From THE HINDU group of publications
Sunday, October 29, 2000


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Strategy: Making the elephant dance

A. Srikanth

THE BUSINESS model for a commodity chemical company has traditionally been to exploit economies of scale to reduce unit cost, and simultaneously look for structural and locational advantages to limit cyclicality in the demand-dynamics through consolidation.

The business model for a specialty chemical company, on the other hand, has been to derive better price realisation through value addition and reduce unit cost by exploiting economies of scope (increase product range).

Thus, while the commodity business relies on physical and financial capital, the specialty chemicals business relies on intellectual capital (R&D, highly-skilled manpower and knowledge management). Value-addition is in the form of unique products and solutions. Product innovation, customer-oriented solutions, product range to spread the intellectual capital costs and superior marketing have served been the business model's key drivers for a specialty chemical company. Typically, this model is expected to produce steady revenues (less cyclical) and higher margins. Consequently, specialty chemical companies have been attracting higher P/E multiples in the market.

But the recent steep fall in the P/E multiples of most specialty chemical companies has raised doubts about the soundness of this business model. The earnings of specialty chemical companies have dropped due to the high raw material costs and price pressures because of intense competition. In the face of increasing competition, companies are finding it extremely difficult to do product innovation, increase product range and provide unique products. Customer consolidation is also applying pressure on prices. This could mean that the business model for a specialty chemical company is not working.

Is the business model of a specialty chemical company flawed? No, not really. The basic business model still holds good. What is needed is refinement, and if the recent industry trends and the rationale behind some of the recent mergers are anything to go by, the refinement process has begun. Globally, the industry is poised for another round of consolidation. The recent M&A activity involving Eastman and McWhorter and Geon and M. A. Hanna is just the beginning. And the decline in both the stock market and M&A valuation multiples has prepared the ground for such a development.

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The entry of financial buyers, which generally enter only at low multiples, is another signal. In the first half of 2000, eight of the 36 chemical transactions valued more than $25 million involved financial buyers, compared to just 7 out of 75 in 1999. Recent transactions include Morgan Grenfell/Ciba Specialty Chemicals' performance polymer division, Industri Kapital/Dyno ASA, KKR/Laport's specialty business.

The drive towards achieving critical mass to increase the R&D cost and spread it over a larger base is still the agenda of most consolidations. While this may provide the right conditions for increasing the pace of product innovation, the actual discovery or invention is not in anybody's hands. For example, in the pharmaceutical industry, the lead time for coming up with a new molecule is 15 years compared to five years earlier. This is despite the higher R&D costs. With increasing competition, the pace of new product innovation is bound to slow. The search for critical mass (which itself would keep changing) is only to postpone the inevitable.

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But a more important reason for achieving critical mass is to reduce the cost structure. And it is this concept most recent restructuring exercises are trying to emphasise. At a time when companies are seeing margins squeezed because of increasing raw material costs and the inability to pass on the cost to the customers, purchasing leverage and the flexibility that come with size is critical. This is so especially when raw materials account for 50-55 per cent of the total production cost.

Increased raw material purchasing leverage has been cited as the key benefit in recent M&A deals such as Rohm and Haas/Morton, Hercules/Betz-Dearborn, Geon/M.A. Hanna and Valspar/Lilly Industries. For example, Valspar's acquisition of Lilly Industries (both in coatings) is expected to result in incremental operating earnings of around $50 million. Of this, nearly $25 million is expected to come from raw materials and other purchasing leverage. Along with purchasing advantage comes information discovery which aids purchase negotiations.

There is actually nothing new about this concept. Companies such as Valspar, Spartech, Rohm and Haas and Ciba Specialty Chemicals have benefited from purchasing advantage before. This concept is becoming more popular now. The strategy of some of the recent M&A deals was to derive purchase advantages through size and global focus. If a European specialty chemical company, selling mainly in that market, faces a price hike in raw material costs, it may have to look at alternative supply opportunities only in the European market. Whereas, for a company with a global focus, there are more alternatives. The need for an alternative source is more when the raw material prices start rising.

A global focus offers the flexibility to shift towards the cheapest raw material sources. The core of the strategy is to make the elephant dance. For example, Ciba Specialties has shifted a substantial part of its purchasing from its traditional geographic locations to Asia and Eastern Europe to take advantage of the pricing discrepancies in different regions of the world. They have moved business to areas generally viewed as low cost places of doing business.

For all these years, companies might have neglected the idea to move to the non-traditional market on quality considerations. But their views are changing. As far as this issue is concerned, there is greater realisation that it is better to manage a problem than avoid it. For example, Ciba Specialties has come up with ways to overcome the quality problem by forging alliances with suppliers. With this, instead of absorbing a price hike in traditional markets, the companies can take advantage of a price drop in another market. The point is that customers are still consolidating and going global. So every time one piece moves, it changes the playing field.

Section  : Industry
Previous : Specialty chemicals -- The
           price-product-competition chemistry
Next     : The future is the colour of R&D -- Mr
           Prakash R. Rastogi, Managing Director,
           Clariant India.

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