The Long and Short
Priced for a downside that may not materialize
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Westlake Chemical (WLK, Baa2 (n)/BBB-/BBB (n)) is trading like a low BBB credit, despite the potential for the company to keep its current ratings. While the company’s last round of year-over-year results were negatively impacted by Hurricane Laura, the sequential improvement was solid. Growth was fueled by higher demand and better pricing in its vinyls business, which accounts for over 75% of net sales. Both PVC and downstream vinyl products have improved dramatically with the rebound in new home construction and the repair/remodel markets, coupled with increased demand from autos and appliances. If total leverage declines as expected over the next two years, it could lead to a stabilization of rating agency outlooks and a tightening of WLK bonds relative to peers.
Exhibit 1. Chemical BBB 3-year to 10-year curve
Source: Bloomberg TRACE; APS
Moody’s and Fitch maintain negative outlooks on the credit, but they plan to rate through the cycle and believe improvement in the total leverage metric will begin in 2021 as the top line grows on a year-over-year basis and the EBITDA margin expands. Relative to peers, WLK trades considerably wide to Eastman Chemical (EMN – Baa3/BBB-/BBB-). While WLK does not have an on the run 10-year, its 4.5% 2028 bonds are currently trading around +50 bp (+76 bp g-spread), which is 42 bp g-spread tighter than WLK 3.375% 2030 bonds. WLK’s net leverage of 2.0x is much lower than EMN’s, which currently stands at 2.8x. Leverage is expected to decline further when WLK reports fourth quarter results on 2/18/21, due to continued debt reduction of $154 million and year-over-year growth in both revenues and EBITDA.
Exhibit 2. Peer Comparison
Source: Company Reports; Amherst Pierpont Securities
Liquidity Solid and Debt Maturity Profile Very Manageable
WLK ended the third quarter of 2020 with cash on hand of $1.2 billion and remains in a positive free cash flow position, which totaled $613 million on an LTM basis, nearly $100 million more than it generated in 2019. The company should generate roughly $625 million of free cash flow for full year 2020. Furthermore, the company has nothing drawn on its $1 billion revolver as it repaid the facility in full after drawing down on it at the start of the pandemic. WLK also cut its capital spending budget in 2020 in an effort to preserve cash while ensuring the safe operation of its plants. Additionally, WLK has nothing maturing until 7/15/22 when $250 million comes due. We expect WLK will use cash on hand to repay this maturity versus refinancing it. After the 2022 maturity, WLK has no debt maturing until 2026. This manageable debt maturity profile provides WLK with some headroom to increase its capital spending budget for operating improvements at its plants or look at tuck in acquisitions that will help to improve its margin profile. While the company pays a dividend, it has not repurchased shares since the pandemic started. Management has not indicated when share repurchases will resume.
S&P Downgrades WLK and Peers
S&P downgraded WLK to BBB- with a stable outlook on 3/26/20 reflecting the global economic downturn that would affect both earnings and credit metrics to weaken below expectations. Although it was one of the first credits of the chemical peer group to be downgraded, EMN and LYB were downgraded shortly after by S&P for similar reasons. It appears that S&P chose not to rate through the cycle as timing on recovery was uncertain. Moody’s and Fitch took a different approach to WLK and put the outlook on negative with both looking for total leverage to return to roughly 2.0x in the 2021-2022 time frame.
With no debt maturing until 2022, total leverage closer to the 2.0x area is likely to occur in 2022, unless the company were to conduct a tender or look to make-whole the 2022 bonds. We estimate that WLK will end 2021 with EBITDA in the $1.5 billion range, which would put total leverage at 2.5x. If the company were to reduce debt by an additional $250 million (the maturity in 2022), leverage would decline to roughly 2.2x-2.3x. Any upside to our EBITDA estimates only reduces leverage further.
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