How 20 Years Have Transformed the Chemical Industry
For the second consecutive year, the Boston Consulting Group has conducted a total shareholder return (TSR) analysis of the chemical industry. The top 10 chemical companies have excellent returns-fourth best, in fact, among the 25 industries BCG analyzed. There have been big shifts in the composition of the top-performer list compared with the year before. US and European chemical companies have come roaring back, displacing the emerging-market chemical producers that were getting the best TSRs only a few years ago.
Until recently, the TSR differences among regions and subsectors followed a predictable pattern: Emerging-market chemical companies had the highest returns of all regions, and agrochemicals and fertilizers had the highest returns of all sectors. But that changed during the most recent five-year period. Although some emerging-market companies with five-year TSRs still approach or exceed 30%, there are also quite a few emerging-market companies whose five-year TSRs are negative. As a result, the average five-year TSR of emerging-market chemical companies is a dismal -2%; only Japan's average (-8%) is worse.
Strength In Maturity
The average five-year TSRs of European and North American chemical companies are much higher: 7% and 4%, respectively. Emerging-market chemical companies tend to focus on the base-chemical and basic-plastic sub-segments, leaving them vulnerable when demand cools off in those sectors. We expect all of these factors to change in the next decade, and for Asia-Pacific and Latin American players to emerge as much stronger competitors. But for now, the less mature structures and business models of chemical companies in these regions have put them at a disadvantage.
In contrast, conditions are becoming more favorable for North American chemical companies, particularly with the rise of shale gas as a resource. Shale gas, which serves as a ready form of low-cost feedstock, stands to make the entire North American chemical industry more competitive. To date, most of the shale gas benefit has been captured by petrochemical divisions of integrated oil companies that are not included in this survey, but the benefit eventually will extend to many of the more than two dozen North American companies on our list.
Europe is the region in which chemical TSRs have remained strongest.
This may be because of the abundance of multispecialty companies there. At one time, companies in this subsector were among the worst performers of the chemical industry. But since 2012, the average TSR of multispecialty chemical producers has improved dramatically.
Investors seem to be focusing on three developments with potentially favorable implications. One is the portfolio restructuring happening at companies such as Arkema, which divested its vinyl-product business, and Rockwood, which divested its titanium-dioxide business. These divestitures are indications that the European companies are disciplined about shedding businesses that have yielded disappointing profits. Another is the trend toward teaming up in a multispecialty: the Rhodia-Solvay and Clariant-Süd-Chemie mergers have fueled expectations of further consolidation. The third development is the likelihood of outbound M&A: for example, Chinese investors have made moves to acquire stakes in foreign multispecialty companies or acquire them outright.
Looking more closely, we see that eight of the top 10 companies are based in developed economies, and only two have headquarters in Latin America. The top companies achieved their superior TSRs in one of four ways: through aggressive revenue growth (for example, Synthos, Mexichem and LG Chem); through feedstock-based margin expansion (Westlake and SQM); through pricing-based margin expansion (Croda); and through valuation multiple improvements resulting from improved macroeconomics (Sherwin-Williams, Eastman and W.R. Grace).
A different analytic approach - viewing the top companies through three different time periods - suggests that there are two strategic points of control that chemical companies use. Either of these two strategies can give chemical companies market values that vastly exceed the replacement value of their physical assets - the clearest indication of the power of a company's business model.
The first, more common point of control is advantaged access to scarce physical assets. For instance, mining assets have been a powerful source of advantage not only in the potash industry but also in businesses as diverse as sulfur derivatives, fluorine chemistry, tungsten carbide, lithium derivatives and bromine-based flame retardants. In BCG's lists of top performers, Potash, K+S, Mexichem, Israel Chemicals and SQM have all benefited from their advantaged access to scarce resources. Other asset-based strategic points of control include standard setting (Victrex getting its specialized PEEK polymer defined as a certification requirement for some aerospace and medical applications), brands (the position Sherwin-Williams has carved out for itself in the US paint industry), easement (SABIC's access to low-cost feedstock), and scale (BASF's longtime leveraging of its Verbund structures).
The second point of strategic control is having a superior business system. An example is Ecolab's 'Circle the Customer - Circle the Globe' strategy. The company's new products and services are based primarily on its understanding of its customers and only secondarily on its roots of selling cleansers and other hygiene chemicals to institutions such as hotels. Other powerful business systems give companies control of intellectual property (for example, Victrex), or allow them to do more innovative application development (Croda).
How the Top Performers Created Value
Chemical companies can improve their performance in a number of ways: They can use technology, switch to a new kind of feedstock, go after a new customer segment or enter a new region, or make a business model change. Eventually, all of these show up in operational metrics - specifically, in the seven measures we believe are the most closely tied to TSR:
- revenue growth;
- innovation and R&D;
- selling, general, and administrative expenses (SG&A);
- fixed-asset productivity;
- working-capital productivity;
- portfolio management
Revenue Growth: As with companies in other industries, there is usually a positive correlation between revenue growth and chemical company TSR. However, the correlation has been less pronounced over the past 20 years, and in some cases, other factors appear to outweigh revenue growth in determining TSR.
Indeed, a few chemical companies have achieved TSRs in excess of 10% while generating almost no growth. The companies that have done this tend to be either highly disciplined about margin management or creative about generating profits from noncritical business units.
Some companies have had low TSRs despite rapid revenue growth. Most of these have benefited from some sort of commodity price inflation, and their poor TSR performance suggests that investors are hesitant to reward companies whose revenue gains may be attributable to external trends.
Margin: The big change with respect to chemical company margins has been the improvement in Europe. European companies have become much more profitable, closing what was once a big gap with their US counterparts. Portfolio transformations, the divestiture of subcritical businesses, and the shift away from the commodity business to more advanced chemical segments have all contributed to European companies' improving margins. These companies have also focused on productivity in a variety of ways, including consolidating country structures into regional structures, setting up shared services for administrative functions, unwinding complexity in the reporting matrix, and removing layers from their organizations.
In contrast, Japanese companies have continued to struggle to improve and now have the bottom of the profitability rankings to themselves.
Within the sectors, the big profit accelerator has been the world's rising need for food from the agricultural sector. Agrochemicals and fertilizers have benefited from the huge demand and from the resulting price increases. The loss of arable land combined with an increased need for agricultural output has boosted demand for productivity-enhancing chemicals. The dynamics of the food commodity boom have also benefited precursor businesses that supply active ingredients, aromatic feedstock, mining chemicals and formulation aids for fertilizer and agrochemical companies.
All other sectors have undergone some margin erosion, with base-chemical and basic-plastic companies faring the worst. These companies have had to absorb oil price increases since the Iraq war in 2002, and they lack the value-added products that would allow them to recover their increased costs.
Innovation and R&D: Theoretically, innovation is important for high-margin businesses. But as the data shows, there is not necessarily a positive correlation between R&D expenditures and TSR in the chemical industry. In fact, only one of the companies in our sample with R&D expenditures exceeding 4% of revenues achieved an above-average TSR, and that result is distorted by the fact that the company has a sizable pharmaceutical business. Indeed, many emerging-market companies with high TSRs devote remarkably little to R&D: less than 1% of revenues.
What explains the absence of a correlation between large R&D programs and the success of a chemical company? To some extent, companies' thinking about R&D may be outmoded. Many chemical companies, including some scientific blue chips that are still magnets for the world's best chemical talent, emphasize chemical breakthroughs. This is true of many Japanese chemical companies, as well as some European and US ones. Companies in these regions all make relatively large R&D investments.
Yet it is legitimate to ask how many breakthroughs can be expected from the world's chemical labs. In most chemical segments, it is probably less important to find the next breakthrough innovation than to be creative about applying and adapting compounds that already exist.
This is not to say that R&D has lost its value - far from it. But the evidence suggests that companies should revisit the goals of their R&D programs and manage their R&D expenditures more rigorously, shifting their R&D efforts toward finding solutions and innovations for specific customers and customer segments.
Selling, General and Administrative Expenses: SG&A costs diverge widely within chemical segments, but in the past 20 years the trend in all regions and sectors has been the same: downward.
On average and across all regions, SG&A spending has come down in the past 20 years - from almost 20% to 15%. A lot of this improvement has resulted from the effective use of technology to improve productivity. This is particularly true of European chemical companies since 2000. Heavy investments in ERP and CRM - undertaken to minimize IT-related problems when fears about the Y2K bug were at their height - have allowed companies to improve the efficiency of their accounting, sales, back-office and supply-chain functions. Today, European companies have SG&A levels comparable to those of US and Japanese companies.
Companies that operate internationally can reduce SG&A costs by not maintaining the same infrastructure in every region. US companies have been particularly smart in their approach to apportioning overhead, putting highly skilled managers in emerging markets that can't reasonably be expected to run on autopilot while eliminating administrative layers in more mature markets. European companies have not followed this tactic nearly as faithfully, and as a result, some of them still have layers of management that are more complex - and costly - than necessary. To the extent that they can let go of their insistence on organizational consistency, European companies may be able to get a few more percentage points of cost out of their SG&A functions.
Fixed-Asset Productivity: The chemical industry is, in general, capital-intensive, and diversified chemical companies in particular face a big challenge in allocating capital. Chemical companies have a tendency to overinvest in the activities that led to success in the past and to underinvest in activities that might be important in the future. Indeed, executives need to watch for this, as one of the ongoing impediments to value creation in the industry.
Nevertheless, in the past 20 years, the chemical industry has made strides in its overall fixed-asset productivity. Until 2000, average annual capital expenditures exceeded 10% and sometimes topped 20% in the area of base chemicals and basic plastics. In recent years, capital spending has been much more restrained. This is partly because of the thresholds that most non-Asian companies - reluctant to saddle themselves with excess capacity - have put on large-scale investments, and partly because of the move away from the 1990s mentality of investing one's way out of bad results; nowadays, the mindset is more that operations and business units must earn the right to invest. The big exception to the rule of caution in capital spending seems to be China, which is creating overcapacity in many areas relating to base chemicals as part of a move to outmaneuver Western chemical providers.
In most other areas, fixed-asset productivity has been converging, not diverging. Twenty years ago, European companies' ratio of revenues per dollar of capital invested was twice that of emerging-market companies. Now, most regions' ratios are clustered around 1.5:1. In North America, however, the ratio is closer to 1:1. The good news for North American companies is that the shift reflects huge investments in shale gas, which is likely to boost the region's financial performance for years to come.
Working-Capital Productivity: Working-capital management varies widely among chemical companies. Because inventory levels are a critical part of working capital, companies that have a flexible supply chain - and therefore don't have to carry as much inventory - tend to have better working-capital ratios. Many factors determine why one company has a good supply chain while another company's is inadequate, but one significant factor is the interface between sales and manufacturing. In companies with a good sales-manufacturing relationship, the supply chain is typically better, and the working capital-to-revenue ratio is usually lower than in other companies.
The other two components of working capital are receivables and payables. European companies appear to have benefited from unification and from the move to a single currency, which have made payment more efficient in the core European Union market. There has been no equivalent to economic unification in emerging markets or in Japan, which may explain their relatively high levels of working capital. Whatever accounts for it, working capital is a third area (after profitability and SG&A spending) in which European companies have made big strides in the past 20 years and are now virtually on par with their North American peers.
Portfolio Management: The available data does not allow for a 20-year analysis of M&A activity. Still, the 10-year data reveals a striking pattern: From 2003 through 2012, US and European companies conducted a number of transactions, but US companies concentrated mostly on acquisitions, while European companies focused more on divestitures. This difference almost certainly stems from the European industry's greater diffusion. European companies had more ill-fitting parts to shed. In emerging markets and in Japan, M&A activity of any sort has generally been more sporadic.
Although the data about US and European company M&A activity is necessarily focused on the past, we think it offers a forward-looking implication: US companies have greater skill in the risky business of adding new businesses. US chemical executives are continually scouring the landscape for companies to buy; they may be said to have an always-on approach to M&A. If, as we believe, this always-on M&A capability will be a major source of future value creation, European chemical companies, as well as those in other regions, may be at a disadvantage compared to US companies.
M&A: Opportunity and Risk Ahead
Higher prices that chemical companies have been able to charge and more rigorous expense controls have left many companies with excess cash. As a result, these companies may be on the prowl for acquisitions - or looking for other ways to grow inorganically, by, for example, taking minority stakes in joint ventures.
Japanese companies provide perhaps the clearest example of a group that should be taking advantage of their financial flexibility. For senior executives at Japanese companies, the challenge will be to enter the world of outbound M&A and divestitures - a world from which they have been largely absent.
But the Japanese aren't alone in facing risks in an era of accelerating M&A. Many agrochemical and fertilizer companies face risks and will have a harder time than, say, multispecialty companies in finding adjacencies that make sense for them. A multispecialty company that is in one type of plastics could move into another type or into hybrid materials. These companies have product boundaries that are, in a sense, permeable. Fertilizer companies typically don't.
One of the implications of this is that the quality of a company's M&A function - already important - is going to become critical in the next few years. It is inevitable that many chemical companies will acquire their way into sectors in which they don't currently have expertise. Knowing how to make these moves successfully is one capability that is going to separate the value creation leaders from the laggards.
Who Will Create Value in the Future?
It doesn't take a deep knowledge of the chemical industry to see that it has changed over the past decade. Many companies that were around 10 years ago - including some with storied histories - are now gone. Nor does it take great predictive powers to see that 10 years from now, a similar set of dynamics will have played out and some companies that are around today will have been acquired and absorbed by others.
The coming period of consolidation will present many opportunities and risks - especially in an environment of higher multiples. The survivors will be those that demonstrate speed, flexibility, and strategic focus.
In terms of speed, the chemical industry is undergoing huge changes - in terms of demand and supply and regional power shifts. On the demand side, formerly hot growth areas - notably renewable energy in Europe, defense programs in the US, and e-mobility everywhere - have cooled. But there are numerous up-and-coming growth applications that are taking the place of those demand drivers, including 3D printing and wearable electronics. On the supply side, there's the influence of shale gas in North America and of coal-to-olefins in China. Chinese companies are by far the biggest new regional force; their push into high-value chemical sectors is likely to create challenges for many Western companies and jeopardize the profits of those that are currently operating in Asia.
To thrive in this environment of change, chemical companies are going to need to quickly adjust their resource allocations and be creative about seeding new businesses through their venture-capital arms, investing in joint ventures, and rethinking their supply chains and business models. It won't be enough to understand the tactical options; the winners will be those that anticipate where the market is going and get there the fastest.
Regarding flexibility, companies often hesitate and display a kind of "collective myopia" when change looms on the economic and social horizon.
Perhaps it's not all that helpful to say that companies need to be smarter than their peers in anticipating the second-order effect of trends in feedstock, technology and customer demand. The more actionable advice might be that companies need to improve the quality of their corporate planning and foresight functions.
When it comes to strategic focus, too many chemical companies are in the habit of letting operational matters become preoccupations of the corporate board. There is no mystery about why this is the case: chemical companies are complex, and internal departmental issues often require resolution. But a plethora of operational topics in the top-management suite keeps many companies from focusing on more strategic issues. Leaders have to find ways to minimize their operational involvement, preferably by pushing their direct reports and operational entities to act effectively at the interfaces and to resolve cross-unit conflicts with minimal escalation.