LNXSY - Lanxess Is Undervalued But It Stands Against The Economic Current

2023-04-01 06:59:47 ET

Summary

• LANXESS is a cheap chemicals player, and over the last few years it has gone from being primarily a basic chemicals to a majority specialty chemicals company.
• The recent creation of the JV with Advent values a good chunk of LANXESS' business at a multiple higher than 10x EV/pre-synergy EBITDA, where the whole business trades around 5-6x.
• The problem is that almost half of their margin is in automotive, construction and electronics where we are very concerned about a prolonged down in the credit cycle.
• We see the value case but we're staying away as there are more high probability opportunities still out there.

LANXESS ( OTCPK:LNXSF ) is a chemicals company that has becoming dramatically more specialty oriented over the last 4 years after a series of divestments and investments. It has made a recent transaction concerning its advanced intermediates business that puts a nice valuation on much of the business, much higher than the current multiple. While there is a strong value case, many of their end-markets are standing directly against the strongest economic currents in a credit downturn. There remain better opportunities on the market.

Quick View on LANXESS

LANXESS has always been a bit of a strange case. It has become more specialty over the years, which means stronger margins and lower earnings volatility, yet its multiple has continued to fall. This is not what one would expect. Its current segments are as follows.

Currently they are of similar profitability , but advanced intermediates is where a lot more earnings volatility can be seen.

While inflation has broadly been an issue for LANXESS, they are fully in a position to pass on these cost increases to customers with slight delays and make back the money. In the latest quarter we see that they are struggling due to contractions in construction, already signaling tighter credit conditions, as well as a reversal in inventory management practices as the effects of the Ukraine invasion become more normalized, and bloated inventories are allowed to destock.

Volume declines were the lowest (almost flat evolution) in the consumer and agriculture facing businesses, where agri volumes are around 10% of LANXESS' overall chemical profile, and consumer is up to 30%. In specialty additives it was higher, but in advanced intermediates it was a pretty substantial decline.

The advanced intermediates business is where a lot of the exposure is to the more credit-levered markets, including automotive and construction.

Developments

The major development is that they are likely to close a transaction in April 2023 that will carve out their high performance materials business, responsible for about 20% of the company's EBITDA, into a JV which will also contain another advanced polymers company financed by a PE group called Advent. The pre-synergy multiple is a bit over 10x EV/EBITDA, and large synergies are expected. The deal is good for LANXESS which will be able to sell out of the JV at the same multiple on EBITDA at the earliest in 3 years' time, which assuming synergies should result in additional profits. They received 1.1 billion in relation to this transaction to be able to buy back shares for a 10% buyback yield as well as deleverage.

Having done this transaction, LANXESS demonstrate that for 17% of their business, the sponsor market applies much higher valuations than the current 5-6x multiple on the comprehensive LANXESS business.

The HPM business is still owned by LANXESS for the time being, and the latest quarterly presentation no longer includes its results as it is discontinued. This is what the presentations used to look like before those operations were declared discontinued - HPM dominated EM which was its own segment.

Bottom Line

While synergies are nice, they are still pretty exposed to end-markets that we would be wary of. The JV transaction will diversify a part of their exposures to automotive with more durable consumer exposures, which is a positive thing. But much of their remaining and especially volatile but high-contribution businesses are still exposed to construction and automotive which we believe will begin to suffer quite substantially in 2023 and 2024. Electronics are also subject to a fair bit of disruption as there is a large consumer finance and discretionary component in that industry.

Our belief is that while semiconductor shortages created some pent-up demand, this is being exhausted soon, and that credit tightening that we've seen thus far will accelerate on banking concerns. We think there are more fault lines and banks that will further and non-linearly worsen credit conditions, thus pressuring construction and automotive markets, both highly dependent on credit on the demand side, into a pretty long-tailed depression in 2023-2024 - not a crash but a certain decline. Due to operating leverage and innate volatility, with also vulnerability to mix effects, the LANXESS picture is not unambiguously positive, even taking into account the great JV deal and synergies.

We think that while the company remains undervalued, the precedent from Advent happened in mid-2022, with the capital environment likely having changed quite a lot. LANXESS is a cheap company with a good value case and a nice earnings yield. The buybacks will probably pay off too in the longer-term, but the case is weakened by capital markets on the comp side and the fundamentals are quite vulnerable relative to other plays on the market at around a 10x forward P/E with synergies included. It's a pass.

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