GRACE MATTHEWS INSIGHTS

Outside of pure strategic acquisitions where products, technologies, markets, facility overlap, or other true synergistic factors are dominant, financial trends and outlook are the primary value and buyer interest determinants. In the current environment, volume headwinds have been at the forefront of M&A discussions. Are these driven by customers destocking material after months of inventory building? Is it demand softness in core end markets? Is it a combination of both? What do volume trends mean for pricing? When will the headwinds end?

In order to gain a better understanding of these trends and their impact on M&A, we did some digging. At Grace Matthews, we track performance of ~100 public chemicals and materials companies in the Grace Matthews Index (see page 4 for 10-year EV/EBITDA chart). We recently sampled the Q1 2023 earnings transcripts for 20 industry leaders spanning multiple sectors – from commodity chemicals to specialty materials. It is no surprise that volume trends were a key focus across nearly all of the earnings calls we reviewed. In 16 of those transcripts, industry executives referenced significant volume declines – in many cases, executives noted double-digit percentage declines relative to last year. You’ll see excerpts from these transcripts scattered throughout this publication. Interestingly, nearly all pointed to robust pricing largely offsetting revenue lost from volume declines. Furthermore, companies seem to have more success maintaining price increases than in prior years given increased “stickiness” of their customer base, reshuffling of global supply chains and higher service levels. We recognize that trends and drivers likely vary significantly across the chemicals value chain. What we found interesting though were the similarities in both the challenges faced and the strategies utilized to counter recent volume declines, regardless of end market or vertical. In other words, this is a universal theme in that it spans the entire chemical value chain. 

In light of these trends, the key question we are asked by clients is, “How does this impact the M&A process?” Let’s first revisit events of the past two years:

Supply gets tight (2021-2022): Starting with COVID-19 and the subsequent Texas freeze, supply chain challenges became the norm. This was compounded by a labor shortage, reshaping of the European energy market, and more cautious views on China, all of which led to further squeezing of supply chains. It was commonplace for materials to be in limited supply (allocations were common), and pricing in many cases spiked to all-time highs. Despite the increased cost, the reaction by many was to increase inventory on hand to secure supply and attempt to pass through any price increases to customers. It was a bit of the wild west in terms of stockpiling materials, and we often heard clients note “if we could get more inventory…we could sell it.” As companies were faced with these challenges, elevated purchasing became typical, as executives valued stable supply to customers over working capital efficiencies. It is no surprise that this strategy was frequently referenced in transcripts by multinational public companies:

Patrick Joseph Winterlich (Executive VP, CFO & Acting Corporate Controller of Hexcel): “We deliberately allowed our inventory to grow, recognizing some of the supply chain challenges and bringing in the materials. And we did that in order to make sure that we didn’t delay or impact our customers…”

Supply chain easing (H2 2022 – Current): In late 2022, as customers started transitioning away from excess stocking strategies, suppliers began to anticipate declines in their sales volumes. Significant destocking occurred as companies found themselves holding elevated levels of (and in many cases, high-priced) inventory. While it isn’t possible to quantify the exact impact and timing of destocking throughout the value chain, the dynamic was very real (and in some cases, is still ongoing). This exacerbated inventory management issues for many companies, as they had to deal with customers reducing or delaying orders to resolve their own overstocking issues.

Macroeconomic events certainly didn’t help the outlook, raising concerns of subdued demand moving forward.  While demand and outlook vary by sector, demand softness remains a large concern among industry executives. 

Matthias Zachert (CEO & Chairman of the Board of Management of Lanxess): “We get feedback from customers that they are still living from inventories that they built up in course of 2021, 2022 when supply chains were disrupted…”

Robert Patterson (CEO, Chairman & President of Avient): “From a destocking standpoint, it seems like many customers really still feel like they’ve got a lot of inventory on hand. I know some of that’s anecdotal. I can’t tell you what percentage of customers that is, but we certainly hear that routinely.”

Luis Rojo (Vice President and Chief Financial Officer at Stepan): “What you saw in Q1 was, we are still depleting high-cost raw materials that we have in the system…And we believe we’re going to need at least Q2 to finish the depletion of some of these materials…”

Andrew Tometich (CEO, President & Director of Quaker): “Volumes continue to be impacted by a continuation of softer end market conditions, primarily in the steel and industrial markets…We continue to see softer end market activity across all regions and at varying degrees.”

Christian Kullmann (CEO & Chairman of the Executive Board of Evonik): “We do have a broad-based weak demand, which is combined with continued destocking across most of our businesses…”

Ilham Kadri (CEO, Chairman of the Executive Committee & Non-Independent Director of Solvay): In February, “We shared some insights on our early view of the first quarter, including our expectation that volumes would decline in a weak macro demand environment as destocking effect from quarter 4 would linger into the first half of the year. We also said that pricing would offset the volume decline, and we were confident in our team’s ability to sustain profitability and margins. And this is exactly what happened.”

It is impossible to separate the impact of destocking and soft demand on total volume declines, but one thing is clear – both would generally be a value detractor in a sale process. However, in most instances, pricing power has remained strong and bolstered financial performance across the industry. Inflationary pressures and corresponding margin enhancing strategies have driven price increases over the past year; these increases generally held and currently are helping to mitigate the impact of volume declines. Additionally, increased raw material availability is leading to lower raw material prices (for some products) and providing additional bottom-line cushion from volume declines. 

The outlook for pricing and volume trends is uncertain, and several key questions remain for the future: when will customers work through inventory stockpiles, how will end market demand trend, and when will prices return to “normal levels”, if ever. While most executives indicate that volume declines are ongoing, it does seem that demand softness and destocking may be starting to abate in some markets. A review of all 20 transcripts suggests that the exact timing for destocking normalizing and/or increased end market activity varies by sector (no surprise). While some companies saw easing in late 2022/early 2023, others are just now seeing easing.

Albert Yuan Chao (CEO, President & Director of Westlake): “Results reflect significant improvement in volumes, margins and earnings from the fourth quarter of 2022 as customer destocking activity moderated, end market demand improved…”

James Fitterling (CEO & Chairman of DOW): “While we expect near-term conditions to remain challenging through the year, we continue to see positive underlying demand trends driving above GDP growth across our attractive market verticals over the next few years…”

Timothy Knavish (CEO, President & Director of PPG): “…as availability of raw materials returns to pre-pandemic levels, we expect our earnings to start benefiting from moderate deflation from recent historic inflation highs. As a reminder, aggregate raw material inflation since early 2021 remains at historically high levels… the high-level statement is, we expect to continue to see moderation as we move through the year…but hard to quantify the scale of that at this point because there’s still so many moving parts…”

Let’s now revisit the question: “How is this impacting a potential M&A process right now?”  M&A deal volumes are down across the global market; however, certain sectors and deal sizes have remained resilient. In particular, deals in the lower middle market (less than roughly $30M in EBITDA) remain active as they are less dependent on financing sources that may be restricted in the current capital market environment. Additionally, the chemical sector is viewed as resilient long-term – its products and services are critical to the global economy and investors generally recognize that long-term success outweighs short-term volatility. 

On a more granular level, we wanted to share a few noteworthy M&A takeaways in the wake of recent trends.

1. Flight to Quality: The ability to achieve continued performance in today’s environment is a differentiator for businesses. As a result, companies that can demonstrate strong performance, particularly as it relates to volume growth, are receiving outsized market attention, as companies with a resilient business model are coveted in the current environment. Our recent transactions have demonstrated this flight to quality.
2. Expect Increased Scrutiny During Diligence: More than in past years, we see buyers digging in on the quality of revenue, volume and margin trends, with an emphasis on sustainability of current performance. Given heightened scrutiny on granular performance drivers – buyers are often looking in-depth at customer and SKU-level trends – pre-process preparation is as important as ever (see point #3).
3. Upfront Work to Quantify “Sustainable” Performance is Key: Trailing 12-month EBITDA is a key variable in M&A processes, as it is widely viewed as one of the best metrics for gauging run-rate or sustainable performance. Given current market variability, buyers are heavily scrutinizing near-term performance for acquisition targets. Doing the work to quantify go-forward performance and craft a defensible story to support outlook ahead of a transaction process is critical. In periods of strong economic activity, crafting a story is less important. However, given current economic uncertainty, the upfront work we do to position our clients is critical, and we leverage the industry experience we’ve developed over the last 25 years to most efficiently structure an opportunity for success.
4. Timing: In many instances, sellers may benefit from waiting to launch a sale process, allowing the company to demonstrate continued performance (e.g., adding a quarter to demonstrate that price increases have taken hold and are sustainable, or to demonstrate that a poor quarter of volume declines are a temporary blip due to destocking). We have shared this advice with many clients over the past year, and suggest we use the extra time to work together to prepare for a sale process and ensure the company is ready when we click “GO”. Pre-process preparation is critical (again, see point #3) and the timing for a launch doesn’t inhibit important work ahead of time. 

Because Grace Matthews is privately held, we are not dependent on transactions closing in a given quarter or year in order to meet internal financial forecasts. As a matter of policy, we believe that what’s best for our clients is best for our firm – sometimes, that means waiting to start a process until market conditions or business fundamentals are in the “right” place. 

Performance trends are at the forefront of every conversation right now. How long the current dynamics will persist is hard to say, but we know volume declines and price increases are having a material impact on the industry. These trends are driving an emphasis on well-performing assets and leading to increased buyer scrutiny during financial diligence. If you are considering a transaction, pre-process preparation is as important as ever. Doing the up-front work to “prove out” a story of sustainable performance and growth is critical.