 60’s (vs. the pre-announce price of $75.70).  From today’s close, this would be a drop of ~15%.  Furthermore, stand-alone ROC lacks real leadership due to the loss of its highly regarded CEO in the middle of the merger process (to Air Products), which lessens the appeal of a no vote.

For ALB shareholders, concern over the deal is focused on high pro forma leverage (3.5x Net Debt / 2014E EBITDA including synergies) and some question over the synergy estimates ($100mm annual synergies by 2016).  Some ALB shareholders also expressed concern over the high multiple paid for Rockwood and the lack of any out in case of the HUN deal failing to close.  Given the recent closing of the HUN transaction, we think there’s less financial risk than at the time of deal announcement. 

Also, ALB’s weak 2H guidance provided during Q2 earnings reinforces the need to diversify away from the bromine markets.  Albermarle appears to be highly exposed to oil demand, as refinery/oilfield together make up 33% of its end markets, so the stock has been crushed along with the recent decline in oil prices.  ALB further faces global cyclical exposure as non-Americas countries make up 54% of revenue and other significant end markets include electronics and chemicals / plastics.  While ROC faces some similar risks, including significant exposure to EMEA (53% of revenues, total non-Americas 79%), its end markets are stronger and stand-alone Albemarle does not have an equivalent for the long-term drivers behind lithium demand.  This makes the deal continue to be appealing to ALB SH and also limits the chances that someone else steps in to buy them and break up the deal.

Investment Paths 

We recommend putting on the fully hedged risk arb spread as it has the best return profile (by limiting market exposure).  As explained above, the hedged irr approaches a mid-teens return with limited deal risk.  Also, Rockwood ran a fairly limited sale process and contacted only 6 other strategic buyers (4 of whom were previously considered merger of equals candidates in a February 2014 review).  While it’s been several months since deal announcement, there’s still the possibility that a third party shows up with an over-the-top bid for Rockwood – especially given the unique nature of its lithium assets.  Importantly, Rockwood’s sale of its TiO2 assets to Huntsman recently closed (on October 1^st), and rival bidders may have waited for that deal to close as those assets are less desirable than core Rockwood.  The background to the merger, as described in the proxy, gives some detail on the interactions with potential buyers, several of whom showed interest in the surface treatment business and one who gave an indication of interest for all of ROC at $80 (cash and stock).  It’s possible that a larger buyer could show up in the next few weeks with a cash offer above ALB’s cash/stock package (think BASF as a logical buyer given its other investments in battery materials).              

Alternatively, given that Albemarle is trading at an undemanding multiple (PE of ~12.8x vs. a recent average closer to 15x), it could make sense to simply go long ROC as a discount buy into an Albemarle position while owning ROC at the same levels as its pre-deal price.

Catalysts:

Catalyst