Speciality Chemicals

Paddling against the stream

Can speciality chemicals companies survive a downturn by looking downstream? Sean Milmo reports

After the financial crisis of 2008, forecasters were predicting a variety of scenarios for the future of the world economy. Some foresaw a quick bounceback in both developed and developing worlds or an initially slow but accelerating growth in the mature economies and continued powerful growth in the emerging economies, particularly in Asia.

The pessimists, meanwhile, warned that developed world would go through a lengthy period of stagnation as it struggled to sort out its debt problems. This would reduce growth rates in the rapidly expanding economies of Asia, Latin America, the Middle East and Eastern Europe. At present, the downbeat predictions seem closer to reality.

The threat of a global economic downturn after 2008 had forced speciality chemicals companies to start rethinking their strategies. The outcome may now be that the move downstream will gather pace even more rapidly.

Lower demand could speed up the commoditisation of their products, especially in developing countries, as excess capacity in base chemicals and cheaper raw materials enables less specialised competitors to cut their prices. The squeeze on margins would become even tighter.

In the event of a relatively quick recovery from the post-2008 economic difficulties, speciality chemicals businesses had certain choices. They could have cut production and administrative expenses to help maintain profitability, while taking advantage of the temporary decline in demand to step up R&D so as to be in a position to roll out innovative products once demand picked up.

However, the 17-nation Eurozone and other European countries like the UK are teetering on the edge of a double-dip recession, while even the US is at risk of sliding into another sharp downturn. Companies are abandoning hope of a fast return to robust demand and considering more radical changes in strategy, more suitable for a period of slow growth in the developed world and moderate growth in the emerging economies.

The battle against the commoditisation of speciality chemicals is likely to become even fiercer as competition intensifies. "Speciality companies have reached a crossroads at which they are having to think about changing directions because of more extreme price competition," says Paul Hodges, chairman of the London-based consultancy International eChem. "They will either have to cut costs to fight the competition from commoditisation or expand into new competences in order to remain competitive."

One option is to shift further downstream, a step taken by speciality chemical producers in previous recessions that looks likely to become a major strategy following the painful post-2008 economic recuperation. This downstream shift could involve expansion into areas already covered by distributors or the customers of speciality chemical producers.

Bayer has moved downstream from crop protection to plant breeding

It is more likely to involve establishing closer and more extensive ties between technology and services, especially technical support linked to sales and marketing. Innovation would result not only in new products and applications but new types of services.

In a recent study on the world market for chemicals over the next two decades, German-based consultancy Roland Berger identified the development of new distinctive business models, leading chemicals companies to step into downstream customer industries to increase profitability, as a key trend. This is becoming evident in the M&A policies of both large and medium-sized companies with speciality businesses.

"Many chemicals companies, including ones in specialities, have plenty of cash at the moment because of restructuring, cost-cutting and reductions in capital following the recession," explains Ariel Levin, co-founder of the Valence Group, a specialist investment bank providing M&A advice in the chemicals sector.

"They can return this cash to their shareholders or redeploy it for acquisitions in the higher growth businesses, offering a lot of added value while giving themselves the protection of high entry barriers. One way of doing this is to move downstream to get much closer to the customer, while retaining control of the technologies which are at the core of chemical manufacturing."

There is a widespread search for opportunities in higher value segments both among commodity and speciality chemicals companies, in particular in North America and Europe, because of the prospect in the developed world of sluggish growth or even stagnation becoming a long-term phenomenon.

This could mainly result from changes in demographics with the proportion of elderly people increasing throughout the world's population, including Asia and Latin America. Even China is projected to have within a few decades an old-age dependency ratio - the numbers of elderly compared to the size of the working-age population - similar to that of existing rich countries such as the US and the UK.

"The most fundamental economic ramification of ageing is fewer employees and this means, in principle, less GDP growth," says Alexander Boersch, head of research for Deloitte Germany, part of Deloitte Touche Tohmatsu (DTT). Consequently pressure will rise on production costs, as more and more people in the rich world will have less to spend. The new middle classes in the emerging economies will have much lower disposable incomes than their counterparts in the West before 2008.

"The main driver in the manufacturing world will be affordability in which chemicals and other products will be judged by their ability to bring down the costs of finished products," says Hodges, who has co-authored an ebook on the impact of the changing demographics on the chemicals and other sectors.

As well as making the materials, BASF develops tools to simulate car seat performance

The surprising maintenance or even improvement of profitability after 2008 may be short-lived as margins shrink again. A study of chemical companies between 1998 and 2008 by DTT's Chemical Group showed that profitability in the speciality sector was declining before the crisis. Gross margins fell by 4.8% during the ten-year period and, of 158 companies in this group, 40 failed to make returns covering their cost of capital.

In response to the strain on profitability, speciality chemical companies had begun to move gradually downstream in some segments In raw materials for coatings and printing inks, for example, resin producers started supplying dispersions, which left paint manufacturers needing only to carry out only a few processing steps to complete their formulations.

Even in higher margin sectors like crop protection, agrochemicals producers extended their activities into seed development and the provision of services directly to farmers. Bayer CropScience, for instance has introduced a service for more efficient application of crop protection products through the use of satellite data on soil conditions. In water treatment, most of the leading suppliers now provide a broad range of services, even including the running of water treatment plants.

"The move downstream is a strong trend but is not new," says Paul Harnick, chief operating officer for global chemicals at KPMG. "If we look at the industry over the last ten years, we've increasingly seen an evolution along the chemical industry value chain, with many companies seeking downstream expansion to capture a greater share of margin."

There are both push and pull factors driving this, he continues. "On the one hand, the customers are increasingly demanding more complex products and solutions. At this high-value end of the market, closeness to the customer and the ability to innovate to provide bespoke solutions have always been critical success factors."

Push factors, according to Harnick, include the increasing dominance of commodity chemicals markets by companies from the emerging economies. This is driving established market majors down the value chain where they can bring their technological advantage to bear.

The shift downstream has recently been gathering extra momentum among integrated chemicals companies with both commodity and speciality chemical businesses as they prepare for a new era. Some global leaders, such as BASF and Dow Chemical have been reorganizing their operations to have a higher proportion of specialities in their portfolios.

After its takeover of Ciba Speciality Chemicals three years ago, BASF also bought Cognis, the oleochemicals specialist, in late 2010 to give it a stronger presence in sectors like personal care, cosmetics and food ingredients. The acquisition also gave the petrochemicals-dominated company greater access to biomaterials.

Nalco's marketing stresses services as much as products

BASF has been pursuing a strategy of downstream extensions outside of acquisitions for many years. In the automotive sector, for example, its coatings operation goes beyond just supplying products via application systems in which the company's own personnel work in car manufacturers' paint shops to control part of the coating process,. The business is paid on the basis of numbers of coated cars rather than on volumes of paint.

In car seats, for which BASF makes engineering plastics, foams and other materials, it has developed for seat design purposes its own computer simulation tool to characterise the different factors which can influence the performance of plastics within the seating. It has also used the modeling concepts behind the simulation tool for providing testing services, for converters and end-users of engineering plastics, on the strengths and properties of polymers and plastic compounds.

Over the past year, there has been a series of acquisitions or planned takeovers by smaller integrated companies with the objective of becoming bigger players in specialities. Last May, for instance Ashland paid $3.2 billion for ISP, whose main markets are the skin care, pharmaceuticals and energy sectors.

The deal raised Ashland's current margins by two percentage points to 12.5% and the share of specialities in its portfolio to 75% compared with 15% in 2004. In January 2012, Eastman Chemical announced a $3.4 billion acquisition of Solutia, which makes speciality plastics and other materials for the automobile and other sectors.

"Although not necessarily the main driver, an interesting feature of some these recent takeover deals in specialities has been the emphasis on services in at least some of the businesses of the companies being acquired," says Levin. "There is a tendency at the moment for more services-orientated acquisitions. Services are a major means of getting closer to the customer."

Within the specialities sector itself, the biggest recent M&A deal has been the $8 billion acquisition by Ecolab of Nalco. Both companies followed a business model of close combinations of product technologies and services.

Nalco was the world's largest maker of water-treatment chemicals and a leading player in oilfield chemicals and energy services. Ecolab supplies cleaning, sanitation and pest control products and services in food processing and catering and in healthcare and has long been a pioneer on linking services and product development.

Among Ecolab's strategies was the use of a large sales force as a front line in service support. For several decades, senior Ecolab executive have stated that their objective is to use their sales and services staff to know more about cleaning processes than their customers do.

Nalco has become so focused on services that some analysts argue that it can no longer be considered as a pure-play chemicals company. The merger creates a new force in specialities, with total sales of around $11 billion/year and a strong commitment to both innovation in technologies and services based on awareness of customer needs. It may become the model followed by many of its competitors in an era of low growth.

 

 

From Online Issue: February 2012