Description

Crazy deal for Cytec (CYT).  Solvay just capped its upside for the rest of the year with significant downside exposure.  Solvay recently announced an agreed deal to buy Cytec for $5.5bn. Cytec is a composite materials business, making carbon fiber products, formulation resins and separation chemicals. Its key end market is aerospace, which accounts for around $1bn of sales. Solvay sees significant synergies with both its Advanced Materials and  Advanced Formulations segments.  Management appears to have done a significant amount of due diligence but lacks any clear view on areas where Solvay can bring something to Cytec (autos). Still, the stakeholders who matter are committed to the deal and their share of the cap increase. Managment is adement that deal is not a way to buy their way into the targets. Cytec is at a key point in its history: roll-out of a new ERP system, capacity start-up in mining and vertical integration in carbon fibers. All three should be accretive to margins and return on capital.  Management argues that is not the final step in the group transformation. Thats the bull case, I guess.

However, the market is currently not fully reflecting the high price paid for Cytec (12x next year's EBITDA after synergies) and the sector’s track-record of doing value-dilutive M&A. With hindsight the acquisition of Chemlogics was poorly timed, coming just before a collapse in the share price, but the integration appears to have gone smoothly. But keep in minds that Cytec is almost 500% larger and significantly more complicated than Chemlogics. It is therefore understandable if investors exercise more caution this time – putting a cap on the shares.  Indeed, Solvay’s $75 per share offer represents a 30% premium to CYT’s price. In other words, Solvay has offered to pay $1.2bn more for Cytec than its fair market value. Solvay has proposed US$110mn synergies from the deal, or $85mn after tax. Assuming these cost savings can be retained and persist into perpetuity simplistically implies a net present value of US$1,040mn. In other words, the premium paid is covered only if Solvay can over-deliver on these synergies by 15%. The bigger issue, is the fact that Solvay is trading on 7x 2015 EV/EBITDA buying a company for 12x EV/EBITDA!!  I expect the market’s gradual devaluing of Solvay as divisions that is expected to lead (and fail to do so) become a bigger proportion of the group. For example, the existing Specialty Polymers business could be worth 10-11x EV/EBITDA given its growth characteristics and profitability. However, the market has so far been unwilling to devalue the shares to reflect this portfolio realignment. If the market values the incremental earnings from Cytec at Solvay’s existing (lower) group multiple the result would be immediate value destruction. Said differently, an acceleration in the re-rating of Solvay’s shares is necessary to avoid destroying value. This can only be achieved through delivery, not through promises, and the current operational headwinds from weaker oil and gas demand and destocking in acetow are making that delivery increasingly tough to achieve. Is that possible? The market is clearly forgetting return on invested capital.

External, sector-related issue will haunt the company.  Specifically, Solvay needs to address slowing copper production.  Copper makes up  nearly  half of Cytec’s mining chemicals business. Many bullish predictions on the copper price is on a rapid deceleration in supply growth from 2016. The core driver of demand for In Process Separation is volume so if growth in total tonnage of copper produced begins to slow in 2015 from lack of new capacity.  Whith such high valaution and low roic, that will have an impact on the shares.  This is also wrong time in the cycle to get into mining exposure. While the impetus behind the deal was probably the acquisition of the composite materials business (and hence why it got more attention on the conference call), Cytec’s In Process Separation division earns higher margins (23% operating margin in FY14). While the mining sector has fallen firmly out of favor in recent years, the leverage to volume is clearly more attractive than exposure to prices. However, our concern centers on the fact that Cytec’s mining customers are likely to be under significant cost pressure for many years. While this could spur higher demand for chemicals which improve the efficiency of processing falling ore grades, it could also attract unwanted competition from cheaper suppliers. Solvay will need a clear strategy to defend these margins.

Clearly, this deal complicates an already complicated investment case because investors are not big fans of Solvay’s diverse corporate structure with four operating divisions and a dozen sub-divisions. While this diversity brings advantages in the form of lower earnings volatility, it does make Solvay a more difficult company to understand. Adding another four businesses from Cytec will only exacerbate this problem. Solvay has openly expressed its ambition to continually refine its portfolio which will inevitably entail further disposals. Nevertheless, the integration process will inevitably bring its own complications and distractions.  If you think about this, why such a high price?  My view is that Solvay probably wasn’t the only company looking at these assets: The structural growth potential and high profitability of Cytec’s composite materials business probably attracted a number of suitors. Solvay’s interest in the whole portfolio (rather than just composite materials) probably helped to differentiate its bid. US takeover rules stipulate that counter-bids can be made until the last minute but, although we obviously can’t rule this out, the termination fee of US$140mn and implicit support from Cytec’s management reduce that risk.   Solvay is aiming to extract 100mn euros or $110mn in synergies from the deal: 75% from reducing costs and 25% from the top-line. This represents 5.3% of the target’s estimated 2015 sales, in-line with historical precedence in the chemical sector. However this could prove to be aggressive.  The automotive opportunity is also potentially risky: While Solvay’s intimate relationships with the major auto OEMs, built over years of partnership, should help these medium-term plans develop, realistically, however, automotive sales of composite materials are unlikely to make a meaningful contribution in the next five years and so this represents a source of upside rather than being pivotal to the investment case. In other words, the justification for the deal does not rely on developing composites for automotive applications. Management also thinks knowledge of the aerospace market brings potential for cross-selling – not convinced.  

Catalyst

October 16 report

Ongoing synergy target misses