Better a diamond with a flaw than a pebble without - Creating value in Petrochemicals
Creating value is the essence of business; our purpose and greatest challenge.I will address approaches to creating value in the European chemical industry and consider the fine distinction between value and valuation.
Competition is healthy, but having none is health-ier! Successful businesses have a 'moat'to protect them from competition. The chemical industry is susceptible to an erosion of competitive advantage; commoditisation of once-speciality products reduces barriers to entry.Where technology is readily available, and with declining customer service models, barriers to entry fall and the consequences can be severe. Consider 1,4-butanediol, where unrestrained investment in China saw margins plummet and producers forced to shutter capacity.
Sources of sustainable competitive advantage are limited, they include: a cost advantage; a technology advantage giving either superior product performance or a cost advantage; or a hard to replicate service model.
Models of building and shaping a business in our industry:
The Traditional model is to build new production assets. Success requires access to significant capital, investment in world scale, state of the art assets that deliver competitive economics across the cycle and an operational life in excess of 20 years. We see signs of a much needed renaissance in Europe with a number of capital projects being mooted along the olefins and derivatives chain (see Matthew Thoelke's article). Without a renewal of the asset base, the foundations of the industry erode as plants age, becoming uncompetitive and costly to maintain.
A Transformational approach shifts the business to focus on areas of higher value creation. Transformation might include integration, value chain extension, portfolio diversification, addition of product development capabilities or expansion of R&D efforts. Exiting less attractive business areas is as important to the transformation as enhancing the higher value offerings. Transformation is typically achieved through a mix of new build and transactional changes, which brings us to the third and most dynamic growth lever: the Transaction.
Many industry leaders have grown up through mergers and acquisition. Examples include Ineos, Huntsman and Lyondell Basell, to name but three. Transactions deliver instant gratification versus the snail's pace of large scale capital projects.
Chemical M&A transactions continues to rise, both in number and value, driven partly by mega deals such as the DuPont-Dow merger and Chem China's acquisition of Syngenta. Purchase multiples are also rising to historic highs. Does this mean the value of the industry is higher than previously? Or are buyers over paying?
There is a wealth of data detailing the (usually disappointing) outcome of mergers, and it is more important than ever that an acquirer truly understands the business it is buying and the outlook for the industry segment. Effective due diligence is an imperative, expert insight is critical in assuring value delivery through M&A. Acquirers frequently believe they can manage a business better than the incum-bent. Statistically this is not so, and a structural rationale is imperative in order to raise the opportunity for success.
Optimists rule the world,but pessimists are seldom disappointed
Daniel Kahnemann in his wonderful book Thinking Fast and Slow states "Optimists are normally cheerful and happy…they are resilient in adapting to failures and hardships…they feel healthier than others..."
Optimistic individuals play a disproportionate role in shaping our lives. Their decisions make a difference; they are the inventors, the entrepreneurs, and the business leaders, they live longer and take more risks in life. As businesses are almost entirely led by optimists,there is a cognitive bias at play most transactions.Justifying a purchase based on 'superior ability to manage the business' could be true, but statistically 50% of the time it's incorrect.
Transactions require an anchor in data and statistical rigour. The acquisition process can take a life of its own, being led by zealots. Advisors are frequently incentivised upon a transaction's close, an arrangement certain to see soothing words whispered in the acquirer's ear confirming the farsighted wisdom and world class team, assuring future riches. For a rational grounding, independent due diligence is required to set an analytical framework against which to test the likely future performance of the business.
When acquirers are asked to score the probability of a successful, value accretive transaction, they will make an earnest assessment that the likelihood is over 70 percent. The real world differs, with 60 percent*of M&As destroying shareholder value. This is cognitive bias in action.
It is critical to ask tough questions: "of transactions of this nature, what percentage meet our criteria of success" and "why do we believe our probability of success is much higher?".
IHS Markit's involvement in numerous due diligence support exercises demonstrates the importance of understanding the changing landscape with respect to energy, macro-economics, and geopolitics. It is critical to address demand outlook, the competitive landscape, the role of disruptors, pricing mechanisms and regulatory environment.
IHS Markit's rigorous due diligence process delivers a clear view of the underlying value of the business through evaluation of:
- Clear industry benchmarks and cost positioning
- Sustainability of margins
- Testing the business plan under a range of scenarios
- Independent view of accessible market share
- Independent view of competitor positioning
- Assessment of risks: macro-economic, energy and feedstocks, demand drivers, regulatory and country level political risk IHS Markit's recent analysis of the cellulose acetate industry for a potential buyer was able to identify structural decline in the generally vigorous China market. This conflicted with the Vendor's views and was an important element in understanding a weak outlook for a historically robust business.
Separating value from valuation
A material element of the rise in M&A activity is the activist investor, pressuring management into delivering shareholder value in a relatively low growth environment. Here, we can separate the notion of a business's true value from its market price, or valuation. Benjamin Graham famously observed "In the short run, the market is a voting machine but in the long run, it is a weighing machine."
The stock market loves a growth story and will pay a premium for such potential, but beware, it is quick to snatch it away at the first hint of a company's serene progress being interrupted.
Activist investors are arguably focussed on valuation ahead of value-creation. Increasing a trading multiple is the easiest way to enhance valuation. In stock price terms, a ten percent shift in price:earnings ratio is as valuable as a ten percent increase in earnings (at unchanged multiple). A rise in price-earnings ratio can be far easier to achieve than a hard won rise in real earnings.
Take the Dow-DuPont merger as an example:
Chemical Week reported "activist hedge fund Third Point (New York), led by investor Dan Loeb, called for the companies to shift several "high-multiple" businesses from their planned materials science spinoff into the planned specialty products company. Third Point argues that the change could create $20 billion in additional value by shifting high-multiple businesses into more focused companies that it thinks will trade at premium multiples."
This is simply cutting the deck in a different way;we don't gain more cards and as we slice and dice, we risk adding dis-economies of scale, potentially sacrificing value for valuation. We play to the voting machine yet lose mass for the weighing machine. Of course there are cases of focused companies being unshackled and growing rapidly, delivering on both value and valuation, however again the statistics are against us.
Businesses must deliver across three planning horizons: short term; paying attention to valuation, keeping the activist wolves at bay; mid-term to keep margins and volumes progressing in the next two to three years and long term to ensure value growth and development of the business for years to come.
Roger Green is Vice President, Europe, CIS & Africa, Chemical Consulting at IHS Markit
Posted 9 October 2017
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