Description

I recommend a position in Hexion’s first lien notes at 81 following the company’s Chapter 11 filing on April 1. Assuming pro rata participation in the rights offering outlined in the restructuring support agreement, you are effectively paying 30c for an equity stub that could be worth 35c-45c in the next six to nine months (15%-50% return) based on the following:

• Elimination of the 'Apollo discount' that has caused Hexion bonds to consistently trade wide of peers
• Management will own 10% of the equity and will be highly incentivized to create value
• A public equity listing should encourage better disclosure on the company's varied business segments, highlighting Hexion's segment diversity and stable earnings potential

Executive Summary

Hexion Inc. (“Hexion”) was formed in 2005 through the combination of Borden Chemical Inc. (“Borden”), Resolution Performance Products LLC and Resolution Specialty Materials LLC. Hexion is a leading producer of thermoset resins, which serve a wide array of industrial purposes. Thermosets are a critical ingredient in most paints, coatings, glues, and other adhesives produced for consumer and industrial uses. Hexion’s products are sold into diverse end markets including industrial/marine, construction, consumer/durable goods, automotive, wind energy, aviation, electronics, architectural, civil engineering, repair/remodeling and oil and gas field support.

Hexion is headquartered in Columbus, Ohio and is controlled by Apollo Management.

The company is organized in two segments (figures below are LTM 9/30/18):

• Epoxy, Phenolics and Coatings Resins ($2.1bn revenue, $239mm EBITDA): Epoxy resins are the fundamental component of many types of materials and are used in the automotive, construction, wind energy, aerospace, and electronics industries due to their superior adhesion, strength and durability
• Forest Products ($1.6bn revenue, $281mm EBITDA): Produces formaldehyde, a key raw material in thousands of other chemicals, and formaldehyde-based resins, which are key adhesives and binding ingredients used in engineered lumber products, including medium-density fiberboard, particleboard, oriented strand board, and plywood

Hexion has been distressed for years and was viewed as a likely restructuring candidate within the next year given large impending debt maturities in April 2020. Faced with upcoming interest payments on its 6.625% and 10% first lien notes, Hexion filed for Chapter 11 bankruptcy on April 1, 2019 after entering a restructuring support agreement with support at every level of the prepetition capital structure.

The RSA is predicated upon a total enterprise value of $3.1bn at emergence, including an exit facility of ~$1.6bn and a stipulated post-new money equity value of ~$1.4bn. The new money results from a backstopped rights offering of New Hexion common shares offered at a 35% discount to the stipulated value and sized to yield $300mm in proceeds.

Under the RSA, Hexion will propose a plan that will distribute

• To first lien holders, $1.45bn in cash (less adequate protection payments reflecting interest on the notes, equal to ~$0.60 of face value), and 72.5% of New Hexion common shares and 72.5% of the rights to purchase $300mm of New Hexion common equity at a 35% discount to stipulated post-money equity value at emergence
• To the 1.5 lien, 2nd lien, and unsecured notes claims, 27.5% of New Hexion common shares and 27.5% of the rights in the rights offering

Valuation Summary

Set forth below is a summary valuation and return sensitivity based on the contemplated restructuring support agreement.

Prepetition Capital Structure

Comparable Company Valuation

Comparable Company Operating Statistics

Investment Thesis

Hexion’s bonds have long traded wide to peers as the credit has been plagued by information asymmetry, which has led to misconceptions about the stability of the company’s earnings. While Hexion has many cyclically volatile sub-segments, overall earnings have been stable even as commodity prices experienced substantial volatility in 2014-2016. Yet under Apollo’s ownership, management has been unwilling to provide beyond scant detail on the company’s sub-segments, leaving analysts to guess about the magnitude of the underperforming segment du jour.

For example, in 2014 Hexion’s resin-coated proppants accounted for 28% of Hexion segment EBITDA, but were below breakeven EBITDA by 2016 (a decline of ~$150mm) as drillers shifted to raw sand proppants in a falling oil price environment. Along the way, management noted proppants accounted for less than 10% of Hexion sales but consistently refused to provide a window into their EBITDA contribution.

In general Hexion has a strong operating business with a positive outlook. The company benefits from a global footprint of strategically located operations, a diversified portfolio, and a substantially integrated manufacturing process that helps avoid supply disruptions. As a testament to this diversity, overall Hexion EBITDA declined just $29mm between 2014 and 2016, when the proppants business essentially evaporated.

Hexion has a strong foothold in the growing wind power segment (estimated ~8% of revenue), where its products are stickier with customers due to specific technology requirements. Hexion’s wind business is global with significant recent growth in China.

Hexion’s forest products business is largely driven by U.S. homebuilding, where housing starts are still well below pre-crisis levels. The forest product business stands to benefit from increased housing growth in Latin America, where the company has two relatively new facilities and where customers use formaldehyde and its derivatives in wood applications in furniture more than in North America.

Finally, Hexion has demonstrated an ability to maintain profitability in falling commodity price environments. Raw materials account for 70% of cost of goods sold, with phenol, methanol, and urea constituting 43% of the raw material slate.

Risks

• Hexion serves many cyclical end markets that have experienced years of uninterrupted growth
• The elimination of Hexion’s share services agreement with Momentive may impose a larger than expected cost burden on New Hexion
• Hexion equity may remain private and illiquid for longer than expected
• More detail on Hexion’s underlying businesses in connection with a public equity offering may not lead to higher earnings multiples

Business Description

Hexion was formed in 2005 through the combination of Borden Chemical, Resolution Performance Products and Resolution Specialty Materials. The legacy companies had been leaders in specialty chemicals for over a hundred years, dating back to the 1899 formation of Gail Borden Jr. and Company, producers of milk and the milk byproduct casein, which was an ingredient in early plastics and remains an adhesive for wood products.

Legacy companies also developed Bakelite, a thermosetting phenol formaldehyde resin, an extraordinarily versatile, strong, and moldable synthetic plastic. Phenolic resins found a number of modern uses, including on the Space Shuttle engine nozzles due to their fire resistance.

Other developments within legacy companies include the first patented epoxy resin. Epoxy resins remain a key product for Hexion today and are used in a wide range of coating and adhesive processes as well as for forming plastics and composites. Hexion-legacy epoxy resins helped build the first modern wind turbines and developed the first waterborne epoxy resins, improving versatility and reducing emissions relative to solvent-based resins.

In 2010 Hexion and Momentive Performance Materials Holdings (“Momentive”) became the subsidiaries of a newly formed holding company, Hexion Holdings LLC. Like Hexion, Momentive was controlled by Apollo. Hexion and Momentive maintained a common parent but separate capital structures. A shared services agreement was instituted to allow Momentive and Hexion to utilize a common management team and share administrative costs (estimated $50-$80mm annual savings). As a result of the Chapter 11 proceedings of Momentive in 2014, Hexion and Momentive no longer share a common parent, and as a result of Hexion’s current Chapter 11, the shared services agreement will be dissolved.

Hexion’s business is divided in two segments: Epoxy, Phenolics and Coatings Resins, and Forest Products.

Epoxy, Phenolics and Coatings Resins

The EPC segment comprises a variety of epoxy and phenolic specialty products and is divided into five sub-segments:

• Base Epoxy Resins & Intermediates: Base epoxy resins are used primarily in coatings including 'electrocoat' applications for the automotive industry, powder coatings for automotive, oil and gas, general industry and white goods, and heat-cured coatings for metal packaging, coiled steel, and general industry
• Epoxy Specialty Resins: Epoxy specialty resins include infusion resins and bonding pastes for the wind turbine industry, low-emission waterborne coatings to combat corrosion, and blends and resins for lightweight materials and composites critical to the automotive and aircraft industries
• Versatics: Versatic acids and derivatives are specialty monomers that provide performance advantages for finished coatings, including superior adhesion, water resistance, appearance, and ease of application
• Phenolic Specialty Resins: Phenolic specialty resins are used in applications that require extreme heat resistance and strength, such as after-market automotive and OEM truck brake pads, filtration, aircraft components and foundry resins. Hexion's phenolic specialty resins are sold under globally recognized brand names such as Borden, Bakelite, Durite and Cellobond. These resins are also known for their binding qualities and are widely used in the production of mineral wool and glass wool used in commercial and domestic insulation applications.
• Oilfield: Hexion's oilfield specialty products include additives for both drilling and cementing, and resin-coated proppants.

Forest Products

Hexion’s Forest Products segment is further divided into two business units:

• Formaldehyde: Formaldehyde is a key raw material used to manufacture thousands of other chemicals and products
• Forest Products Resins & Wood Adhesives: Formaldehyde-based resins are a key adhesive and binding ingredient used in the production of a wide range of engineered lumber products, including medium-density fiberboard, particleboard, oriented strand board and various types of plywood and laminated veneer lumber. These products are used in applications in the construction, remodeling and furniture industries

Path to Restructuring

Hexion is more than 8x levered relative to LTM 9/30/18 Adjusted EBITDA and had $1.8bn of debt maturing in April 2020. Liquidity has become a critical issue given high debt service costs and would have been further stressed in the first half of 2019 as Hexion typically builds more than $100mm of working capital during the first quarter.

As mentioned above, Hexion has a diverse, global business with 60% of revenues generated outside the U.S. and no end market making up more than 18% of revenue. This diversity has been both a benefit and a challenge for Hexion’s growth as global and business cyclicality resulted in flat to declining EBITDA from 2012-2017.

In 2014 a large part of Hexion’s profitability was related to its oilfield business unit. This segment produces Hexion’s resin-coated proppants, which were in high demand at the peak of the shale oil cycle. The segment represented 8% of Hexion sales and 28% of EBITDA in 2014, but following the drop in oil prices and producers’ shift away from resin-coated sand, oilfield subsegment EBITDA had fallen by ~$150mm by 2016. Growth in other business units have not been able to fully offset this loss, and continued low oil prices have resulted in an apparent permanent shift away from the use of higher-priced resin-coated proppants by many oil producers. Despite cost reduction efforts, this business is still operating below breakeven EBITDA levels.

Hexion has continued to explore paths to improved profitability and cash flows. In 2018, Hexion further reduced its global headcount and reduced its cost base by ~$50mm. These cost reduction efforts contributed to strong 2018 performance. Segment EBITDA of $440mm represented Hexion’s best operational performance since 2012 and an improvement of 21% over 2017. Despite this improvement, Hexion was cash flow negative in 2018 when including debt service.

In response to growing challenges, Hexion’s board pursued a number of strategic alternatives including debt restructuring, asset sales, or debt or equity financings. Following negotiations with holders of the company’s first lien notes, 1.5 lien notes, and certain crossholders, the company reached a global agreement across ad hoc creditor groups and executed a restructuring support agreement on April 1, 2019. The RSA is supported by holders of ~70% of the debt to be restructured, including 62% of the first lien notes, 98% of 1.5 lien notes, 84% of the second lien notes, and 76% of the Borden debentures.

The RSA is predicated upon a total enterprise value of $3.1bn, including an exit facility of $1.6bn and a stipulated post-new money equity value of ~$1.4bn. New money will come from a backstopped rights offering of New Hexion common shares offered at a 35% discount to stipulated equity value and sized to yield $300mm in cash proceeds. Total leverage at emergence is anticipated to be less than half of Hexion’s prepetition leverage, based on 2019 EBITDA estimates.

Appendix – Rights Offering and Pro Forma Share Calculation

Appendix – Recent Bond Price History: 10% and 6 5/8% 1st Lien

Appendix – Recent Bond Price History: 13.75% 1.5 Lien and 9% 2nd Lien

Appendix – Baker Hughes U.S. Rig Count & Global Installed Wind Capacity

Appendix – Historical Segment Financials

Appendix – Historical Financials & Cash Flow

Appendix – Historical Returns on Invested Capital

Appendix – Prepetition Corporate Structure

Additional Reading

I recommend reading Hexion CFO George Knight's first day declaration, and for sporadic historical segment detail, Hexion's quarterly earnings presentations and call transcripts. 

Catalyst

Emergence from Chapter 11 bankruptcy and cleansing/gradual selling by current Hexion bondholders.