How to do a business analysis of chemical companies
Try to differentiate businesses into bulk/commodity manufacturers or specialty chemical manufacturers.
Bulk and commodity are two segments of the chemical industry, which have different business characteristics.
Bulk Chemicals
Bulk chemicals are also known as materials, integrated chemicals, upstream chemicals as well as commodity chemicals.
This is because these chemicals are always produced and used in large volumes (bulk); these are used as key building blocks (raw materials) in end-user industries.
They have large integrated chemical complexes, where many intermediate products are made in-house.
These chemicals are commodities in nature i.e., a product from one manufacturer is non-differentiable from another.
These chemicals primarily include organic chemicals like
Petrochemicals:
polyvinyl chloride (PVC),
high-density polyethylene (HDPE),
low-density polyethylene (LDPE),
polypropylene (PP) and
methanol,
As well as inorganic chemicals such as
caustic soda and
soda ash.
Specialty Chemicals
Specialty chemicals are also known as functional chemicals, as well as downstream chemicals.
These chemicals are used to bring in specific properties or changes to the main chemical products.
As a result, these are used in a very small quantity in the final products of end-consumers.
The consumers of specialty/functional chemicals expect these chemicals to provide a specific outcome in their manufacturing process for which a lot of research & development (R&D) is done by the specialty chemical producers.
Specialty chemicals include products like
adhesives,
catalysts,
water treatment chemicals,
leather chemicals,
pigments,
surfactants etc.
Specialty to Commodity Journey of a Chemical
At any point in time, various chemicals can be classified as bulk/commodity chemicals or specialty chemicals.
If an investor studies any particular chemical, then he would notice that it follows a lifecycle. In this lifecycle, the chemicals go through a journey from specialty chemicals to becoming commodity chemicals.
The Japan Credit Rating Agency classifies the lifecycle of any specialty chemical into three phases:
initial phase,
product growth phase and
stable product phase.
Initial Phase - the risk of whether the customers would accept the new product and its technology.
Product Growth - the product is accepted by the customers; however, many competitors also enter the market.
Stable Product - many competitors also master the technology, which results in intense price-based competition.
Therefore, an investor would note that over time, a chemical, which starts as a specialty chemical with new technology and a few producers, ends up becoming a commodity chemical with many established producers competing on price. Therefore, after some time, the specialty chemicals get commoditized as they are duplicated by many manufacturers.
Key characteristics of the business of chemical companies.
Pricing power and competitive intensity
In the case of bulk/commodity/integrated chemicals, the products made by one company are non-differentiable from the products of another company.
As a result, a customer can easily switch the chemicals from one manufacturer to the chemicals from another manufacturer.
For example, if a customer needs 99% purity phenol then he can use 99% phenol from any manufacturer and it would serve his purpose.
Due to such commoditization and non-differentiation of products,
bulk/commodity/integrated chemical producers face very intense competition and do not have any pricing power over their customers.
They are effectively price takers in the market where the lowest-cost producer sets the market price and all the producers have to match that price otherwise their customers would shift to buying from the lowest-cost producer.
As a result, most of the commodity chemical producers end up competing on the prices.
The pricing position of commodity chemical producers is so weak that even the most established players in the industry do not get any pricing advantage. Such established players may have a strong long-standing relationship with their customers; however, the customer is unlikely to give them a high price because of the same.
APIs are commodity chemicals, which are used by drug companies to make ready-to-eat medicines.
Management of NGL Fine Che Ltd.
“Rahul Nachane: So see we are selling to, it’s a B2B business… The purchaser is also very educated and very well experienced person. I have not come across any buyer who is willing to give a higher price because of any brand recall of that sort. Only thing what he will do is, all things being the same he will give preference but he will first challenge on the pricing.”
An investor would appreciate that in the commodity chemicals space, a customer would not pay premium pricing to its suppliers. The suppliers have to match the price available in the market.
Therefore, marketing exercises like branding do not have any positive impact on the financial performance of commodity chemical companies.
However, the entire picture of pricing power changes when an investor shifts his attention from commodity chemical space to specialty chemicals.
An investor would remember that specialty chemicals are a result of significant R&D in order to produce specific desired changes/properties in the overall product.
Specialty chemicals are used in very small quantities in the overall manufacturing process; however, they have a very high impact on the final properties of the end product.
Therefore, the customers of specialty products are very particular about choosing a specialty chemical product and its supplier. Any lapses/defects in the specialty chemical can lead to poor quality of a very large quantity of the final product of the customer. As a result, any customer undertakes a lot of testing before they approve any specialty chemical supplier for their manufacturing process.
Therefore, the customers do not switch their specialty chemical suppliers for a minor price difference. This is because the monetary benefits from switching to a low-cost specialty supplier may not be much; however, the risk it carries is huge. As a result, there is a huge switching cost/risk when any customer decides to shift its specialty chemicals supplier.
As a result, specialty chemical producers are somewhat protected from intense competition and they get a pricing power where they are able to pass on any increase in their input costs to their customers.
An investor can see a real-life example of high switching costs influencing customers’ behavior when she analyses Deepak Nitrite Ltd. She comes across a situation where Deepak Nitrite Ltd started producing a specialty chemical, an optical brightening agent (OBA); however, despite its best efforts for many years, the company was not able to run the OBA division profitably.
This was because the customers are very cautious before approving any new supplier for OBA. As per the company, any problems in the OBA may lead to the rejection of millions of metres of cloth for a textile mill or millions of tons of paper for a paper mill.
As a result of the very strict approval process by the customers, Deepak Nitrite Ltd faced many challenges in getting approvals for its OBA products.
An investor would appreciate that the products of specialty chemical companies are highly differentiated from each other. As a result, such companies benefit from branding, especially in segments where direct purchases by retail consumers form a significant part of sales.
In fact, a specialty chemical player must have a higher profit margin than a commodity chemical player. In case, the profit margins of a specialty chemical player start declining, then it may indicate a situation where its so-called specialty products have now started to become commodity products and it has started losing its pricing power.
Lower cost producer; economies of scale
The technology to make commodity chemicals is mature and widely available.
The key competitive strength for any commodity chemical producer comes from being the lowest-cost producer in the market.
This is because, in the long term, the lowest-cost producer sets the market price and all other players have to match that price to gain business.
Commodity chemical companies undertake many strategies to become low-cost producers:
Locating the plant near the key raw material source like a refinery for petrochemicals.
near the key customers for lower transportation costs.
long-term take-or-pay agreements with their suppliers,
Efficient utilization of by-products of the manufacturing process.
The biggest impact on the cost structure of a commodity chemical producer comes in the form of economies of scale where it increases its size of operations by capacity expansion.
As the size of the commodity chemical player increases, its fixed costs are spread across a higher volume of production, which reduces its overall per-tonne cost of production and provides a competitive advantage over other smaller players.
As per the Japan Credit Rating Agency, the size of the commodity chemical company is one of the key indicators of its competitive advantages.
On the contrary, for specialty chemical industries economies of scale are not very important.
The market size of any specific specialty chemical is not large because they are used in small quantities in their customer’s manufacturing process. So the total market size itself for any particular specialty chemical may not be large enough to justify a very large plant.
At times, the market size of specialty chemicals is so small that the companies produce many specialty chemicals on the same production line to use the facilities optimally.
Specialty chemical companies have the ability to pass on the increase in input costs. Therefore, they do not need to be the lowest-cost producer in the industry to sustain their business.
Specialty chemical companies can price their products as per the value they provide to their customers. Therefore, specialty chemical companies may earn a high-profit margin despite not being a low-cost producers in the market.
Capital intensiveness and R&D costs:
The technology for making commodity chemicals is widely available; therefore, a high investment in R&D by commodity chemical companies is not highly fruitful and does not add any significant competitive advantage.
Large-sized cost-competitive plants are the biggest advantage for them. It makes the commodity chemical sector a capital-intensive sector.
The requirement of large-sized investment for commodity chemical companies does not end with the creation of a new manufacturing plant. They need to continuously spend money on working capital as well as meet the stringent guidelines for safety and environmental norms.
In order to sustain/increase their market share, commodity chemical players need to continuously add investments in new plants and maintain/upgrade their existing plants.
The commodity chemical companies do not have very strong entry barriers to restrict the entry of new players. The requirement of large capital investment forms the only significant entry barrier for new players. Nevertheless, the industry is so sensitive to new entrants that many times, the entry of a single new player can seriously impact the profitability of existing players.
The specialty chemicals require a relatively small investment in their manufacturing plants because the plants are usually smaller in size and cost-competitiveness is not the only determinant of competitive strength. Therefore, specialty chemical players do not have a large capital investment burden.
An investor would appreciate that in the specialty/functional chemicals segment, the competitive advantage of the players arises from their technical knowledge and R&D.
Specialty chemical players need to spend a lot of money on R&D to create products. The technology is usually patented. At times, the technology developed in-house is kept a trade secret. As a result, specialty chemical companies also face the risk of technology theft.
The complexity of the technology determines the extent of competitive advantage for specialty chemical players. Competitors find it difficult to copy complex technology and as a result, the specialty player can continue to earn high-profit margins by selling its products.
Specialty chemical players solve specific problems of the customers and produce high-value-adding products. As a result, specialty chemical players have strong relationships with their customers and customer stickiness is very high.
Therefore, an investor would note that the key competitive strength of specialty chemical players is their R&D. In fact, the need to continuously invest in R&D is so high for specialty chemical players that it becomes almost a fixed expenditure for them.
An investor would appreciate that a specialty chemicals company cannot reduce its R&D spending for reporting short-term profit benefits. A reduction in R&D will have a significant impact on its competitive strengths. In contrast, the technology for commodity chemicals is mature, is widely available and more investment by commodity players in R&D may not give any outsized benefits.
On average, specialty chemical companies spend about 3% of their revenue on R&D.
Chemical sector players, whether commodity or specialty, need to continuously invest money in their business. The commodity chemical players need to invest a large amount of money in creating a big manufacturing plant initially and then subsequently for its expansion and upgradation. In addition, they need investments for working capital as well as safety & environmental protection needs.
Cyclicity and volatility of performance:
The chemical industry especially the commodity chemicals segment faces very high cyclicity i.e. boom and bust phases. The prices of bulk/commodity chemicals are very volatile.
As per the credit rating agency, Standard and Poor’s, the revenue and profitability of commodity chemical companies show a high cyclicity. The revenue of commodity chemical players declines on average by 7% during recessions with a maximum decline of 23%. The profitability (EBITDA) margins of commodity chemical players declined on an average by 15% with a maximum decline of 28%.
The bulk chemical industry shows high cyclicity due to the following reasons.
Raw material costs are the single largest expense for chemical companies whose prices are very volatile.
The chemical manufacturing process is very energy-intensive, which makes energy costs one of the major input costs for commodity chemical players.
An investor would appreciate that energy costs, which usually follow crude oil prices are very volatile in nature. As a result, high energy requirements also increase the cyclicity in the profit margins of commodity chemical players.
The prices of the final chemicals produced by bulk chemical producers depend on their global demand and supply situation and have no linkage to the cost of raw materials/inputs of these chemicals.
As a result, many times, bulk chemical producers are stuck in a situation where the raw material prices have increased and the final product prices have declined. Therefore, their profit margins are very volatile.
The third reason for the cyclicity in the business of commodity chemical companies is the dependence of the demand for chemicals on the general economic situation in the country. In fact, the demand for commodity chemicals increases sharply during the up-cycle phase of the economic cycle and the demand declines sharply during the down-cycle phase.
The specialty chemical players witness a much lower cyclicity in their business performance when compared to bulk/commodity chemical players. There are many reasons for the same.
The specialty chemical players are able to pass on pricing pressures from their input costs and in turn, are able to maintain their profit margins, which helps them beat the cyclicity.
The raw material costs form a smaller part of the overall costs of a specialty chemicals company when compared to a commodity chemicals company. As a result, an increase in the input costs has a smaller impact on the business performance of a specialty chemical company than a commodity chemical company.
One of the key costs that specialty chemicals players are required to control is employee costs because these companies usually have a large sales and marketing team.
Due to relatively lower fixed investment, specialty chemical companies are able to sustain their profitability even at lower demand/production levels. As a result, even in the economic down-cycle phases, specialty chemical companies continue to get a certain amount of business from their key customers as well as from aftermarkets.
Many times, bulk chemical players who work with large capacity plants, announce capacity expansions, which are going to commence operations after a couple of years. At the time of announcing the expansion, the companies are not certain what would be the level of demand when the new capacities would become functional.
Therefore, there were instances when the capacity expansion plants of multiple players became operational at the same time, which led to an oversupply in the market and led to a crash of prices. An investor would remember that the commodity chemical producers work on low-profit margins and a decline in the product prices may force many players out of business.
Most of the time, companies attempt to reduce the cyclicity in their business by diversifying into different products, geographies, etc. so that they may mitigate the impact of the downturn in any one product or country.
At times, the commodity chemical players diversity by producing specialty products as well to mitigate cyclicity in their business.
As the raw material costs are the largest input costs for a commodity chemicals company; therefore, an ability to change the raw material as per market dynamics is very helpful to deal with raw material price fluctuations i.e. when costs of a raw material increase, then use a different raw material or use a different grade of the same raw material.
Integration of operations:
Chemical producers especially the bulk chemical players need to be very cost-competitive to generate sustainable profit margins.
Apart from the large manufacturing capacities of any chemical, the bulk chemical producers also go for vertical integration (both forward and backward) in order to retain a higher value of the supply chain within the company.
An investor would appreciate that most of the bulk chemical plants operate 24*7. It helps them get the maximum capacity utilization of their plants and in turn, be very cost-competitive.
There are times when vertically integrated firms, which produce their raw material/intermediate products themselves become at a disadvantage to the firms that buy such intermediate products from the open markets.
An investor would note that the prices of chemicals are very volatile and are not related to their input costs i.e. the cost of production. Therefore, there are times, when chemical products are available in the open market at a lower price than the price at which an integrated chemical player can produce them.
Therefore, despite being vertically integrated, a chemical company may be at a cost disadvantage. As a result, it must develop the ability to start its manufacturing process from the intermediate steps by procuring low-priced intermediate products from the open market if their prices are lower.
Therefore, despite being vertically integrated, a chemical company may be at a cost disadvantage. As a result, it must develop the ability to start its manufacturing process from the intermediate steps by procuring low-priced intermediate products from the open market if their prices are lower.
Therefore, an investor would note that in the case of commodity chemical producers, being vertically integrated helps in becoming more cost-competitive, and improves profitability. It also helps to avoid the unavailability of critical raw materials. However, the company needs to be flexible in its manufacturing process so that when market prices provide opportunities, then it may start manufacturing using intermediate products or sell intermediate products without waiting for the production of final products.
The specialty chemicals players usually have small manufacturing plants because their target market size is small. Therefore, economies of scale and vertical integration, though beneficial, are not very critical to generating competitive advantages for specialty chemical players. They depend more on R&D and technology to generate competitive advantages.
Integration of operations:
The chemicals sector is one of the sectors, which involves a lot of tariffs-related activity. There are import duties, anti-dumping duties, etc. in order to provide a level-playing field to the domestic producers when compared to the nations with an oversupply of different chemicals especially when such nations resort to exporting their chemicals to India below the cost of production.
The linking of the Indian chemical industry with the global market was initiated in a big way in the 1990s when India aligned its import tariffs in line with the opening up of the economy.
From then, the prices of chemicals in India started following global prices because companies started pricing chemicals at import parity prices.
India provides protection to chemical manufacturers, especially against the dumping of products at very low prices by foreign companies.
Location of manufacturing plants:
In the case of bulk/commodity chemical manufacturers, the intense price-based competition leads to low-cost production becoming the best competitive advantage. The commodity chemical players are price-takers with very low or nil pricing power.
Apart from having large-integrated plants (economies of scale), bulk chemical manufacturers also attempt to reduce their costs by way of reducing their transportation costs.
It is seen that in the case of low-value chemical products, chemical companies attempt to make them near to their consumers.
It is a situation similar to cement plants where cement being a bulky low-value adding commodity, is difficult to transport over long distances. Therefore, companies attempt to construct cement plants at such locations where they can minimize transportation costs.
On the contrary, for high-value chemicals, the companies attempt to keep their plants near the raw-material sources to keep their input costs low.
In India, most of the chemical producers are present in the states like Gujarat and Maharashtra (the west coast). One of the key reasons for the same is easy access to the ports, which serve both for easy access to cheap raw materials overseas (imports) and easy access to high-paying customers present overseas (exports).
Location on the west coast of India also benefits Indian chemical producers, which are able to easily integrate with the large chemical manufacturing units existing and upcoming in the Middle East region.
Therefore, while analyzing any bulk/commodity chemical company, an investor should note that the location of the manufacturing plant provides a key competitive advantage to the company. If due to any reason, a bulk chemicals company finds itself in a locational-disadvantaged situation, then it would be very difficult for the management to overcome its challenges.
Environmental and safety regulations:
Chemical manufacturing is a very environmentally sensitive process because it generates a lot of effluents, which have the potential of damaging the environment and causing pollution. As a result, the companies need to invest a significant amount of money in treating the effluents before recycling them or releasing them back into nature.
An investor would remember from the above discussion that a continued requirement to spend money to meet ever-changing environmental/pollution-control regulations is one of the reasons that make chemical manufacturing a capital-intensive process.
In the past, there have been many instances where chemical manufacturers have had to pay penalties or shut down their operations because they failed to meet environmental protection guidelines.
The environmentally damaging nature of the chemical manufacturing industry became clear to the whole world from 2014 onwards when China which is the world’s largest chemical manufacturer tightened its environmental regulations and as a result, a significant number of Chinese chemical plants shut down.
As a result, the chemical exports from China declined suddenly and the chemical manufacturers in other countries including India got an opportunity to fill in the gap created by Chinese manufacturers.
While analyzing any chemical company, an investor should pay due attention to the aspect of compliance with environmental regulations. She should analyze its track record of meeting the guidelines in the past, any shutdown or penalties imposed on it by Govt. or any investments done by it to meet pollution control norms to understand whether the company takes environmental preservation responsibilities seriously.
Meeting environmental guidelines is essential because, in the current times when awareness in society about pollution-related issues is very high, any noncompliance may lead to a shutdown of the business of the company.