Plastic drag

Bayer's $11 billion plastic IPO looks far from fantastic

It is easy to see why Bayer, a drugmaker, wants to get out of plastics. Less obvious is why investors would buy into the euro 9.3-billion ($10.5 billion) flotation of Covestro, the division it is spinning off in an initial public offering. In 2014, Covestro contributed 28 per cent of Bayer's revenue but just a tenth of operating profit, and has been value-destroying for years. Its owner could afford to be a bit more pliable.

Covestro products are ubiquitous, from foams used in mattresses, car seats and fridges to transparent plastics, coatings and adhesives used in cars, computers and construction. Annual sales of euro 11.7 billion make it one of Europe's largest chemicals makers. While less profitable than Bayer's other divisions, the unit's operating profit margin grew in 2014, to 4.4 per cent. And the top line is growing, too. In the first quarter of this year, revenue increased 9.5 per cent, though currency moves helped a lot.

The trouble is, by Bayer's own benchmarks, Covestro -which is raising money from new shares mainly to pay down debt - has destroyed value for four years running. The shortfall between free cashflow after essential investment and the division's cost of capital added up to euro 454 million from 2011 and 2014, Bayer's annual reports show - although the rate of value-erosion has slowed lately.

That reflects a problem as well as an opportunity. Bayer has invested heavily in its plastics unit, but the industry still hasn't recovered from recessions in 2009 that hit demand. Overcapacity has weighed on prices and overinvestment has made things worse. Rising demand for wind turbines, cars and IT equipment should help use some of that excess capacity. Consultancy Nexant thinks global demand for Covestro's products by weight will grow by about five per cent a year until 2020.

Investors aren't getting that cheaply. At the midpoint of the price range, and including net financial debt of euro 2.4 billion, Bayer is valuing Covestro at 7.7 times last year's EBITDA. According to Starmine, that's three per cent above chemical giant BASF and 17 per cent higher than speciality chemical maker Evonik Industries. Given its mixed track record, Covestro's shares might perform better were Bayer to flex its expectations.