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Chemical distribution in 2009: challenges and uncertainties

Chemical distribution in 2009: challenges and uncertainties
This article was published in the English version of @CheManager on line 19.03.09 and in the printed issue of Chemanager on 27.04.09  

http://corporate.gitverlag.com/media/article/168786/DistriConsult_CMI0409.pdf

In 2008, the chemical industry experienced the realization of the most severe global economic crisis since sixty years. Initially centered on the housing and real estate markets, it then expanded into the banking and financial sectors before reaching globally the real economy and the chemical industry. Time was spent to analyze the causes of the crisis whereas now comes the sobering task to assess its short and long term consequences on chemical distributors and their suppliers. This article highlights the impact of the new financial and economic scenario on the distribution industry and the specific challenges and opportunities faced by chemical and polymer distributors.

1. Producers’ turmoil

Most chemical manufacturers recently experienced considerable decreases in raw material prices as well as significant drops in demand for their products. As the various asset classes, namely housing, shares, energy and raw materials values bursted, the disposable incomes of various population segments significantly decreased and could remain deflated over a longer period of time. Declining disposable incomes affect indiscriminately retirees, employees, unemployed, investors and consumers. It is be the key factor which will shape future chemical demand.

In January, news of the bankruptcy of the US arm of the third global chemical producer LyondellBasell hit the whole industry. As a result of the bankruptcy, banks had to write down over 10 billions dollars. This news was shortly followed by the fall of the titanium dioxide producer Tronox which also filed for Chapter 11. Both companies were affected by demand and margin drops, as well as by very high indebtedness levels. 

Simultaneously, the financial crisis and the decline in oil prices forced the collapse of the KDow joint venture earlier concluded between Dow and Kuwait Petrochemicals. This turnaround left Dow in quandary with limited financial resources to complete the generously valued acquisition of Rohm and Haas and the joint project with Aramco in Saudi Arabia. During the last few months, the demises of Ineos, Hexion, Huntsman, LyondellBasell, Nova, Dow have marked the end of easy credit availability and highly leveraged buy outs in the chemical industry.

Due to the banking sector systemic crisis, shrinking end customer demand and lower production levels, the recession is expected to last all of 2009 and most of 2010 while a pick up in demand prompted by governmental rescue plans may eventually support a soft and gradual economic recovery. Whilst some producers may continue out-sourcing more volumes through distributors, some others may consider in-sourcing direct deliveries and some smaller lots transactions. Overall, the recession will lead automatically to the restructuring of several industry sectors, including the chemical industry. This will bring later a new outlook in sectors where chemicals are transformed like paints and coatings, building, infrastructure, automotive, paper and polymer processing. It is clear now for distributors that dependence on a few large suppliers or customers become very precarious. Finally, in relation with slow or negative industrial growth rates, producers and distributors have no choice but adapting their organisations to shrinking demand on declining industrial markets.

2. Private Equity in reflux

Table 1
Overview of private equity owned distributors

As we see it on table 1, several leading European chemical distributors are owned by private equity firms. The inroads of private equity in distribution started in 2001 and expanded during the following years to achieve an overall European industry market share above 30%. Private equity investments in chemical distribution have some specific characteristics which differentiate them significantly from similar investments in other sectors.

Those specific characterisitics are the following: high ownership rotation, short holding periods, secondary or tertiary exits, increasing leverage levels. All exits completed recently were secondary or tertiary placements. These exits present a significant inconvenience which is being verified now, namely the formation of a speculation bubble where the company values increase significantly and bear no relationship anymore with the market reality. The likely collapse of some of the company values might lead soon to a new phase of the chemical distribution sector restructuring. It seems likely that new secondary or tertiary placements will be difficult to complete in the present credit squeeze environment and IPO’s will not be on the agenda before 2012 or 2013.

Table 2
Effect of decreasing multiples on equity values

This example identifies the financial challenges faced by private equity owned distributors, at times when acquisition multiples fall. It is considered that the net value of a company is equal to its enterprise value (EV) minus its debts. The Enterprise Value is often assumed by private equity to be an EBITDA multiple. Most transactions were dealt in the recent past on the basis of multiples between 8 and 10. In the future, they are likely to be dealt on the basis of multiples between 5 and 7. Consequently, the current strategy of private equity owned distributors aims at maintaining the value of their equity investment by eventually growing sales and EBITDA to compensate the unavoidable decline of acquisition multiples, which is a challenging if not unattainable goal. The main driver for distributors’ sales growth since 2005 where price increases and for some of them, "Buy and Build" strategies. With the present trends of depressed prices and declining volumes, the overall picture could look even bleaker than what is illustrated on table 2.

If the chemical distributor model remains powerful and a viable engine of value creation in the supply chain between producers and end users, the specific and sometimes conflicting roles of private equity, bankers and insurers create new uncertainties. Private Equity is facing new regulatory rules which impose that they value their owned companies at what they are worth on the market today, rather than disclosing only the original cost of their investment. In addition the reported value of goodwill, classed as the difference between the price paid for an acquisition and the value of the tangible and intangible assets purchased, will be assessed now on an annual basis. This may inevitably lead to a large number of balance sheet write-downs, called goodwill impairments. By some calculations, the actual losses could far exceed 30 per cent, since many of these companies were bought at the peak of the financial frenzy. In many deals – particularly the ones struck from 2006 to 2008 – private equity firms paid a 25 per cent premium to public market levels to take their targets private. They put large amounts of debt money into their companies, suggesting that the drop in value could be more like 40 to 50 per cent, as some analysts estimate.

For these reasons, bankers are reluctant to further expose themselves by taking additional risks with private equity investors, particularly as they are confronted with numerous requests to review previously concluded credit covenants.  The challenges lingering above private equity owned distributors are twofolds,namely: can they cope now with the interest payments defined in their covenants? Will they be able to pay back the matured loan principals which their Bankers gave to their sponsors to acquire them? These are the  two main uncertainties faced now by private equity owned distributors. The limits of the private equity model in chemical distribution will be tested along these lines during the coming months.   

Additionally, credit insurers like Euler Hermes or Coface who suffered recently important write-offs have drastically reduced distributors’ insured customer credit limits. Distributors have the option to increase risks by giving up credit insurance, take on additional risks by selling above the credit limits, reduce customer payment terms or require prompt payments from their customers. Overall, these depressed credit insurance restrictions additionally contribute to reducing distributors’ sales. Several producers took similar steps and are reducing sales to companies which are not providing them with full financial transparency on their debt costs and loan structure. Distributors who provide sound balance sheets, low indebtedness levels and solid cash flow streams benefit from higher and better credit and payment terms from their bankers and suppliers, as well as increasing new outsourcing opportunities.

3. Distributors’ challenges

Within a bleak business environment, chemical distribution remains an entrepreneurial and flexible industry sector able to overcome difficult challenges and find adapted solutions. We describe now some innovative examples in the area of REACh implementation and Information Technology integration.

2008 marked 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 was 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 producers and some of their distributors, 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. REACh implementation is a bigger challenge for specialty chemical distributors that rely on overseas imports from USA, China and India. They often have to cover the registration costs on behalf of their overseas suppliers without being certain of recovering these cost investments on the market. REACh implementation is now creating two types of European distributors based on distinct competencies, namely the importers and the domestic players.

Table 3
Importers and Domestic distributors’ capabilities

Distributors who apply mostly a domestic model of distribution will be restricted by REACh to freely import chemicals from Asia. To manage those complex activities, there will be a limited number of specialized importers that will trade larger volumes either for their own account or on behalf of other distributors or resellers.

In 2008, some companies that did not have adequate import expertise got burnt as they bought chemicals in Asia during the spring and got their shipments delivered during winter. They often had to absorb significant price and margin losses. Few distributors have the means to act as true importers and bundle the required products and services, while mastering all the REACh intricacies. Besides larger generalist distributors like Brenntag, Helm, Univar, Quimidroga, IMCD or Azelis, we find also specialized importers like CH Erbsloh, Faravelli, Goldmann, Harke, Impex, Indukern, Tieffenbacher or Welding who have comprehensive import skills.

4. Information technology inroads

Due to the complexities of the sector, the integrated information technology inroads into chemical distribution took  time. Information Technology moved by leaps and bounces in various phases during the last twenty years. Initially, the adoption of adapted ERP systems by most distributors was driven by reporting, internal cost and margin management. Then it gradually moved into information exchange with suppliers and customers. It rarely got involved into the transactional side of the customer interface due to the multiplicity of products, the variety of packaging and the complex daily pricing issues.

The most spectacular developments took place in the area of customer management processes like supply chain integration, procurement outsourcing and vendor managed inventory. In terms of supply chain integration, telemetry systems which had been pioneered by several producers in the nineties is now used by bulk distributors to monitor the stocks of their customers. Distributors can flexibly plan the deliveries to their customers' tanks and customers don't have to monitor their tank levels anymore. They pay each month for what they consume and not only for what they order.

Single sourcing procurement agreements transform distributors from chemical sellers into purchasing agents for their customers. They tend to provide a full range of chemicals and related services to a selected group of larger customers in the chemical and other related industries like paints and coatings, automotive or pharmaceuticals. Customers reduce their overall purchasing costs by buying from fewer distributors, simplify administration costs, reducing inventory levels and by delegating the management of packaging, returnable containers and spent chemicals to a competent and knowledgeable procurement specialist. IT system integration became the process facilitator in the management of these complex activities.

5. Corporate governance

As global industry leader, Brenntag issued new corporate governance guidelines which are being adopted by most distributors. They state that all employees are informed about the requirements of competition laws and are given support to observing these rules. Employees must avoid any kind of activity that result in conflicts of interest and antitrust infringements. Proprietary information must remain within the firm and unjustified transmission of any data to third parties is prohibited. These rules illustrate the importance of governance and ethical rules in chemical distribution. It is only by implementing these rules that legal or judicial liabilities can be avoided. Until recently, competition law compliance was considered a minor issue to manage. It is now considered a critical corporate issue for all distributors and it is particularly significant for larger international firms with decentralized operations where internal controls could be looser than for national or regional players.

Chemical distribution is facing considerable challenges and opportunities. The most significant challenges to overcome are on the financial and credit sides. Distributors with reduced indebtedness, strong balance sheets and solid organizations are in a good position to benefit from the market recovery expected to take place in 2010 or 2011. The picture we will have then of chemical distribution will be different from what we see to day.