Overview
I don’t like surprises. I work as a private credit analyst and I didn’t like the surprise delivered by the chemicals firm Lanxess last month when it announced its second-quarter earnings would fall to around half of the previous quarter’s (despite only a few weeks earlier forecasting they would be roughly in line).
And in the chemicals industry, Lanxess hasn’t been alone in delivering unexpected news. The German giant BASF cut its full-year earnings guidance, citing falling demand from industrial buyers. In the private credit world, these sector announcements have triggered a sell-off of names in the industry and pushed prices lower. For instance, a euro-denominated term loan from Arxada, the Swiss firm specialising in microbial control chemicals used in disinfectants, preservatives, and personal care products, traded as low as 81 cents per euro (it was priced at 99.5 in 2021).
These events might set alarm bells ringing. After all, the chemicals sector is usually one of the first to feel any shakiness in end-market demand. These companies are at the start of broad supply chains and the industry is often seen as a bellwether for wider economic malaise. The products developed and manufactured by Lanxess, for example, are used across sectors from construction to footwear, mining to pharma, energy to paper production, and personal care to water treatment.
But is there more to this? I regularly meet Fidelity’s chemicals analysts who cover the sector for public equity and fixed income assets so that we can compare notes. In one of our recent discussions, I wanted to explore whether they shared my view that the current weakness facing chemicals firms is a result of destocking - where their customers have opted to wind down existing inventories they built up during supply chain uncertainty, rather than reorder products.
The sector has now faced almost a year of this destocking, which is unprecedented. Even during the Global Financial Crisis, the destocking trend only lasted around nine months. But this time the pandemic, Russia’s invasion of Ukraine, and the supply chain issues that followed are in themselves unprecedented.
My colleague, Michael Dolan, a director of fixed income research, notes that from his perspective firms further down the supply chain in the public markets had taken positions that made an extended period of destocking more likely.
“A lot of these companies were overearning from 2021 and into the first half of 2022 because supply was tight and because pricing was very strong,” he says. “Some firms reported record quarterly earnings and record margins, and that perhaps emboldened them to carry more stock than they needed.”
From the equity research team, chemicals specialist Panpan Xiao agrees that destocking still has some way to go.
“In the 18 months since Covid, the supply disruptions meant that throughout the chain everybody was focused on adding safety stock,” she says. “Now the inventory-to-sales ratios are really high – in some markets they’re at a 20-year high – and it will take some time for those stocks to wind down. This is compounded by some end-market weakness.”
But while there has been shakiness in end-market demand – not least because appetite from China is yet to return in the way many anticipated – demand has not collapsed completely. And although companies are facing a longer period of destocking in this cycle, these analysts share my optimism in the outlook for Europe’s chemicals industry.
“We are close to the bottom, if not there yet,” says Panpan. “I quite like the setup of chemicals companies on the equity side, because fundamentals seem to be reaching the bottom while valuations are very attractive.”
I agree: chemicals companies in the private credit sector have gone into this downcycle with lower leverage levels and stronger balance sheets than in previous crises, while a lack of covenants on recent deals means that firms are less likely to face difficulties when terms do grind tighter. Michael sees a similar paradigm playing out for the public debt world:
“Whilst leverage is rising and will continue to do so in the near term, many of these companies entered this phase with record low leverage ratios and very low levels of debt,” he says. “Broadly speaking, the sector’s in good shape.”
Despite analysing the industry from three different asset-class perspectives, we have found our views on the sector are reassuringly consistent. We have been able to challenge each other on our approaches, and although there is little visibility on just how long this destocking cycle could run for, we agree that the chemicals industry is well positioned to come through the other side.
More of our analysts’ discussion on this topic can be heard in the latest episode of ‘Rich Pickings’.
