By Dylan 718 Investing :
Looking at Chemours ( CC ) today reminds me of the night Michael Spinks fought Mike Tyson in June of 1988. As an undefeated professional fighter, Spinks, in theory, had a chance but the deck was stacked massively against him and, midway through the first round, the smart bet paid off.
- Massively overlevered . Per CC's 2nd quarter earnings release, Debt/EBITDA is approximately 5.2x. CC's balance sheet is even worse - per CC's June 30, 2015, 10-Q, total assets of $6.685b are supported by only $405m of equity - and this figure is most likely overstated (discussed below).
- Facing massive litigation risk . From page 6 of CC's Second Quarter Earnings Presentation, CC is responsible for/engaged in:
- 170 Environmental Remediation sites (of which they assert 65% are resolved and the remainder well understood). CC has reserved $295m, but has stated that the actual cost could be up to $650m higher.
- 2,500 Asbestos cases alleging personal injury, against which they've reserved $38m.
- PFOA (aka C8). Most intriguing, DuPont ( DD ), the parent of CC until June 19, 2015, knowingly (or at least negligently) pumped toxic chemicals into the water supply of Parkersburg, West Virginia, and surrounding communities for decades. Now CC, which indemnified DuPont, is about to face the music - approximately 3,500 personal injury claims have been filed, including 37 for wrongful death. If punitive damages are awarded, good estimates range from $300-700m (with upside) in total liability. If you like conspiracy novels, give this a read . So far, the company has reserved $14m. There is the potential for public policy arguments against indemnifying for punitive damages (i.e., DD could be on the hook) but don't bet on it. Oh - and of the 3,500 cases, 6 have been designated as test cases and in the first, Bartlett v. DuPont, a jury found DuPont liable for $1.6m last night (in the U.S. District Court for the Southern District of Ohio). It's worth noting that DuPont selected Bartlett as a test case (each side selected 3 cases). It is expected that the 6 test cases will form the basis for a broader settlement. In CC's favor, it appears that the jury decision last night may not result in punitive damages but each case will be put to a jury so there are plenty more bites at the apple. Note that this litigation has been in process for a very long time and is now reaching a head; in the Leach v. DuPont settlement in 2005, DuPont agreed not to contest general causation for 6 diseases linked to C8 - which means the plaintiffs today carry a lesser burden of proof.
- TiO2 market isn't going to get better soon . TiO2 accounts for 43% of CC's sales and 63% of Adjusted EBITDA (numbers from CC's August Investor Presentation, Adjusted EBITDA % looks at the 3 operating businesses total Adj. EBITDA of $894m). The industry has a supply imbalance and Chinese producers are flooding the market with cheap product. Production cuts by major players are largely offset by upcoming new supply coming online in Mexico and China. Moody's and CC both estimate a recovery in the TiO2 market won't take place until 2017. Per CC, global demand is almost perfectly correlated to GDP so unless you see a real short term turnaround there, don't expect CC's business to earn their way out of these problems near term - or even to offset the current supply/demand imbalance. Of the other two businesses, Fluoroproducts has relatively low cash generation and they are looking to sell Chemical Solutions - which had a 2% Adj. EBITDA margin in 2014. Analysts believe Flouroproducts may provide an incremental $200m in EBITDA in 2017 from their Opteon sales in Europe as new environmental standards kick in (Mobile A/C Directive in the EU).
- 2nd Quarter Balance Sheet most likely overstates liquidity . The Separation Agreement from DuPont is really worth a read; it spells out exactly what liabilities CC assumed as well as defining a number of business principles going forward. Most interesting to me is Section 2.13. Section 2.13(b) sets a post-spin cash target of $200m for CC and requires a true-up once the final number is calculated. The basis for these calculations is the June 30th financials - meaning payments aren't yet reflected in the June 30th audited financials. The final cash calculation was $247m - meaning CC owes DD $47m - a reduction in cash and equity (payment must be made by 12/31) from the already grossly overlevered balance sheet. But there's more - 2.13(c) is entitled "Secondary Adjustment for GCAP Cash-Comparable Items". This provision requires a second true-up payment after considering changes to AR, AP, Inventory, Taxes, and Fixed Costs. This provision was written in an incredibly confusing manner - but eventually we traced this through the definitions and learned that the benchmark for determining whether another payment was due is found on Schedule 1.1(139) - which was not in the filing. Comparing these items to the prior period from their 10-Q resulted in a pretty big positive number (i.e., potential for another payment to DD if that were the basis for the benchmark). Again, we do not have the actual starting point to benchmark these figures against so this is purely conjecture. Emails to the company on this issue were not returned and a phone call to IR resulted in a voicemail message stating that they are in a quiet period. You have to wonder what CC's book equity looks like once they make adjustments for these payments and a reserve for the C8 cases - does Bartlett give them enough certainty around this liability that a huge reserve is now warranted?
Addressing the next logical question - is this risk already priced into the stock? No. CC has performed inline vs peers since the spin (Tronox ( TROX ), Kronos Worldwide ( KRO ), and Huntsman ( HUN )). TROX, the worst performer, has a higher exposure to TiO2 (66% of sales) than CC, but has recently exited bankruptcy (so they are completely clean from any exposures similar to CC). TROX recently did a nice deal with FMC where they acquired a highly cash generative soda ash business, has a mountain of tax attributes, continues to maintain a 15% dividend (for now), and is much less levered than CC at 3x EBITDA. That's not a plug for TROX, it's an attempt to illustrate that CC's price decline reflects pure business fundamentals and not their other issues (although we are warming to a TROX/CC relative value trade). To make matters worse, CC filed an 8-K on September 25 th announcing amendments to their May 12, 2015 Credit Agreement with JPMorgan Chase (JPM) acting as administrative agent. Among other changes, they capped annual dividends for 2016 and 2017 at $22m - down from $400m. Best case dividend yield for 2016 and 2017 is 1.5% (at current $8 price) in an industry where the dividend has historically been a key for investors.
So what can save them? We think CC is legally insolvent today if they took adequate reserves to cover their contingent liabilities - that's not to say they are able to do so under GAAP, it's a comment about valuation and solvency.
They have already announced a restructuring in which they are targeting $140m in incremental EBITDA in the 2nd half of 2016. It sounds great, but they now have $4.0b in long term debt, and approximately $500m per annum in property, plant and equipment expenditures (See Note 14 of 10-Q and cash flow statement from June 30, 2015 10-Q). At an average interest rate of roughly 6.75%, annual interest payments on their debt are approximately $275m (assuming the revolver is fully drawn). The amendment to the Credit Agreement referenced above also imposed interest coverage and leverage ratios on CC that will most likely result in additional concessions to bondholders upon any further deterioration in the business or adverse decisions.
Using numbers from their August 2015 investor presentation for the year ended June 30, 2015 - the incremental $140m results in annual Adj. EBITDA of $850m for 2015 (assuming no decline in the 2nd half of 2015 which is a gift) - leaving only $75m in free cash per annum in excess of interest and property, plant and equipment costs and a fraction of their contingent liabilities. Bloomberg average analyst estimated EBITDA for 2015 is $666m and $863m for 2016; so the reality is probably much worse than our calculations and even with the restructuring, they have little to no excess cash flow in 2015 and no short term ability to reduce debt. Analyst reports on the name forecast several hundred million in negative cash flow for each of 2015, 2016, and 2017.
Reports surfaced Wednesday night that Apollo is exploring the idea of buying CC. This seems unlikely as buyout funds typically look for underlevered, high cash generation businesses, not to mention the massive contingent liabilities CC faces. While we think the tax risk is low, CC has also agreed to indemnify DuPont if they cause the June spinoff to lose its tax free status; while pretty low risk, just not the type of thing you usually see buyout funds step into. We spoke with a senior banker at a competitor of Apollo who agreed with this analysis. Moreover, if they did want to buy CC, what would they bid? I don't think you're looking at much upside from the current price; Apollo doesn't overpay often. We also think a roll-up with Tronox is unlikely - TROX just closed a nice deal, buying the soda ash business from FMC for $1.7b which will help them monetize their U.S. tax attributes. Triggering a change of control (per IRC Section 382) will impose material limits in their ability to use the attributes. The bankruptcy filings by TROX also give you a data point here - Kerr McGee tried to sell TROX to the buyout funds and they all passed due to a comparable contingent liability situation.
We need to do more work on the local West Virginia and Ohio legal issues, standard for punitive damages, and appeals process but the numbers jumping out at us are so large I don't see this changing the conclusion.
That leaves CC in a solvency race for its existence, walking a tightrope to limit cash payments and avoid further concessions to bondholders. We think management is acutely aware of this - when they amended the Credit Agreement and sacrificed almost all dividends in 2016 and 2017, the trade-off was concessions on their Net Leverage Ratio covenant - which requires them to reduce their EBITDA multiple over the next 2 years. Can they extend litigation long enough to allow a global recovery to lift the TiO2 market out of the doldrums and return the company to solvency? In CC's favor, no major debt matures until 2023 and they may net $5-600m from the sales of Chemical Solutions (excluding the Cyanide business which they intend to keep). While the Chemical Solutions sale and further restructurings can help a little along the way, we think the only way they can survive without a bankruptcy filing is if the core business recovers. From a timing perspective, depending on how successful they are in cutting costs and selling the chemicals business, they may limp along until C8 litigation appeals are final (think 2017). The pace could accelerate if the TiO2 business continues to deteriorate or if they are boxed into a global settlement in the C8 cases. If I owned CC's unsecured debt, I would be spending a lot of time thinking about the waterfall.
A conspiracy theorist would bet a lot of money that inside DuPont there are many legal briefs discussing the value to DD of hiving off these contingent liabilities. Looking at CC's balance sheet, fraudulent conveyance arguments are easy to envision - APC/TROX all over again (although most likely in smaller size)? In short, we think CC has a puncher's chance, they might pull off a miracle but most of the time the deck is stacked this hard against you, you end up like Michael Spinks - flat on your back after 91 seconds.
See also CONMED (CNMD) Q3 2015 Results - Earnings Call Webcast on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.