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Chemical
Chemical
Companies
Published: 22-Mar-22
Modified: 23-Mar-22
1. Classification of chemical companies
2. Key characteristics of the business of chemical companies:
3. Summary
The current article aims to highlight the key characteristics of the business model
of chemical manufacturers. After reading this article, an investor would be able to
identify the key strengths as well as the challenges faced by chemical
companies. She would get to know the features that make any chemical
company a strong player.
Whenever an investor comes across any chemical company, then first, she
should try to find out whether it is a bulk/commodity chemical manufacturer or a
specialty chemical manufacture. This is because, bulk and speciality chemicals
are the two key segments of the chemical industry, which have very different
business characteristics.
1) Bulk chemicals:
2) Specialty chemicals:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
1:
The Japan Credit Rating Agency classifies the lifecycle of any specialty chemical
into three phases: initial phase, product growth phase and stable product phase.
Each phase of the lifecycle brings in different characteristics in terms of
acceptability from the customers and challenges from the competition.
In the initial product stage, there is a risk of whether the customers would accept
the new product and its technology. In the product growth phase, the product is
accepted by the customers; however, many competitors also enter the market. In
the stable product phase, many competitors also master the technology, which
results in intense price-based competition.
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012 (click here), page 2:
In most cases, however, various types of competition arise at each stage of
product growth. At the initial stage, a product faces competition in the
establishment of a technology. At this stage, there is a risk that the product will
not be continuously adopted by the users, which tends to be a restrictive factor in
assessing credit rating. In the product growth stage, increased sales in response
to growth in demand for the product can be expected. However, many
competitors expand their production capacity to capture the demand, which often
increases the burden of debt. In addition, when an item enters the stable product
phase, it is required to note that there is a risk that an increasing number of
competitors will catch up with the required technological level, intensifying the
price and other types of competition while reducing the profit margin.
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 commoditised as they are
duplicated by many manufacturers.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
4:
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013 (click here), page 3:
Pricing competition is high in most commodity chemical segments. Because of
the interchangeable nature of commodity chemicals and the lack of product
differentiation, competition is primarily based on price.
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.
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, pages 4 & 6:
Commodity chemical companies that are able to defend or grow market share
are unlikely to gain a pricing advantage, but might enjoy a more favorable cost
position or better relationships with suppliers and customers.
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 may read our detailed analysis of NGL Fine Chem Ltd in the
following article: Analysis: NGL Fine Chem Ltd.
Therefore, an investor would appreciate that in the commodity chemicals space,
a customer would not pay a premium pricing to its suppliers. The suppliers have
to match the price available in the market.
Therefore, marketing exercises like branding does not have any positive impact
on the financial performance of commodity chemical companies.
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 6:
From the above discussion, an investor would remember that the 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/defect in the specialty
chemical can lead to poor quality of a very large quantity of 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.
An investor may read our in-depth analysis of Deepak Nitrite Ltd in the following
article: Analysis: Deepak Nitrite Ltd
From the above example, an investor may note that in the case of speciality
chemicals, customers do not change their suppliers just because any new
supplier is offering the product at a cheaper price. This is because it might turn
out to be a situation of “penny-wise and pound-foolish” for the customer.
Key credit factors for the specialty chemicals industry by Standard and Poor’s,
December 2013, page 3:
Companies are generally able to offset the impact of higher input costs via higher
selling prices and maintain or improve profitability.
Key credit factors for the specialty chemicals industry by Standard and Poor’s,
December 2013, page 4:
Key credit factors for the specialty chemicals industry by Standard and Poor’s,
December 2013, page 3:
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.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
5:
An investor would remember from the above discussion that the commodity
chemical companies compete with each other on prices as their products are
non-differentiable commodities and the customers can easily switch from one
supplier to another. The technology to make commodity chemicals is mature and
is widely available.
Rating methodology for the chemical sector, CRISIL, February 2021 (click here),
page 11:
Bulk chemicals: The technology is easily available and typically there is more
than one way to manufacture a particular product.
As a result, 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.
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012, page 3:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
5:
For commodity chemicals, in general, an entity with superior economies of
scale and efficient utilisation of by-products would have a lower cost of
production than a smaller entity.
Further advised reading: Operating Performance Analysis: A Simple &
Complete Guide
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.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
3:
As per the Japan Credit Rating Agency, the size of the commodity chemical
company is one of the key indicators of its competitive advantages.
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012, page 4:
Rating methodology for the chemicals sector, Pefindo Credit Rating Agency,
Indonesia, November 2021 (click here), page 1:
Economies of scale together with a large market share and volume production
are critical to maintain cost leadership and ensure sufficient margin, which
include the analysis of raw material sources and costs, especially for commodity
chemical companies, which primarily compete on the basis of prices due to
the inability to differentiate products by performance.
On the contrary, for specialty chemical industries economies of scale are not very
important because of the following reasons.
First, 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.
Market sizes for specialty chemicals are often small to medium. We consider the
absolute size of many specialty materials markets to make the large investments
required to develop new products less attractive for bigger chemical players.
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.
Rating methodology for the chemical sector, CRISIL, February 2021, page 11:
Third, 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 producer in the market.
Rating methodology for the chemical sector, CRISIL, February 2018, page 1:
Specialty products are small-volume chemicals, which perform some critical
function in the user industry…prices are not driven by demand-supply equations
alone, but also by functionality and utility to the user.
Therefore, an investor would note that in the case of commodity chemicals, the
products are non-differentiable and easily switchable. As a result, the companies
have to compete on pricing and they attempt to become the lowest-cost
producers to earn sustainable profit margins. On the contrary, the specialty
chemical companies aim to be meet the specific requirements of the customer by
selling high-technology small-volume chemical solutions. They have a high
customer stickiness; therefore, they do not need to be very cost-competitive to
survive in the market.
An investor would appreciate that for the commodity chemical companies, having
low production costs is essential to remain profitable. Moreover, a low production
cost is a direct result of the high capacity utilization of the manufacturing plants.
As a result, the commodity chemical companies attempt to run their plants at
high utilization levels even if they have to accept orders at slightly lower prices.
This strategy of commodity chemical players reinforces the price-based
competition between them and reduces their pricing/negotiating power over
customers.
Rating methodology for the chemical sector, CRISIL, February 2021, page 11:
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012, page 3:
Because most commodity chemical products are hard to clearly differentiate
using technology, competition relies heavily on cost competitiveness. The cost of
procuring raw materials generally depends on market conditions and so doesn’t
really vary among individual companies.
Therefore, an investor would note that for commodity chemical producers, their
high fixed cost structure, non-differentiable products and high raw material/input
costs lead to a situation wherein to become the lowest-cost producers to gain
profitability, the companies end up weakening their pricing power.
From the above discussion, an investor would note that commodity chemical
companies usually have a large manufacturing plant to benefit from economies of
scale to run cost-efficient operations.
In fact, the requirement of being a large player where economies of scale help in
lowering the cost of production is so important for the commodity chemical
industry that it is believed that a commodity/integrated chemical manufacturer
needs to achieve a basic minimum size before it can even be relevant for its
industry.
Product innovation and R&D intensity are of lower importance in a market with
commoditised products. The vast majority of products in this industry are late in
their life cycle stage and largely have commodity characteristics, from a return on
invested capital point of view, making large R&D investments unattractive.
Consequently, the commodity chemicals industry is dominated by large-sized
corporates.
Moreover, 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 meeting the
stringent guidelines for safety and environmental norms.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
5:
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 4:
The effectiveness of barriers to entry in the commodity chemicals industry is
typically limited. Capital requirements necessary to set up new processing plants
can act as a barrier to entry…Moreover, because of sensitivity to supply and
demand balance, even a single new entrant can cause changes in
industry conditions that have a significant impact on the profitability and cash
flows of existing participants in an industry segment.
On the contrary, 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, the specialty/functional chemical players do not have a large capital
investment burden.
Rating guidelines for the chemical sector by the credit rating agency, Rating and
Investment Inc., Japan, June 2021 (click here), page 4:
In general, per-plant cost-efficient output of functional products is smaller than
that of materials, and the capital investment burden of the functional products
sector is light.
However, 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.
Rating methodology for the chemical sector, CRISIL, February 2021, page 11:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
4:
Rating guidelines for the chemical sector by the credit rating agency, Rating and
Investment Inc., Japan, June 2021, page 5:
For functional products, the burden for depreciation and amortization and other
fixed costs normally is lighter than in the case of materials. Even so, a certain
level of R&D spending is required regardless of the rise or fall in sales,
turning this expenditure into something of a fixed cost.
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012, page 4:
Specialty chemicals often require substantial investment in research and
development to continuously improve the level of technology.
Rating methodology for the chemicals sector, Pefindo Credit Rating Agency,
Indonesia, November 2021, page 1:
On the other hand, the specialty chemical players need to invest significant
money in R&D because it is their biggest competitive advantage. They need to
maintain R&D spending irrespective of any decline in the business, making it a
fixed expense for them. On average, specialty chemical companies spend about
3% of their revenue on R&D.
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 an 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%.
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, pages 3-4:
First, the raw material costs are the single largest expense for chemical
companies whose prices are very volatile.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
3:
raw material cost is the single largest component of the cost structure of a
chemical entity
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 4:
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 4:
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012, page 1:
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 5:
Rating guidelines for the chemical sector by the credit rating agency, Rating and
Investment Inc., Japan, June 2021, page 5:
The fact that bulk/commodity chemical players are usually large plants with
substantial investment in fixed assets increases the impact of cyclicity on their
profit margins. Due to high fixed costs, during the phases of low demand when
the capacity utilization declines, then the companies face reverse operating
leverage i.e. the high fixed costs are spread over lower volumes and the profit
margins of the company decline sharply.
Rating methodology for the chemical sector, CRISIL, February 2021, page 10:
First, as discussed previously, 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.
Key credit factors for the specialty chemicals industry by Standard and Poor’s,
December 2013, page 2:
Rating methodology for the chemical sector, CRISIL, February 2021, page 10:
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.
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 4:
Rating methodology for the chemicals sector, Pefindo Credit Rating Agency,
Indonesia, November 2021, page 1:
Key credit factors for the specialty chemicals industry by Standard and Poor’s,
December 2013, page 3:
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 9:
5) Integration of operations:
An investor would appreciate that the chemical producers especially the bulk
chemical players need to be very cost-competitive to generate sustainable profit
margins. Previously, we noted that companies employ economies of scale as a
primary means of becoming low-cost producers of commodity chemicals.
Apart from 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. Integration also
becomes a source of competitive advantage for chemical producers and
improves their profit margins.
Rating methodology for the chemicals sector, Pefindo Credit Rating Agency,
Indonesia, November 2021, page 1:
Well-integrated firms can also benefit from an ability to add value along the
supply chain and can realize some opportunity to differentiate products, which
can be translated into higher margins.
A higher level of integration also helps in reducing the volatility of the earnings of
the manufacturers because, they are able to generate a lot of intermediate
products in-house, which protects them from the volatility of prices of these
products in the open market. Integration of operations helps the companies to
avoid the risk of unavailability of the key raw material, especially for raw
materials, which do not witness much trading/are not easily available.
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019,
pages 3-4:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
3:
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 the chemical products are available in the open market at a lower price
than the price at which an integrated chemical player can produce them.
Rating Methodology for Entities in the Chemical Industry, ICRA, December 2014
(click here), page 3:
if intermediates prices in the market are lower than captive production due to
supply-demand mismatches, that can impact the overall profits of vertically
integrated companies, unless they have the flexibility to use market sourced
intermediates, through either imports or domestic purchases.
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 the low-priced
intermediate products from the open market if their prices are lower.
Similarly, on the downstream (end-product) side, there might be times when the
prices of intermediate products increase so much that selling the intermediate
product may provide higher profitability than selling the final product. In such a
situation, the chemical player needs to be versatile where it may sell the
intermediate products in the market and not wait to convert them into the final
product before selling it.
Rating methodology for the chemical sector, CRISIL, February 2021, page 11:
From the above discussion, an investor would note that the speciality 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.
6) Regulatory protection/tariffs:
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.
Rating methodology for the chemical sector, CRISIL, February 2021, page 10:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
5:
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 4:
The global nature of the industry also exposes producers to new competition
from regions that offer lower-cost raw materials or labor.
Nevertheless, India provides protection to the chemical manufacturers, especially
against the dumping of products at very low prices by foreign companies.
The level of import duties on different bulk chemicals is so important that the
profit margins of the companies are highly dependent on the prevalent tariffs.
Credit rating agencies give a lot of importance to the prevailing tariffs and their
continuation while determining the future financial position of chemical
companies.
Rating methodology for the chemical sector, CRISIL, February 2021, page 10:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
4:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
1:
Though the chemical industry is spread across the country, there is relatively
a high concentration along the west-coast, largely due to the proximity to raw
materials and ports.
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.
Rating methodology for the chemicals sector, Japan Credit Rating Agency,
March 2012, page 2:
Large, new plants, using ethane—a major component of natural gas that is far
less costly than naphtha—are being built, one after another, in the Middle East
Therefore, while analysing 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.
Key credit factors for the commodity chemicals industry by Standard and Poor’s,
December 2013, page 9:
Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page
4:
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.
An investor may read the example of Bodal Chemicals Ltd, which produces
dyestuff, which produces a lot of effluents. In FY2014, the company indicated
that its profitability has improved due to the reduced supply of dyestuff in India
because of declining manufacturing in China. The dyestuff production in China
had reduced due to strict enforcement of environmental protection regulations,
reduction in export incentives and electricity subsidies.
The FY2014 annual report of Bodal Chemicals Ltd, page 2:
Furthermore India and China are the major supplier at globe level. Both countries
are now strict in following the implementation of various environment and
pollution norms and provide environment safety and this has lead the players to
either exit or reduce the size of operations by many small units in India
and forced shutdown of many dye intermediate units in China.
Advised reading: How to study the Annual Report of a Company
The reduced supply of the dyestuff from China has reduced the competition in
the industry and as a result, Bodal Chemicals Ltd is able to get higher prices for
its products in the market. This has resulted in the improvement of the OPM for
the company.
An investor may read our detailed analysis of Bodal Chemicals Ltd in the
following article: Analysis: Bodal Chemicals Ltd
To understand the problems faced by an Indian chemical manufacturer who had
to repeatedly shut down its operations when it was found lacking in meeting the
water-pollution norms, an investor may read the analysis of NGL Fine Chem Ltd
in the following article: Analysis: NGL Fine Chem Ltd
Therefore, while analysing any chemical company, an investor should pay due
attention to the aspect of compliance with environmental regulations. She should
analyse 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 for meeting
pollution control norms to understand whether the company takes environmental
preservations responsibilities seriously.
Summary
The chemical industry is one of the most important parts of any economy. The
strong linkage of chemical consumption with economic growth makes it an
indicator of upcoming slowdowns. It is divided into two key segments:
bulk/commodity chemical producers and specialty chemical producers. Both
these segments have very contrasting business characteristics.
Vertical Integration is one of the key ways for commodity chemicals to counter
cyclicity and poor profitability. It ensures the availability of key raw materials as
well though it may create challenges if raw materials in the open market become
cheaper than in-house production. Specialty chemical players have small plants
where they make many specialty chemicals on the same production lines. Large
integrated plants are not important for them.
Low cost of production is essential for chemical players. Many bulk chemicals are
low-value adding and cannot afford transportation over long distances. High raw
material costs may make them economically unviable; therefore, the location of
chemical plants is very important. It is very difficult to overcome locational
disadvantages.
Low profitability and global competition make the business model of bulk
chemical producers highly vulnerable. In economic downturns, many players go
out of business. As a result, foreign companies try to kill local production by
dumping commodity chemicals at very low prices. Govt. acknowledges such
practices and protects domestic producers by tariffs and duties. In fact,
regulatory protection is a very significant aspect of the competitive strength of
commodity chemical players. An investor should always be aware of the benefits
of any protective duty used by the bulk chemical players. Otherwise, she may
face negative surprises when protection like anti-dumping duty expires.
Overall, while analysing any chemical company, an investor should keep in her
mind the following characteristics of a chemical business.
Regards,
Dr Vijay Malik