shareholder activism in chemicals - valence group · shareholder activism in chemicals highlights...

Shareholder Activism in Chemicals

Highlights

� Chemicals has been one of the most favored sectors for shareholder activists

� Chemical companies’ portfolio structures combined with high profitability will continue to be highly attractive to activist investors

� European chemical companies will become increasingly vulnerable as the saturation of shareholder activism in the US encourages increased focus abroad

� More proactive and robust defence strategies are needed to successfully resist activist intervention

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IN THIS ISSUE

Activism in Chemicals

Why Chemicals?

Conflict with Activists

Activists - The Next Step in Chemicals

Defence Strategies & Analysis

SPECIAL EDITION Issue 1 January 2015

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2 | Shareholder Activism in Chemicals January 2015 www.ValenceGroup.com

Activism in Chemicals

One of the most striking developments over the last several years has been the rise of activist investors in public chemical companies. These investors have taken positions in even the largest chemical companies such as Dow Chemical, DuPont and DSM and have often instigated highly vocal campaigns for change. It appears this spotlight on the chemicals industry has actually heightened investor’s interest and there are now

more than 15 public chemical and related companies with activist investors holding equity positions (key examples shown in Figure 1). Furthermore, European chemical companies are now actively being targeted.

Chemicals now make up a sizable proportion of the total target list of activist hedge funds. More than 10% of all activist investments are in chemicals related businesses (Figure 2). It is straightforward to see the attraction of chemicals for activists: Portfolio structures, multiple capital allocation options, high profitability and numerous strategic Figure 1 Key Activist Investments in Chemicals

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choices, all combine to create fertile ground to question senior management decisions.

Success breeds success: As activists’ focus on chemical companies has been rewarded with attractive returns on investment, they have plowed ever more resources into the chemicals sector. Innophos and Omnova are two of the most recent examples. With average activist returns for the sector above 20%, and in many cases significantly more, the flow of funds in support of activist strategies is unlikely to diminish. Indeed more than $14bn has flowed into activist funds in 2014 alone. With so much capital to be deployed, 2015 is expected to be an even more active year for shareholder activism, with the chemicals sector promising to again be one of the most targeted sectors (Figure 3).

Although targeted companies are becoming more adept at dealing with activists, the costs of defending activist overtures – both in terms of financial costs and misdirected management focus – remain considerable. Recent analysis indicates that companies can spend upward of $20m defending against a comprehensive activist campaign1.

1 Source: McKinsey research

As activists become more sophisticated investors in chemicals, with a deeper level of understanding and analysis, their actions will put even more pressure on CEOs to deliver improved performance or execute on M&A in the short term.

Since value-enhancing acquisitions are difficult to effect in the current very strong chemical M&A market, the focus inevitably turns to senior management performance and strategic decisions. Increasingly, what begins as a friendly dialogue about the company’s prospects becomes hostile and confrontational (Figure 4). The recent DuPont-Trian and Dow-Third Point public exchanges exemplify this dynamic.

Is there a more effective way of meeting the activist challenge? We believe so. A fundamental understanding of what attracts activists, coupled with a proactive and comprehensive vulnerability assessment, are the best preparation for meeting an activist overture effectively.

Figure 2 Activist Investments by Sector 2013 Figure 3 Shareholder Activism in the next 12 months

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Figure 4 Evolution of Activist Campaign

Why Chemicals ?

Chemical companies are unique in having highly integrated portfolio structures with broad product ranges, each with different commercial dynamics. This combination creates a broad degree of strategic optionality for management and boards of directors, which are only further enhanced by today’s robust cash flow and strong balance sheets. The resulting wide range of available strategic and financial alternatives is a highly attractive draw for activist investors.

Integrated PortfoliosHistorically and even to this day, expansion within the chemicals sector has often followed a product chain approach in which vertical integration has been the growth avenue of choice; for example, models which seek to leverage technology or raw material advantage by progressively

adding downstream operations. In The Valence Group’s view, this is a highly effective and a balanced strategy when the downstream integration is both broad and optimised along the chain. Examples include BASF and Taminco (now Eastman) on a narrower product basis (see Fig 5).

The integrated portfolio strategy often yields complexity, which arises from two sources. Firstly, there are over 200 sub-sectors across the chemical industry. Each sub-sector (product/market sub-segment) is almost its own industry, with its own market and profitability dynamics and sometimes its own business model. Secondly, and related to the diversity of products, is the diversity within the chemical sub-sectors of business cycles and investment horizons, which greatly complicates operational planning and cash flow management. Hence both managing and balancing a diverse portfolio of assets with multiple business models can be highly complex.

Figure 5 Typical Chemical Company Portfolio Structure with Multiple End Markets

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No other global industry has comparable sector and product diversity; and in no other global industry must management master so many diverse competencies – from commodities to high-tech innovative products, and from food and healthcare end markets to gasoline additives and solvents.

ProfitabilityThe chemical industry has been a highly successful profit generator. As Figure 6 shows, profitability has remained at a high level, especially since the industry adopted a rational approach to capacity and utilisation. Since 2009, profits have remained even more robust. As cash and access to capital have become increasingly available, capital allocation decisions in a portfolio structure become paramount.

The confluence of these various factors, the historical evolution of the integrated portfolio model and its inherent complexity, coupled with strong industry profits, results in a broad range of strategic options. This is an ideal scenario for analysis and deconstruction by the growing number of activists.

Conflict with Activists

In practice, the integrated portfolio structure leads to four fundamental inter-related questions that chemical company executives must be prepared to address:

Broad versus Focused PortfoliosOne of the most obvious questions is whether chemical companies are better served with a broad portfolio structure or one that is more narrowly focused. In the absence of clearly articulated synergies or strategic imperatives, the case for holding on to non-core assets may be challenging. If such assets have markedly different financial or growth characteristics than the core business and are likely to trade at some meaningful disparity if separated, the case for divestment will be even stronger. Certainly, activists have had great success in creating at least short-term value in many such cases. The activist campaign against DuPont is a recent example, while FMC has split its own business recognizing the valuation and growth gap across the portfolio.

Capital Allocation and GovernanceWith complex product portfolios, allocating capital for investment can be complicated and open to interpretation of strategy or management preference. Capital investment in the chemicals industry can be substantial, often with long-dated and less transparent financial returns. Such decisions are a common target of shareholder activists, whose business strategy relies on more near term financial returns.

Figure 6 Chemical Company Profitability

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In the absence of a well-articulated capital allocation strategy, management objections are unlikely to override an activists’ well-researched and transparent path to near term shareholder value.

Operational EfficiencyNaturally a diverse portfolio with a broad product mix can be challenging to manage efficiently. Operational excellence is all the harder to achieve for businesses in a mixed portfolio.Activist investors regularly seize on such cases, posing the question as to whether such businesses are undermanaged due to the portfolio breadth and lack of rigorous management attention. These are among the claims made by Trian in its attacks on DuPont, who point to the substantial operational improvements that Axalta was able to make to DuPont’s divested coatings business.

Acquisition and DivestmentGiven the importance of the product portfolio to chemical company business models, M&A is a vital component of a chemical company’s long term success.

M&A in the chemicals sector has been largely positive and any failed acquisitions, in which large scale value is destroyed, are relatively unusual. Although exceptions exist – e.g., transactions completed in the early 2000s in pharmaceutical fine chemicals/custom manufacturing – in general, chemical acquisitions have been a source of value creation when employed in support of an integrated or growth strategy. Accordingly, shareholder activists in the chemicals sector have largely shied away from criticizing acquisitions.

Divestments strategy and timing on the other hand are a main source of friction. There is no doubt many chemical companies hold on to many businesses for too long thereby destroying considerable value for shareholders. Despite clear signs of deteriorating industry dynamics – e.g., capacity build up in

developing economies, raw material disadvantages, end market migration – many chemical companies continued to hold assets through the inevitable deterioration in profitability and cash flow. Understandably, shareholder activists are keenly focused on influencing divestment activity (Figure 7), both in terms of identifying assets for separation, as well as the timing of such separation. Chemical company portfolio structures, which can benefit growing businesses can also shield poorly performing ones, thereby delaying the implementation of the necessary actions. It is no coincidence that many activist campaigns result in business divestment.

Figure 7 Likely Shareholder Influence over M&A Decisions in 2015

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Activists – The Next Step in Chemicals

The explosion in capital devoted to shareholder activism has fueled a great number and diversity of event-driven hedge funds. This growth in activism has been facilitated by its embrace by the more established elements of the investment community. From being seen as aggressive short term shareholders, the perception has now shifted such that the activist’s goals, tactics and analysis are now widely accepted. Indeed, an increasing number of traditional institutional investors work with activists to identify targets whose operations and stock price performance may benefit from activist scrutiny.

Of the great many activist investors currently operating, c.20 devote substantial resources to the chemicals sector. Some of the most prominent are identified in Figure 8. Many of

the most successful activists will leverage their experience by investing in multiple situations within the same industry. This is certainly the case in the chemical sector. Figure 8 also testifies to the limited activity in European chemicals, with DSM being the sole recent target of activist interest. Although other European chemical companies (e.g., Alent, Ciba and Elementis) have been the subject of shareholder activism, in comparison to their US counterparts, European companies have been relatively overlooked. This is likely to change.

Shareholder activists, flush with cash and facing an increasingly saturated US market, will look to the untapped opportunities in Europe. Some activists have already started to do so (Figure 9). Given the suitability of the chemicals sector to activist strategies, and activists’ focus on larger market capitalisations, the European chemicals industry will likely see a wave of shareholder activism over the coming years.

Figure 8 Key Activists in the Chemicals Sector

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Defence Strategies and Analysis

Activists achieve all or some of their goals in a majority of cases (Figure 10). Success takes many forms and can include the appointment of directors to the target company’s board, the removal of the CEO or other members of the senior management team, the sale of one or more businesses, a reorganization of the company and the recapitalization of the company (often through the payment of a special dividend).

Although companies have become more adept at meeting the activist threat, activists’ high success rates suggest that much more work remains to be done. In the absence of a proactive and comprehensive activism vulnerability review, targeted companies will be substantially disadvantaged in any public discourse. Shareholder activists choose their targets carefully

and only after devoting substantial time and resources in defining their investment thesis. By the time the investment is made public, the activist has a well-honed, well-supported message designed for ready consumption by the investment community. Without a complete prior understanding of the full range of potential activist critiques and well developed arguments, the targeted company will be ill-prepared to counter the activists’ message.

Figure 9 Number of EU Activist Campaigns

Figure 10 Shareholder Activism Success Rate (2013)

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A comprehensive vulnerability analysis by The Valence Group would include an extensive chemical company industry and company specific treatment of the following critical elements:

� Portfolio analysis, including a review of the strategic merits of the component businesses and the company’s capital allocation practices

� Review of strategic alternatives, including acquisitions, divestitures and recapitalizations

� Detailed valuation, both absolute and relative to peers � Review of the company’s capital structure, both absolute

and relative to peers � Review of financial and other defense mechanisms � Review of corporate governance practices and alignment

of incentives

This vulnerability analysis will result in (i) a decision to effect certain value-enhancing actions and/or (ii) a well-articulated, detailed defense of the company’s strategy. In this regards, the vulnerability exercise will be of great value regardless of whether or not the company is ever subjected to shareholder activism. Should the company ever be subjected to activist interest, however, the assessment will maximize the probability of successfully resisting calls to engage in activity which management and the board have already considered and determined to be unwise. The assessment will also limit the disruption to the company that is often associated with an aggressive activist campaign.

Conclusions

Activist investors have moved from the investment community’s fringes to its mainstream. The structures of many chemical companies, along with the industry’s high profitability, ensure that chemical companies remain attractive targets for shareholder activists. Given the continued influx of capital into event-driven hedge funds and shareholder activist

strategies, shareholder activism will continue to grow, both in the US and abroad. The saturation of the US market will lead to substantial growth in activism in Europe, including within the chemical sector. With activist success rates in excess of 50%, public companies must do a better job of meeting the activist threat. The Valence Group believes a proactive comprehensive vulnerability assessment is the best mechanism for retaining board and management control over the company’s strategic agenda.

The Valence Group, LLC, is a member of FINRA and SIPC.

This is a market commentary and is intended neither as investment advice nor recommendation for specific securities.

TVG Ltd, authorised and regulated by the Financial Conduct Authority (FRN: 505298.), has approved this as non independent research in connection with its distribution in the United Kingdom. This research is for our clients only. This document is not independent and should not be relied on as an impartial or objective assessment of its subject matter. Given the foregoing, this document is deemed to be a marketing communication and, as such, designed to promote the independence of investment research and TVG Ltd, is not subject to any prohibition on dealing ahead of dissemination of this document as it would be if it were independent investment research.

© 2015 The Valence Group, LLC© TVG Ltd

The Valence Group

The Valence Group is a specialist investment bank offering M&A advisory services exclusively to companies and investors in the chemicals, materials and related sectors.

The Valence Group team includes a unique combination of professionals with backgrounds in investment banking, strategic consulting and senior management within the chemicals and materials industries, all focused exclusively on providing M&A advisory services to the chemicals and materials sector.

The firm’s offices are located in New York and London.

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shareholder activism in chemicals - valence group · shareholder activism in chemicals highlights...

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