Industry Watch: Unrelenting Chemicals M&AReconfigures the Industry

Technological advances, restructuring, globalization, cost-cutting, customer consolidation, and slower organic growth continue to drive an energetic pace of m&a activity in the chemicals industry. Over the past several years, chemicals companies have stepped up the rate of restructuring and m&a to acquire new technology, optimize their business portfolios, increase returns, and enhance shareholder value. Wall Street is exerting its own pressures on companies to attain higher growth rates, since stock prices are driven by growth. When there are no real alternatives for growing internally, companies must begin to think about growing through acquisitions. Some companies are using m&a to expand and revamp troubled businesses in order to prepare them for a sale or spin-off. Others are scrambling to exit lower-growth segments, such as commodity and specialty chemicals, and are building or bolstering life sciences businesses, which enjoy a higher growth rate. Still others seek to reduce costs and boost efficiency through supply chain integration. Brisk dealmaking throughout the greater part of the year indicates that 1999 may end up being as active, if not more so, than 1998, which racked up 175 deals (which include at least one U.S. partner and are valued at $5 million or more) with a total value of $18 billion, according to Securities Data Co. In the first three quarters of 1999, there were 154 deals valued at $23 billion. Yet, Peter Young, president of Young & Partners LLC, thinks that the number of deals will start leveling off soon, although dollar volume, he says, probably will remain high for at least the next year or two before it also starts to decline. Although he expects chemicals dealmaking to begin slowing down, Young, a leading industry consultant, says there is still demand for quality assets, and multiples are still attractive, especially for specialty chemicals companies. Multiples for those firms have averaged between eight and 10 times EBIT-DA within the past year, analysts say. According to Young, a typical multiple today for a specialty chemicals firm is about eight times EBIT-DA. In peak dealmaking periods, he says, it is significantly higher than that, and in trough periods, it is slightly lower. For commodity chemicals, the multiples tend to be slightly lower than those for specialties, he notes. There is a much bigger swing between peak and trough periods, he says, partly because earnings and operating cash flow can fluctuate significantly. According to Young, aggressive portfolio restructuring and industry consolidation have dramatically reduced competition in some chemicals markets, resulting in antitrust resistance to several deals. Regulatory roadblocks stopped several ambitious deals in their tracks, including the proposed American Home Products/ Monsanto Co. merger and W.R. Grace’s planned acquisition of Imperial Chemical Industries PLC’s Crosfield unit. Dynamics of the broad industry segments – commodity (or basic) chemicals, specialty (or performance) chemicals, and life sciences – impact the formulation of business strategies that companies are following to achieve their growth initiatives. Commodity chemicals, which include bulk petrochemicals, plastic resins, synthetic rubber, dyes and pigments, and fertilizers, are produced in large quantities and have no product differentiation, explains Kevin T. Swift, Director of Policy, Economics, and Risk Analysis at the Chemical Manufacturers Association. In this area, which includes many maturing segments, he states, long-term growth is about 0.5 to 0.7 times the gross domestic product (GDP). Prices are largely driven by capacity utilization and raw material costs, resulting in low profit margins and a high degree of cyclicality, he adds. Long-term commodity chemicals prices are declining about 1% to 3% per year in real terms, he says. As an example, the price of ethylene, a key petrochemical substance, has pretty much remained the same as it was in 1980, he observes. Despite all the attention that life sciences and specialty chemicals m&a activity gets, commodity chemicals deals continue to outpace dealmaking in other chemicals segments. Some commodity chemicals companies are reshuffling their business portfolios to focus more heavily on specialty chemicals and life sciences, areas in which growth prospects and profit margins are higher and where cyclicality is more manageable, says Swift. Not all companies, though, are shunning commodities to focus on higher value-added chemicals, Swift says. Some companies are revamping their portfolios in order to focus on gaining economies of scale in core commodity chemicals niches. In one of the largest petrochemicals deals in the last several years, Lyondell Petrochemical Co. acquired ARCO Chemical Co. in a $5.7 billion deal. Ashland Co. added to its petrochemicals business with its acquisition of the Buna SOW Olfinverbund unit of Dow Chemical Co. Swift notes that in commodity chemicals, scale is important because product pricing is the main factor in determining a firm’s sales and earnings. Some commodity chemicals firms are so depressed, he says, that many of them are choosing to form joint ventures and strategic alliances – as opposed to buying businesses – because those are more cost-effective alternatives to acquisition. The higher-growth specialty chemicals segment is characterized by products that are differentiated, often technologically advanced, and are made in smaller volumes than commodity chemicals. Products include adhesives, sealants, coatings, and industrial gases, among others. Long-term growth prospects, notes Swift, are one to three times GDP. Tradi-tionally, specialties have higher margins than commodities and a much lower degree of cyclicality, he says. Although specialty chemicals manufacturers are not as affected by cyclicality as commodity chemicals firms, they do experience fluctuations in their profits, says Young. “They are cyclical with regards to raw materials as opposed to demand,” he explains. Specialty chemical products have a higher value-added because they cannot easily be duplicated by other producers or because they are protected from competition by patents, says Swift. Since specialty chemicals is made up of many niche subsegments, there is less of a need for size and scale, he adds. Rather, much of the dealmaking in this area is used to acquire products, technologies, and businesses that complement core competencies, he comments. Consolidation and globalization are occurring in specialty chemicals, he says, although acquisitions tend to be smaller than those in commodity chemicals. “Specialty chemicals’ margins are eroding as demand has slowed and as supply chain management by large customers has eroded value-in-use.” In addition, he notes, overcapacity is a problem in some specialty segments. As a result, he says, much of the allure of specialties is diminishing. In some of the more visible activity in the specialties sector, ICI furiously has been selling off its industrial chemicals businesses. Rhone-Poulenc, which is aggressively moving into the more lucrative life sciences sector, spun off its chemicals business as Rhodia SA. DuPont Co., which has long been a specialty chemicals concern, also is moving more heavily into life sciences businesses. On the other hand, Hercules Inc. added to its performance chemicals portfolio with the $3.1 billion acquisition of BetzDearborn Inc. and Rohm & Haas acquired Morton International Inc. and LeaRonal Inc., both makers of specialty chemicals. Swift remarks that life sciences, which includes pharmaceuticals, biological products, diagnostic substances, nutritional substances, and crop protection products, is the most dynamic of the three main chemicals businesses, with long-term growth prospects of 1.5 to six times GDP. Patents and other intellectual property protection are very important and development costs are high in this segment, he notes. As a result, life sciences have typically enjoyed profits margins that are multiples of those in commodity chemicals. Long-term prices have been rising about 1% to 3% per year in real terms, he adds. Life sciences is the hot sector for growth and margins Competition in life sciences largely is based on innovation, product development and differentiation, geographical coverage, price, and customer service, notes Swift. Life science products have a high value-added because they cannot easily be duplicated by other producers or because they are shielded from competition by patents, he adds. Strategic acquisitions, alliances, and investment in internal capabilities are important in this area. For those reasons he believes that life sciences-oriented companies will continue to shed lower-margin, non-life sciences assets. “In life sciences, rapid changes in technology and the need to fund R&D are leading to increasing outsourcing of fine chemicals, and a move away from vertical integration, toward a focus on activities leading to improved competitive advantage,” Swift says. “This move from vertical integration to strategic sourcing’ may also lead to the emergence of virtual companies’ that concentrate solely on these value-added activities. All of this is also leading to heightened m&a activity and alliances in life sciences,” he states. As a prime example, Hoechst AG has been divesting its non-health-oriented operations in order to focus on life sciences. And companies such as Pfizer Inc. and American Cyanamid Co. have split off their chemicals operations to concentrate on pharmaceuticals. Another important factor in chemicals dealmaking, according to Young, is that the erosion of chemicals companies’ stock prices may spur additional m&a activity by encouraging hostile deals. “I think we will see increased hostile activity as chemicals firms look for ways to achieve their growth initiatives,” he says. “Chemi-cals traditionally has been a very conservative industry, and for a long time, no one did an unfriendly takeover. The only ones who really did it were ones who were not really part of the fabric of the industry, the more financial types, like Jon Huntsman of privately owned Huntsman Corp.,” remarks Young. It’s “no more Mr. Nice Guy” when it comes to growth The reason for that, he explains, is because the chemicals industry is interlaced by a complicated set of relationships. He says it is very common for two companies to simultaneously be joint venture partners, customers, and suppliers. “Dow sells products to DuPont. DuPont sells products to Dow, they have formed a number of joint ventures, and they compete with each other head-on in certain markets. So, it is more uncomfortable to go out and make an unsolicited offer for someone you have multiple relationships with,” he says. “But that has all changed,” he notes. “Chemicals companies’ CEOs now operate in a less genteel’ and much more shareholder value-oriented environment.” Many of them, he observes, have come to realize that in order to best serve their shareholders’ interests, they must be willing to make an unsolicited bid for a target they believe can offer real value to their company. “I think it is now more accepted, since companies like Dow and Ashland have successfully done unfriendly takeovers. It is now not bad manners to attempt one anymore,” he says. European chemicals dealmaking surpases U.S. activity As high as U.S. chemicals dealmaking has been the past couple of years, in 1998, for the first time since 1993, sales of European chemicals firms outnumbered U.S. deals, up significantly from about 25% in 1993, notes Young. “We’ve pretty much done all of our restructuring in the U.S. and now we are consolidating,” he observes. “In about three or four years, Europe will be done restructuring and then maybe will be ready to consolidate.” As Europe continues to heavily restructure many industries, there is a good chance that European chemicals m&a will also outpace U.S. chemicals dealmaking in 1999. Because the effects of economic recovery in Asia are becoming evident now, that region is where real industry growth will take place in the future, Young believes. “For every competitor that has merged or sold out in the U.S., there is a new company operating in Asia. If you look within the U.S. or in Europe, you will see fewer players. But if you look on a global basis, I expect that we will have just as many players five to 10 years from now as we have now. It’s just that the number in Asia will have increased and the numbers in the U.S. and Europe will have decreased significantly,” he says.