castillodominici
In an article called ‘the seed is planted, now watch returns grow’, the case was made Celanese (NYSE:CE) would grow returns after the acquisition of DuPont’s (DD) Mobility and Materials (M&M) and division. Against the backdrop of a challenging market environment, this acquisition did not yet bring what many hoped for. Or, as Robbert Quillen aptly noted decades ago:
Good times are when people make debts to pay in bad times
The acquisition was supposed to add approximately US$0.9Bn in EBITDA (pre-synergy) to the bottom line and support free cash flow. Furthermore, ‘swift deleveraging with total debt below 3.0x EBITDA within two years of closing’ was foreseen, also see figure 1.
Figure 1 – Deleveraging, Presentation accompanying press release February 2022 (Celanese)
On the back of a deteriorating macro environment, these targets appeared out of reach and Celanese currently is saddled with a large debt and depressed earnings. Yet, management is taking decisive actions to ensure profitability while servicing its debt. That said, it will take until 2026 for the debt to reach more sustainable levels.
Earnings growth?
At the time of the acquisition, the contribution of M&M to EBITDA was estimated to be US$0.9Bn, which was later revised downward by 20%. Previously covering the company, an even lower number of US$0.6Bn was used, unfortunately, the latest earnings release indicated even this number was not met. During FY23, the contribution of M&M to EBITDA was slightly above US$0.5Bn, see figure 2.
Figure 2 – Contribution of M&M to EBITDA, Non-US GAAP Financial Measures and Supplemental Information February 2024 (Celanese)
Apart from the M&M business not contributing as expected, Celanese as a whole has to deal with lower earnings as well. Operating EBITDA reduced to US$2.4Bn (2022: US$2.6Bn), see figure 3. This reduction may not seem very large until one considers the US$0.5Bn contribution of the M&M segment is included.
Figure 3 – Celanese EBITDA, Non-US GAAP Financial Measures and Supplemental Information February 2024 (Celanese)
To drive the point home, post M&M acquisition, total EBITDA is less than the year prior. This goes to show which headwinds the company is facing. On the upside, however, strong free cash flow of US$0.7Bn was booked in 4Q23, bringing the full-year total to a record level of US$1.3Bn. In spite of record FCF, lower earnings feed back into the performance ratios and management had to tweak the targets.
Debt development
End of 2022 total debt was US$14.7Bn (figure 4), significantly higher compared to the situation when I made my estimates.
Figure 4 – Total and net debt, Non-US GAAP Financial Measures and Supplemental Information February 2024 (Celanese)
The 2023 target was to reduce net debt by US$1Bn. This target was easily achieved, especially after debt dropped significantly in Q3 mainly due to the US$0.5Bn gain received after the formation of Nutrinova, a Food Ingredients JV with Mitsui.
Celanese management uses the net-debt-to-EBITDA ratio to gauge performance related to debt. Using the latest figures, this ratio stands at 4.9 ultimo 2023. A number much higher than the envisaged factor of 3.6 for 2023 as mentioned in figure 1, and twice the 2024 target. If anything, the debt load is substantial and much more than anticipated by management at the time of the M&M acquisition.
As a consequence, management actively worked to extend maturities and lower the interest rates, from the 3Q23 earnings call:
With the completion of these refinancing transactions, the Company will extend the average maturity of its debt from 3.3 years to 4.6 years and reduce the total value of the combined 2023, 2024 and 2025 debt maturities from $6.4 billion to $3.4 billion. (…)
Inclusive of the refinancing transactions and the impact of the euro and yen currency swaps, the effective total net borrowing rate for the Company will be approximately 4.67%, a decrease of approximately 14 basis points.
On top of this, the company has agreed with its debtors to amend, or actually increase, the allowable leverage ratio, see figure 5.
Figure 5 – Consolidated net leverage ratio, 8-K filing February 20th 2024 (Celanese)
One can argue whether the ratio was negatively affected by the loss of income due to headwinds in the chemicals market or whether the company took on too much debt, but this is all water under the bridge. After all, the M&M acquisition is history and management is taking prudent actions to increase performance and service the high debt load.
What’s more, it appears the management team is already looking ahead to further pursue the plan to grow the business through acquisitions, from the 8-K filing:
So long as the Financial Covenant has been decreased to 3.50:1.00 for at least two fiscal quarters, if a Qualifying Acquisition is consummated, the company may elect to increase the Financial Covenant to 4.25:1.00 for each of the four fiscal quarters ending thereafter.
With lower interest payments, extended maturities, and a more lenient debt covenant, it can be assessed how debt will develop. Figure 6 shows the debt maturity profile including the expected projected total debt, provided the company can meet its obligations. The principal to be repaid will rise steadily from US$1Bn in 2024 to approximately US$1.5Bn in 2026. In 2027, however, a large amount of US$3.5Bn is due, of which part may need to be refinanced.
Figure 6 – Maturity overview (Data from Celanese; chart by author)
Besides the maturity dates, the question is how much debt Celanese can retire annually. Under the assumption free cash flow will be used to fund debt repayments, a level between US$1-1.5Bn should be manageable. Earnings have shown to behave rather volatile, as can be seen in figure 7, but free cash flow hovered around the US$1.3Bn mark over the last three years.
Figure 7 – A decade of EBITDA and free cash flow (Data from Celanese; chart by author)
Revisiting the goal of deleveraging debt to 3 times EBITDA, it is evident the target will not be achieved within two years of closing the deal as communicated before. The updated target defines a 3.5 ratio to be achieved by 2026. Under the assumption headwinds will prevail and the current EBITDA level of US$2.5Bn will remain constant, this implies net debt may not be higher than US$8.75Bn in three years’ time. In other words, simply meeting the maturities of outstanding loans will ensure this target is achieved.
Outlook
The outlook based on the debt obligations is rather sobering compared to the optimism management, and yours truly, displayed at the end of 2022. Nevertheless, decisive actions by management indicate debt can be reduced even when market conditions are anything but optimal. As a result, and even though the swift deleveraging did not materialize, the stock did appreciate significantly after an earnings update was given on the 6th of November, see figure 8.
Figure 8 – Celanese stock price (YCharts)
In spite of the 4Q23 price appreciation of the stock, year-to-date performance was muted. What’s more, management did not boast any confidence considering the outlook as shared by CEO Ryerkerk in the 4Q23 prepared comments:
We believe these unfavorable commercial dynamics will turn. I wish I could say that we are back to normal demand patterns in 2024, but we are not seeing that yet.
Across the first six weeks of 2024, we are seeing certain combinations of product, end-market, and geography where demand and competitive challenges are easing, but we do not anticipate meaningful sequential improvement in total volume or pricing in the first quarter.
Essentially, the company does not dare to provide a concrete outlook regarding the market. Instead, it highlighted the actions the company does control and indicated to expect FY24 earnings per share up to US$12. For reference, FY23 adjusted earnings from continuing operations per share were US$8.92 (2022: US$15.88).
To be clear, in spite of management indicating earnings per share will be less than two years ago, the stock price reverted to the 1Q22 level when the macroeconomic environment was much more favorable for Celanese, and it did not carry the amount of debt it currently does.
Returns
As shown, Celanese stock gained substantially last year, but a repetition is not to be expected unless earnings get a boost from improving market conditions. While the clear path towards deleveraging combined with the low valuation in terms of P/E ratio suggests upside potential exists, based on other metrics such as EV/EBITDA the company appears to be valued rather rich compared to the sector median, see figure 9.
Figure 9 – Selection of valuation metrics dated March 2nd 2024 (Selection from Seeking Alpha)
On the other hand, merely basing the decision to invest on the expectations for the coming year might be shortsighted. After all, by the time the outlook improves, it will already be reflected in the stock price. Therefore, with management providing a clear path to deleveraging, a better question to ask oneself is how long you are willing to hold this stock before market conditions and earnings improve.
To ease the wait, Celanese still pays a dividend despite the high debt burden. As the company has been building a track record regarding dividend, it is likely a small increase will be announced in October. By October, the dividend has been constant for seven quarters in a row, and a slight bump implies the numbers will show a year-over-year increase. My estimate is the current quarterly dividend of US$0.70 will be raised slightly by about 1 cent. The annual dividend would then go up by 1.4% from US$2.80 to US$2.84.
Such a modest raise would mean total dividend outflows increase to approximately US$310 million. Based on current free cash flow of US$1.3Bn, this would mean both the reduction in debt and dividend payments would be covered.
Looking ahead, it seems logic debt reduction remains top of mind until 2026, after which there will be more room to grow dividends unless the company will continue down the M&A path.
Risks
The fact management didn’t dare to present a proper outlook is worrying. What’s more, recently Evonik (EVKIF, EVKIY), a German chemicals producer, announced it would continue with cost-cutting measures and prepare for a different future. The main take-away was that CEO Kullmann does not regard the current headwinds as merely cyclical:
We must not delude ourselves, even if there are slight signs of a recovery: What we are currently experiencing are not cyclical fluctuations, but massive, consequential changes of our economic environment
In spite of the economy showing strength, chemicals producers are not faring well. While the management actions are yielding results, the question is what will happen when the economy will display signs of weakness.
Furthermore, last years’ goal to deleverage debt by US$1Bn was in no small part achieved through the formation of Nutrinova. As Celanese contributed with assets, technology, and people, one could say this was a divestment. To achieve the debt reduction target for 2024 without further divestments might be challenging. Therefore, the risk exists Celanese will need to cannibalize the business to achieve its deleveraging targets.
Besides macroeconomic uncertainty, Celanese management made clear it intends to grow through M&A. Even after the M&M acquisition, this stance seems to not have changed since management negotiated the option to increase debt when a ‘qualifying acquisition’ is done. What’s more, the previously targeted leverage ratio of 2-2.5 has now been raised to 3.5-4.25. Only time will tell, but at this moment it seems Celanese paid top dollar for the M&M acquisition. As a result, one would expect management showing restraint when it comes to spending, but the example from the 8-K filing highlighted the opposite is true.
Conclusion
The initial goal of swift deleveraging after the 2022 M&M acquisition went up in smoke after macroeconomic conditions deteriorated for chemical companies. EBITDA dropped, which prompted management to renegotiate the debt covenants, extend maturities and lower interest payments.
Looking at the numbers, a pro forma annual free cash flow of US$1.5Bn can be achieved by the company. This amount will allow the company to fund the dividend while deleveraging total debt to 3 times EBITDA by 2026. Yet, management has negotiated the option to increase debt again to fund future acquisitions. If anything, the unfortunate timing of the M&M acquisition did not deter management. Focus on growth through acquisitions remains. Coming full circle, Celanese taking on debt again might be a sign of good times.
What does not help is the continuing uncertainty regarding the environment in which Celanese operates. While management is taking the right actions, earnings will need to grow to support significant price appreciation and shareholder returns. While I believe Celanese is a decent investment for investors with a long investment horizon, short-term risks currently outweigh the long-term upside.
