Chemicals and the Capital Markets - Ravi Raghavan

Publicly listed chemical companies in India are on a roll, quoting at significantly improved valuations in the belief that the industry is on the cusp of strong growth both in the domestic markets and in exports. There is some truth to this; the challenging external environment, marked by the dominant presence of China in several value chains has eased somewhat, affording better prices and margins for producers here.

In this context it is relevant top point out that globally too the industry is back to the top of the table in so far as total returns to shareholders (TRS) is concerned, as reflected in a recent paper published by McKinsey, the eponymous consultancy.

The chemical industry has more often than not outperformed global indices when it comes to rewarding shareholders in terms of capital appreciation and by way of dividend payout. This may surprise many, considering that the industry makes the news mostly for the wrong reasons and is constantly griping about the challenges and difficulties it faces when it comes to running its day-to-day business. There are many reasons for the strong performance of the industry, but an important aspect, often unrecognised, is the sheer importance of the industry as a driver of economic activity and a key enabler of growth. Chemicals and the chemical industry touch every aspect of our daily lives, and that is unlikely to change despite green groups wanting to wish the industry away.

Outperforming others on returns

Over the past year and a half, McKinsey’s analysis reveals that the chemical industry (actually a subset of the industry comprising 200 companies with a market capitalisation of about $1.5 trillion and revenues of about $1 trillion, about a quarter of the global chemical market size) has delivered higher TRS than the world markets as a whole. This is in line with its historical trend of delivering better value to shareholders consistently since the turn of the century, except for a four-year period between December 2012 and August 2016, when it underperformed the overall market.

Since 2016, the chemical industry’s TRS has grown at a blistering pace of 24% CAGR, considerably above the 19% growth seen across all sectors, driven by a consolidation through significant mergers & acquisitions (M&A), and a more favourable demand-supply position for petrochemicals that has enabled strong earnings for companies.

Commodities vs specialities – little difference

There are sectoral variations in TRS growth in different sub-segments of the industry since 2000. Both commodity and speciality chemical companies have, however, posted similar TRS growth numbers – 12.9% and 12.2% CAGR respectively – over the period, even as diversified companies have been underperformers with TRS growth of just 8.6%. On the whole, the chemical sector has posted TRS growth of 10.6% in the period from Dec 2000 to Dec 2017, as compared to the world average market growth of 5.3%. This lends credence to the argument that there is nothing very special about speciality chemicals and that profits are to be had across both, but that capabilities and competencies needed to deliver returns differ. It is also a pointer that focus does have benefits.

The cyclicality of the commodity chemicals business is reflected in the variation of TRS growth rates for brief periods of time. For example, the last two years have seen bumper profits for the industry, thanks to cheap oil and gas (primarily shale gas). Specialities, as would be expected, have shown less volatility in earnings and TRS, but have benefitted immensely from consolidation efforts that have brought some correction to an otherwise fragmented industrial base.

Better than many other segments

What is surprising is that the chemical industry’s average TRS growth is better than that of several other industries like consumer goods, construction materials, automotives, electronics and pharmaceuticals. For Indian capital market watchers – many of whom are obsessed with the growth prospects for pharmaceuticals – there is a lesson here. Globally, the pharmaceuticals industry has delivered TRS growth of just 5.3% since 2000, a figure that reveals the growth and profitability challenges facing it. Numbers for the Indian market are not readily forthcoming, but are probably decidedly better.

Asia – leading in delivering value

Returning back to the chemical industry it is seen that on a regional basis the returns generated by the chemical industry are the strongest in Asia. Leaving aside Japan, TRS growth from Aug 2016 to Dec 2017 have been an outstanding 31% in this region. Companies from the region now account for about 16% of the industry’s valuation, compared to just 7% in 2000, indicating that Asia is now developing businesses that can be counted amongst the bigger ones in the world.

Reasons for the impressive performance

What are some of the reasons for this very impressive performance by the chemical industry? McKinsey provides four reasons: productivity improvements, explosive growth particularly in China, the essentiality of the industry for modern living, and developments in the oil & gas industry.

It is well known that the chemical industry has invested significantly in productivity improvements that go well beyond manufacturing in its plants, to include improvements in its supply chain, sales & marketing initiatives, research etc. The industry has also been able to keep a significant portion of these savings for itself, while passing on some to customers (the extent of which varies from one sub-sector to another). The benefits of the explosive growth seen in chemical demand in China since the last two decades have accrued to companies across the world, besides private and state-owned companies in China itself. Indeed, most major petrochemical projects built anywhere in the world in the last two decades had an eye on this lucrative market. While the pace of growth in China has moderated over the last couple of years, there are still several opportunities that remain to be tapped. While China may not be the sole engine pulling the global economy, it is not one that is about to be derailed.

The vital role for the industry to aid modern living has been briefly alluded too earlier, but it is important to realise that the innovative potential that exists in the chemical industry will enable it to continue to make significant contributions including in areas that prima facie look far removed from the industry – modern electronics, renewable energy, electrification of cars, combating global warming etc. The wealth of knowledge and intellectual property created and protected within the industry will provide a strong engine of growth well into the future.

Another strong driver of the industry’s performance has been access to cheap feedstock – oil-derived streams or shale-derived gas fractions – that has enabled improved earnings for companies privileged to have access to these.

Avoid overpaying for assets

Analyses of the performance of individual chemical companies and specific sectors reveals that a clutch of companies and a handful of sectors have accounted for much of the returns that the industry as a whole has provided. Many of the companies that have done well have been proactive in M&As, allocated capital actively, and, importantly, avoided overpaying for assets in a bid to buy into growth. These companies also have an unrelenting focus on functional excellence, covering all aspects of their business. They are at the forefront of efforts to exploit advanced manufacturing technologies, as well as digital technologies such as artificial intelligence, data mining etc. to boost productivity.

Having said all of the above, being in the right market at the right time with the right portfolio has been crucial for sustained and profitable growth. In the commodity chemicals business, for example, much of the TRS growth has come from companies that have a strong footprint in the fast-growing Asian markets. In speciality chemicals, sectors that have contributed majorly into the earnings growth include paints & coatings and agrochemicals. Demand for the former are underpinned by rising living standards in the developing world, and infrastructure build-up directly or indirectly spurred by governmental actions. In the case of agrochemicals, the challenge of raising food productivity to meet the needs of a more populated world is expected to remain a strong driver.

Strong economic outlook bodes well

The relatively strong economic outlook for the world economy bodes well for the growth of the chemical industry and the returns it will offer to shareholders.

This is not to say that there are no challenges for the industry. The volatility in the oil price, geopolitical tensions and rising protectionism in important markets, could adversely impact growth in the industry.

Captains of India’s chemical companies are optimistic of the industry’s prospects in the near-term, particularly in the light of the challenges faced by companies in China. But this window of opportunity must be seen as a time to modernise, expand, diversify and build integrated capabilities to ensure sustainable growth.