CVVTF - Covestro AG: A Takeover Makes Strategic Sense But There May Be Obstacles

2023-06-21 06:07:57 ET

Summary

• Covestro AG's stock price surged after reports of a takeover proposal from Abu Dhabi National Oil Company.
• The offer is believed to be around €55 per share, representing a 22% premium, but potential regulatory hurdles could hinder the deal.
• Despite the potential upside, uncertainty regarding regulatory approval makes the stock a hold for now, with downside potential if the takeover does not materialize or is blocked.

The stock of Covestro AG ( OTCPK:CVVTF , OTCPK:COVTY ) jumped double digits after news reports that Emirati petrochemical group Abu Dhabi National Oil Company ("Adnoc") had contacted the company, proposing a takeover. While I believe that an offer makes strategic sense for the would-be acquirer and offers the possibility of material upside for shareholders, I nonetheless see significant obstacles and potential downside following the initial price spike.

The Business Rationale

The move would make strategic sense from the perspective of Adnoc. The UAE seek to prepare their economy for a future in which oil will no longer be as important a source of energy as it is today. Adnoc is owned by the government of Abu Dhabi, the largest of the emirates that make up the UAE. Therefore, unlike a private company, its actions have to always be viewed in the larger strategic context.

Given its importance as a main source of state revenue, it is only logical to try to future proof Adnoc. Historically, it has primarily been a producer of oil and natural gas, but in recent years the company has increasingly aimed to diversify. Besides hydrogen and solar projects, (petro-)chemicals are a focus of Adnoc's strategy. The company controls a majority of Emirati chemical company Borouge plc. Notably, Adnoc also owns a 25 percent stake in Austrian base chemicals producer Borealis AG, as well as 24.9 percent of the former's majority shareholder, OMV AG ( OTCPK:OMVJF , OTCPK:OMVKY ). Covestro's product line-up consists primarily of polycarbonate plastics, insulation chemicals and upholstery foams. That complements the portfolio of chemical investments. There is also a certain potential for vertical integration, given the fact that oil is an important base product for many of the aforementioned categories. This kind of diversification also somewhat hedges against Abu Dhabi's massive oil exposure, as petrochemical companies naturally profit from lower commodity prices. Long term, such vertical integration may even help to secure a customer base for oil, even if it is no longer needed as fuel due to electrification of the transport sector.

Another important factor to consider is that Covestro does not currently have any shareholder with a stake of 3 percent or more. That generally tends to make it easier to push a takeover through if one is willing to only offer high enough a price.

Price Implications

The offer is believed to be at around €55 per share. After the initial price hike following the reports of the offer, that would still translate to a 22 percent premium. Baader Helvea analyst Markus Mayer as quoted by " Wirtschaftswoche " believes an offer of around €60 per share to be necessary in order to secure a takeover. Adnoc, being owned by the government of Abu Dhabi, would certainly have the financial firepower to afford such a price.

It should, I believe, be noted that the stock has been trading above €60 per share back for a short while in Q1 of 2021. So, some shareholders, might consider €55 or even €60 per share too low. However, going forward, I assume that it would take a long time before the stock price would reach €55 let alone €60. Based on the upper end of Covestro's guidance (€1.1 to €1.6 billion), a share price of €55 to €60 represents an EBITDA multiple of 6.6 to 7.2. Assuming the lower end of the forecast, even 9.7 to 10.5. Historically, the company traded at average EBITDA multiples of slightly below 6. In the light of negative news such as an earnings warning from Lanxess AG (LNXSF), which generally is a bad sign for the entire chemical sector, and prevailing high cost of energy in Western Europe following the Russian attacks against Ukraine, I believe a valuation above average multiples is not warranted. Hence, it is my belief that, for the foreseeable future, €55 to €60 per share is a better price than shareholders could achieve without a takeover.

Potential Problems

However, the success of a takeover bid will not depend on economic factors alone. One important hurdle for a takeover could be the German Federal Ministry of Economic Affairs. The current Minister, Robert Habeck, tends to be relatively interventionist when it comes to foreign acquirers. The Ministry blocked the sale of Siltronic AG (SSLLF) to GlobalWafers from Taiwan and, more recently , the takeover of Elmos Semiconductor SE by a Swedish subsidiary of Chinese Sai Microelectronics. The reasons behind not selling strategically important production to a Chinese owned entity are apparent. Blocking a sale to a would-be acquirer from a democratic nation such as Taiwan, on the other hand, displays a rather hard-line approach.

Notably, the Hans Böckler Stiftung, a foundation that is closely tied to Bündnis90/Die Grünen ("Green party"), the party of which Mr. Habeck is a member and former co-chair, views the chemical industry as a sector of "strategic importance". The UAE are clearly not a rogue state or strategic adversary of the West like China. But they are a confederation of absolute monarchies and their human rights record, while overall relatively positive compared to other Middle Eastern nations, is not quite up to Western European standards. The Green party is under pressure in the polls and, at the same time, its leadership is under pressure from the left wing of its base regarding human rights policies and the perception of too much pragmatism regarding EU asylum policies. This, I believe, creates an incentive for Mr. Habeck to be especially critical of a takeover of Covestro by a state owned Emirati entity in order to placate his voter base.

There may also be increased scrutiny from an antitrust point of view due to Adnoc's ownership interest in Covestro's supplier Borealis.

Conclusion

A takeover would be excellent news for shareholders. But even if a formal offer is made, I see significant uncertainty regarding regulatory approval. Therefore, despite a potential upside from the current price level in the range of 22 to 32 percent, I still view the stock as more of a hold for the time being. Depending on the price at which the position was entered, it might even be worth considering taking at least some profit at the current levels.

If a formal takeover offer does not come to pass or if it does but is subsequently blocked, I believe there is downside potential of up to 20 percent in the short term based on historical multiples and under the assumption of EBITDA at the lower end of the 2023 guidance.

For further details see: