Newsletter 23, November 2008 (No comments so far)
The new world of Distribution
The new world of distribution
This article was published in ICIS Chemical Business in London/New York on December 1st 2008
Many actors in the chemical industry, blinded by several years of bright results, have been hit hard by the systemic financial disaster of unprecedented magnitude that erupted in September. Although the first phases of the financial turmoil date back to the 2007 subprime crisis in the US, the recent global financial system deterioration brings unexpected pains to an essentially unprepared industry. The business environment before September 2008 is altogether different from the environment, chemical distributors are experiencing now.
As the world heads for a major recession, chemical distributors face numerous and often unprecedented challenges simultaneously, such as the cyclicality of the chemical industry, a new financial landscape and a considerably more regulated business environment, all of which are influencing several critical aspects of their operations.
1. Cyclicality
During the recent crises of 1993 and 2002, most distributors were able to overcome the downward cycles due to their wide product portfolio, their extended industry coverage and the large number of customers served. The present crisis is more severe, more volatile and is affecting globally numerous industry sectors and countries. This time, it is felt that the impact on most chemical distributors, whether they are regional, national or global will be more painstaking, than ever before.
Petrochemical prices are falling significantly from the top summer levels and the hard-fought price increases implemented for a wide range of chemicals are now being challenged by customers and end-users. Competition among producers and among distributors became tougher. There is a run for volumes and market share, often at the expense of prices, which was unheard of until mid-2008. Profitability and margins are likely to be largely affected by the market volatility and declining demand. Distributors closely monitor also their customer credit exposure, while often getting reduced customer credit insurance coverage, compared to what they previously had.
2. A new financial environment:
During the last years, private equity firms made significant inroads into the chemical industry and into chemical distribution. In 2006, they accounted for about 50% of global Mergers & Acquisitions (M&A) volumes in chemicals against a mere 5% in 2000. Similarly in chemical distribution, 80% of European and North American M&A deals in 2006 and 2007 were completed by private equity owned distributors. In Europe and in the US, industry leaders are partially or totally owned by private equity investors.
This is the case for Azelis (3i), Brenntag (BC Partners), Euro Druck Services (3i) IMCD (ABN Equity), Neochimiki (Carlyle), Quaron (Bencis), Solvadis (Orlando), Safic Alcan (ING Parcom), Unipex (AXA Equity), Univar (CVC) and Warwick (Close Brother Private Equity).
Private equity is considerably affected by the credit crunch, as their recent successes were mostly based on their broad access to esoteric financial instruments such as structured investment vehicles “SIV”, asset based securities “ABS” and collateral debt obligations “CDO”. Several of these instruments are occasionally rated in the category of junk bonds which tend to financially weaken the companies for whom they were issued.
It was wrongly considered that ownership of distributors is a minor aspect which has a remote impact on their operations. In reality, ownership is an important feature for distributors and plays a significant role in creating distinct distributors’ profiles and strategies. Ownership stability, traditional financial management and organic growth strategies are powerful cards in the hands of companies like Algol (Helsinki), Caldic (Rotterdam), Helm (Hamburg), NRC (Hamburg), Quimidroga (Barcelona) or TerHell (Hamburg) and many other privately or family owned distributors.
Private Equity owned distributors tend to implement financially driven strategies set out in credit covenants, which meet rigorous criteria in terms of working capital and site maintenance budgets. When they fail to achieve the goals set in their credit covenants, bank interest charges may rise to include an additional risk premium.
Extending loan maturity and debt recapitalization are ways to reduce the increasing cost of debts, but are more difficult to obtain now.
In the recent past, a new breed of chemical distributors surreptitiously emerged, namely the “asset light” distributor. The “asset light” distributor does not own anything tangible: offices are rented, sites are mortgaged, storage and trucking are outsourced and eventually account receivables are factored. The “asset light” distributors’ top priority is to ensure that all the cash created by the leased or mortgaged assets and within the company’s operations are used to pay back the loans their private equity sponsors obtained to acquire them.
The “asset light” model is viable, provided it does not carry hefty debts. If interest costs rise or sales go down and working capital requirements increase, the risk of bankruptcy rises significantly. In the unlikely event of a distributor bankruptcy, suppliers may get nothing back in return for their credit exposure, as bankers might have mortgaged or factored all existing tangible assets.
Most suppliers request now to get a complete overview of the outstanding debts contracted by private equity owned distributors, not only within each national subsidiary but also within each debt holding company registered in other countries or off-shore. Suppliers who consider outsourcing more businesses to distributors are now setting rigorous financial criteria on top of their channel selection listing.
New investments by private equity in chemical distribution are likely to be based upon longer holding periods, lower debt leverage and higher equity contributions, as well as lower multiples. Furthermore, it remains an open question whether the inflated acquisition values, achieved in the recent past, propped up by the vast availability of debt financing, are sustainable and redeemable in the future.
The high debt levels of some distributors represent an obstacle to future exits, as new investors may prefer buying asset rich, low indebted distributors, rather than asset light, high indebted companies. Private Equity will continue playing a key role in the industry, but will have to adapt their model to more drastic market and credit conditions.
3. A more regulated environment:
For chemical distributors in Europe, 2008 marks the year of REACH implementation. At the end of November 2008, the pre-registration process for higher volume products above 1000 MTPA and hazardous chemicals below 100 MTPA will have to be completed. The iterative process of pre-registration proved to be more costly and tedious than anticipated, since it includes comprehensive information about product handling, downstream uses and formulations. These increased registration costs are borne by all distributors and particularly by importers who have to register imported chemicals on behalf of their overseas suppliers. During the next two years, final registration within specific product consortia will take place.
A sensitive issue emerged, which is the transfer of information on pre-registered products to companies which are not yet involved in the sale of these chemicals. As product and sourcing information are attractive information to obtain, ECHA is trying to limit the access to product information to companies which are effectively involved in the sale and manufacturing of those products.
Additionally, suppliers and distributors are aware of the need to observe strict compliance of EU competition laws. Competition authorities are sensitive to the issue of distributors’ increasing dominant positions. For instance, the UK competition authorities suspended recently a couple of transactions, like the acquisition of Ineos’ chlorine packaging business by British Oxygen Corporation “BOC” on the ground that the proposed merger would reduce the number of competing suppliers in the UK. Environmental agencies are also compelling bulk chemical distributors to pay increasing attention to site pollution decontamination, shallow ground water protection and safe handling of chemicals to prevent environmental incidents. Consequently, a number of bulk distributors have to increase their site maintenance budgets to meet stricter safety and environmental regulations.
Chemical distributors are now adjusting to a different economic, financial and legal scenario. Distributors who are well prepared to cope with more difficult market conditions and can readily adapt to a more regulated and demanding business environment are in a favorable position to ride out the recession and enjoy the next upturn.