Nova Chemicals (TSE: NCX) – Bankruptcy, Or A Screaming Buy?

I hate sounding like the perma-bear, but we have another company on the “bankruptcy watch” list: Nova Chemicals (TSE: NCX), Canada’s “premiere” chemical manufacturer… actually, they’re pretty much Canada’s only chemical manufacturer. In the eyes of the equity markets, bond markets, and credit markets (i.e., CDS market) this company may be insolvent within months. But that fate is far from certain. For the gamblers out there, there may be a long-shot trade to be made.

As an introduction, Nova Chemicals (TSE: NCX) is Canada’s major chemicals producer. Basically, they produce a variety of plastic resins and styrenics that go into the manufacturing of stuff like plastic bags, plastic containers, disposable cups, and vehicle dashboards.img4

A Grim Outlook for the Industry

For all commodity producers, the economic slowdown has meant declining demand and a devastating fall in the prices for their products. NCX is no different. Prices for their commodities (ethylene and polyethylene) have plummeted (down some 44%), but the company believes that prices bottomed in December and are now on the rebound. Unfortunately, consumers of ethylene/polyethylene built up their inventory levels of these commodities over the last few years in anticipation of higher energy prices. Now that the economic slowdown is upon us, these consumers are just letting their inventories run down and only buying when needed (which appears to be rarely). In addition, major projects are being brought online in the Middle East, pushing the market into an oversupply situation. So until demand for goods in the marketplace begins to improve, there’s no real reason for prices to increase. The point here is that the industry in which NCX operates is in bad shape.

NCX’s competitors are falling apart as well. The US operations of LyondellBasell and Tronox Inc both filed for bankruptcy last month and Basic Industries Corp – a Saudi chemicals company recently reported 4th quarter profit that was down over 95%.

The Market’s Opinion

While the chemicals industry looks bad, NCX’s situation is particularly worrisome. The market believes they won’t have enough cash to repay their debt – debt that comes due April 1, 2009.

NCX+Bond

The chart above is the price of the company’s Medium Term Note (MTN). This is a 7.40% coupon note that matures in April 1, 2009. NCX issued $250 million of this note. What is alarming about this MTN, is that the bond market is currently pricing it to yield 374%. The bond market clearly doesn’t believe NCX will be able to repay this debt.

Not surprisingly, Credit Default Swaps (CDS) on the company’s debt are currently trading at record highs:

NCX+CDS

Just incase you needed more evidence of the market’s disdain for NCX, the below chart show’s NCX’s share price reaching all-time lows:

NCX+Stock

Nova Chemical’s Financial Situation

I’ll begin by calculating a few of the financial ratios I discussed in my “Introduction To Ratio Analysis” article. Below I’ve included the ones I believe are most pertinent for assessing a company’s ability to pay off its debt:

NCX+Ratios

The company has 5 revolving credit facilities (i.e., lines of credit) totaling $683 million. As of Dec 31, 2008, the company had utilized $184 million of this available credit, leaving $499 million available.

Including the April 1 debt repayment, the company has $333 million in obligations coming due this year (net of restricted cash). Given that as of December 31, NCX had $573 million in available funding (cash plus unused portion of revolving credit facility) it would appear the company should be able to repay their obligations.

However, as you peruse through the earnings release, you come to a section where the company talks about a forward transactions they have in place with a counterparty. The forward is designed to neutralize the mark-to-market impact of the company’s stock-based compensation plan. The problem is a clause that states that the counterparty is allowed to terminate the forward should Nova’s stock price remain below $8 for three consecutive trading days starting February 2, 2009. If the counterparty elects to terminate, then NCX will owe the counterparty $84 million – not an inconsiderable sum when you consider they only have $74 million in cash. Given where NCX’s stock price is now, this $84 million charge is pretty much in the bag.

The latest earning’s release states that two of NCX’s revolving credit facilities are governed by financial covenants that require NCX to maintain their net debt-to-cash flow ratio below 5:1 and their interest coverage ratio above 2:1. So it looks like NCX is ok here. But remember, this is what things looked like at the end of December. Things are going to change dramatically when it comes time for the company to repay the $250 million in debt that’s due April 1, and to pay the $84 million charge on the forward unwind. So in anticipation of these charges, NCX successfully renegotiated some relief on those covenants, with the condition that the company can raise $100 million by February 28, 2009, and $100 million by June 1, 2009.

It appears the company’s ability to remain solvent rests on their ability to secure this $200 million. Management insists they are well on its way to securing the first $100 million, but you really should always take statements like this from management with a grain of salt.

How will NCX gain the additional funding? For the first $100 million, NCX’s best bet is probably the Alberta government and my view is that NCX will actually be able to get this financing. NCX has a major footprint in Alberta. The company employs 1,700 in the province and their Joffre facility accounts for over 20% of Alberta’s natural gas consumption. A Nova Chemicals failure would be bad news indeed for Alberta. The second $100 million, however, is still up in the air. But, NCX only needs the first $100 million to pay down the debt due in April.

The Sunny Side of Nova Chemicals

The situation for Nova Chemicals definitely looks dire. However, to say Chapter 11 is a certainty is a little premature, I think. Here are a few reasons why over the long term, NCX is a good company:

  • Nova Chemicals still generates over $100 million in operating cash flow per quarter.
  • NCX is one of the market leaders in the ethylene/polyethylene and styrene/polystyrene industry.
  • The Alberta Advantage – NCX has a competitive advantage over their peers. Management refers to this as the Alberta Advantage. The advantage comes from NCX’s manufacturing facility in Joffre, Alberta that gives the company a competitive cost advantage in the production of ethylene and polyethylene when compared to its US peers. Historically, this advantage has averaged $0.08 per pound on the cash cost of ethylene production. Lately, however, this advantage has been much lower ($0.02 per pound last quarter). This advantage should improve as commodity prices improve.
  • The prices for Nova’s chemical products move in the same direction as oil prices (one of the reason the industry is doing so poorly right now). They also move in the opposite direction as natural gas (this commodity is one of the main inputs to production). So when the oil to natural gas ratio increases (i.e., oil becomes more expensive relative to natural gas), NCX makes more money. While it’s hard to find a reason to be bullish on oil prices nowadays, I believe over the long term, the supply and demand picture for oil seems a little brighter than natural gas – there’s more natural gas supply out there than there is crude oil, and while demand for both commodities has fallen off a cliff, it’s been the oil companies who have been putting the brakes on current and planned projects, destroying future supply in the process.

Take whatever solace you’d like from those points above – the reality is good companies can go bankrupt. But the point here is that should NCX get through the next few months, the stock should recover dramatically and the company could be a good long term holding.

The Trade

For those that believe there’s a chance NCX could make it out of this alive, buying out-of-the-money call options may be an interesting trade. Since April is the month NCX needs to get through, you’re going to want to buy the options maturing in May or later (no April options available). The May $3, $4, and $5 calls are currently offered at $0.30, $0.25 and $0.20, respectively. Your upside is unlimited and your downside is if the options expire worthless (i.e., the stock price is lower than $3, $4, or $5 at expiry). These options don’t necessarily need the stock to get back to those strike prices, for you to make money. The options will rally as the stock rallies and you can sell the options before maturity. Remember, options are levered instruments, so if NCX’s stock price rallies 100%, the options will rally much more than 100%.

I want to emphasize, this trade is a lottery ticket – for very little upfront cost, you can either earn a substantial amount, or lose your entire upfront cost. Proceed with caution!