How to do Business Analysis of Chemical Companies

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.

Classification of chemical companies

As discussed earlier, we can classify chemicals into bulk chemicals and specialty chemicals.

1) Bulk chemicals:

Bulk chemicals are also known as materials, integrated chemicals, upstream chemicals as well as commodity chemicals. This is because these chemicals are always produced and used in large volumes (bulk); these are used as key building blocks (raw materials) in end-user industries; their manufacturing plants are usually large integrated chemical complexes where many intermediate products are made in-house (integrated chemicals). Moreover, these chemicals are a commodity in nature i.e. the product from one manufacturer is non-differentiable from the product of another manufacturer.

These chemicals primarily include organic chemicals like petrochemicals: polyvinylchloride (PVC), high-density polyethylene (HDPE), low-density polyethylene (LDPE), polypropylene (PP) and methanol, as well as inorganic chemicals such as caustic soda and soda ash.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019 (click here), page 1:

Notable examples of commodity chemicals are petrochemicals such as polyvinylchloride (PVC), high-density polyethylene (HDPE), low-density polyethylene (LDPE), polypropylene (PP) and methanol, and examples of inorganic commodity chemicals such as caustic soda and soda ash.

2) Specialty chemicals:

Specialty chemicals are also known as functional chemicals, as well as downstream chemicals. These chemicals are used to bring in specific properties or changes to the main chemical products. As a result, these are used in a very small quantity in the final products of end-consumers.

The consumers of specialty/functional chemicals expect these chemicals to provide a specific outcome in their manufacturing process for which a lot of research & development (R&D) is done by the specialty chemical producers.

Specialty chemicals include products like adhesives, catalysts, water treatment chemicals, leather chemicals, pigments, surfactants etc.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 1:

Specialty chemicals, on the other hand, include certain types of adhesives, catalysts, water treatment chemicals, leather chemicals, pigments, and surfactants.

An investor should remember that even though at any point in time, various chemicals can be classified as bulk/commodity chemicals or specialty chemicals. However, if an investor studies any particular chemical, then she would notice that it follows a lifecycle. In this lifecycle, the chemicals go through a journey from specialty chemicals to becoming commodity chemicals.

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:

specialty chemicals also get commoditised within a few years post-launch because of duplication by others.

German credit rating agency, Scope, in its credit rating methodology document for the chemical industry, states that over time, chemicals that were once classified as a specialty have become commodities due to many producers entering the market. Moreover, many other products like pigments and additives are on the verge of becoming commodities.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021 (click here), page 4:

due to the market entrance of new producers and expanded production, several products previously classified as specialty chemicals have increasingly become commoditised over the past few years or are likely to become a commodity product, e.g. pigments and several types of additives.

Therefore, an investor would appreciate that any classification of chemicals as bulk/commodity or specialty is at any given point in time. This is because, over time, the chemicals that are currently specialty chemicals will become commodity chemicals.

Further advised reading: How to do Business Analysis of a Company

Let us now discuss the key characteristics of the business of chemical companies.

Key characteristics of the business of chemical companies:

1) Pricing power and competitive intensity:

An investor would note that in the case of bulk/commodity/integrated chemicals, the products made by one company are non-differentiable from the products of another company. As a result, a customer can easily switch the chemicals from one manufacturer to the chemicals from another manufacturer. For example, if a customer needs 99% purity phenol then she can use 99% phenol from any manufacturer and it would serve her purpose.

Due to such commoditization and non-differentiation of products, the bulk/commodity/integrated chemical producers face very intense competition and do not have any pricing power over their customers. They are effectively price takers in the market where the lowest cost producer sets the market price and all the producers have to match that price otherwise their customers would shift to buying from the lowest-cost producer.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 3:

According to our definition, integrated chemical companies engage in the manufacturing of products made in large volumes with limited to no pricing power. The product pricing process is transparent with a well-functioning market, resulting in producers being price takers. Therefore, the respective cost structure is a critical success factor.

This is primarily because the commodity chemicals are easily switchable and any customer can easily switch its suppliers. As a result, most of the commodity chemical producers end up competing on the prices.

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.

However, because commodity chemical products are not differentiated, existing producers do not have an inherent advantage over new entrants.

To see a live example of such a situation of commodity chemical manufacturers, an investor may read our analysis of an API (active pharmaceutical ingredient) manufacturer, NGL Fine Chem Ltd. APIs are commodity chemicals, which are used by drug companies to make ready to eat medicines.

In the July 2020 conference call, the management of NGL Fine Chem Ltd highlighted that it is into B2B (business to business sales) where the buyer is very educated and knows what she is buying. The buyer knows to evaluate the quality of its purchase and thereafter prefers to buy from whoever sells the lowest price. The buyer is indifferent to the brand of the seller until the time the product is of acceptable quality and is priced cheap.

July 2020 conference call, page 20:

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:

Commodity chemical companies do not benefit from product differentiation or brand identification.

However, the entire picture of pricing power changes when an investor shifts her attention from commodity chemical space to specialty chemicals.

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.

As a result, the speciality chemical producers are somewhat protected from intense competition and they get a pricing power where they are able to pass on any increase in their input costs to their customers.

Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013 (click here), page 3:

Pricing competition is not typically a significant factor for specialty chemical companies. The price sensitivity of customers tends to be limited because specialty chemicals often represent a small proportion of customers’ overall cost of production…In addition, in certain highly engineered or regulated end markets, customers can face very high switching costs once a product is specified.

Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013, page 4:

customers are typically reluctant to switch specialty chemical products because they tend to impart specific and integral performance attributes, which cannot be easily replicated, and they usually represent a small portion of total production costs.

An investor can see a real-life example of high switching costs influencing customers’ behaviour when she analyses Deepak Nitrite Ltd. She comes across a situation where Deepak Nitrite Ltd started producing a speciality chemical, optical brightening agent (OBA); however, despite its best efforts for many years, the company was not able to run the OBA division profitably.

This was because the customers are very cautious before approving any new supplier for OBA. As per the company, any problems in the OBA may lead to the rejection of millions of meters of cloth for a textile mill or millions of tons of paper for a paper mill.

Conference call, May 2016, page 15:

Somsekhar Nanda: OBA business actually is not a bulk business, it is a specialized performance chemical and very-very specialized, it has to perform its quality…if chemical is not working as per their satisfaction or as per their chemical perception they might lose a million meters of cloth or million tons of paper. So very-very difficult.

As a result of the very strict approval process by the customers, Deepak Nitrite Ltd faced many challenges in getting approvals for its OBA products.

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.

As a result, the specialty chemical producers are able to charge a premium pricing to their customers and are able to pass on any increase in their input costs. Moreover, they are able to charge pricing as per the value generated by their products to the customers.

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.

Because of their differentiated and value-added nature, many specialty product lines enjoy higher sustained profitability levels than commodity products.

Therefore, an investor would recognize that specialty chemical companies produce a small quantity of chemicals, which is very important for the customers and is not easily replaceable. Therefore, these companies are not price-takers but are price-setters. Low cost of production or economies of scale is not one of the key performance criteria for specialty chemical companies.

Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013, page 4:

Compared with integrated chemicals companies, economies of scale are less important for specialty chemicals companies, given their greater pricing-setting power (they are not ‘price takers’).

The high focus of specialty chemical players on R&D and their strong customer relationships ensure that despite their small size and fragmented industry, they have strong entry barriers against new players.

Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013, page 3:

Barriers to entry in the specialty chemical industry are typically high. The specialized nature of products leads to significant differentiation. Substantial research and development (R&D) requirements, technical know-how, capital intensiveness, service capabilities, customer relationships, and engineered or regulated specifications also create important barriers to entry…. Because of this, even fragmented industry sectors tend to be protected against new entrants.

An investor would appreciate that the products of specialty chemical companies are highly differentiated from each other. As a result, such companies benefit from branding, especially in segments where direct purchases by retail consumers form a significant part of sales.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 10:

subsectors like decorative paints, construction chemicals or adhesives, a company’s market positioning is strongly influenced by the strength of its corporate brand portfolio. As these subsectors tend to a generate a considerable share of their revenue in the consumer sector

Therefore, an investor would note that the commodity chemical companies face intense competition and are price-taker with no pricing power over their customers. On the contrary, the specialty chemical companies are relatively protected against intense competition and are price-setters with a high pricing power over their customers.

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:

For specialty chemical companies, ICRA would evaluate the stability of their operating margins over a period of time to ascertain the extent to which their pricing power has remained intact.

Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013, page 5:

revenue or margins trends that are at odds with prevalent industry conditions or that of other competitors can be indicative of an improving or deteriorating competitive advantage.

Therefore, an investor can assess the current status of the pricing power of a specialty chemicals player by analysing its operating profit margins.

Further advised reading: How to do Financial Analysis of a Company

2) Lowest cost producer; economies of scale:

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:

Cost-competitiveness: Because most commodity chemical products are hard to clearly differentiate using technology, competition relies heavily on cost competitiveness.

Commodity chemical companies undertake many strategies to become low-cost producers like locating the plant near the key raw material source like a refinery for petrochemicals, or near the key customers for lower transportation costs, or long-term take-or-pay agreements with their suppliers, and efficient utilization of by-products of the manufacturing process. However, the biggest impact on the cost structure of a commodity chemical producer comes from in the form of economies of scale where it increases its size of operations by capacity expansion.

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:

Economies of Scale: The chemical industry being capital intensive, achieving economies of scale and having a competitive cost structure are of considerable importance. Some Indian players who have built up relatively large capacities benefit from the resulting competitive advantages. In addition large capacities may also bestow the company a healthy market share and greater bargaining power with suppliers as well as customers.

Therefore, in the case of commodity chemical manufacturers economies of scale for cost advantages become essential to sustain in the industry. This is because lowering the cost of production seems to be the only competitive advantage for commodity chemical players.

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:

Business size: In commodity chemicals, JCR focuses on the indicators related to the business size or a market position, which have a significant effect on the competitiveness of the company.

Pefindo, the Indonesian credit rating agency, in its rating criteria for the chemical industry, highlighted the importance of economies of scale for maintaining sufficient profit margins of commodity chemical companies.

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.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 8:

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:

For speciality products, small volumes generally do not translate into cost-efficient operations and are thus typically produced along with other products sharing common facilities.

Second, as discussed above, specialty chemical companies have the ability to pass on the increase in input costs. Therefore, they do not need to be the lowest-cost producer in the industry to sustain their business.

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:

For bulk chemicals, the cost of production is directly related to capacity utilisation. Thus, it becomes important to maintain high capacity utilisation.

Rating methodology for the chemicals sector, Japan  Credit Rating Agency, March 2012, page 3:

Commodity chemical businesses generally require large capital expenditures, which makes it important to appropriately capture the demand and maintain a high rate of facility operation.

The importance of high capacity utilization by a bulk/commodity chemicals player becomes more evident when an investor notices that the cost of procuring raw material for most of the bulk chemical producers is nearly the same and the operating leverage that comes from running the plant at a high utilization level may be the biggest determinant of competitive advantage.

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.

Further advised reading: How to analyse New Companies in Unknown Industries?

3) Capital intensiveness and R&D costs:

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.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 9:

We believe that an integrated chemical company has to have a minimum critical size in order to be market-relevant.

Therefore, an investor would appreciate that in the commodity chemical space, a company must create a sizable plant to sustain, which makes a large-sized investment mandatory to run its operations successfully.

As discussed above, the technology for making commodity chemicals is widely available; therefore, a high investment in R&D by commodity chemical companies is not highly fruitful and do not add any significant competitive advantage. Large-sized cost-competitive plants are the biggest advantage for them. It makes the commodity chemical sector a capital-intensive sector.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 3:

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.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 3:

Beyond the large capital expenditures typically required to build large-scale production facilities, further capital expenditures result from working capital and the obligations to meet safety and environmental protection requirements.

In order to sustain/increase their market share, commodity chemical players need to continuously add investments in new plants and to maintain/upgrade their existing plants.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 5:

The commodity chemical business is capital intensive…a multi-product entity is also expected to continually upgrade/add new capacities (for commodity chemicals) to keep cost structure competitive and meet stricter environmental norms along with maintaining market specifications of the newer products.

An investor may appreciate that on an overall basis, the commodity chemical companies do not have very strong entry barriers to restrict the entry of new players. The requirement of large capital investment forms the only significant entry barrier for new players. Nevertheless, the industry is so sensitive to new entrants that many times, the entry of a single new player can seriously impact the profitability of existing players.

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.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 8:

Manufacturers of specialty chemicals are also well protected from potential competitors. Key entry barriers are the need for large investments in R&D to acquire intellectual property for customised specialty chemicals

Specialty chemicals players need to spend a lot of money in R&D to create products. The technology is usually patented. At times, the technology is developed in-house is kept a trade secret. As a result, specialty chemical companies also face the risk of technology theft. Therefore, they very closely guard the technology, which is the main source of their competitive advantage.

Rating methodology for the chemical sector, CRISIL, February 2021, page 11:

Speciality chemicals: Technology is typically developed in-house with the critical equipment being outsourced. The process is closely guarded as it can typically be duplicated. This exposes these companies to risks of technology theft.

Actually, the complexity of the technology determines the extent of competitive advantage for specialty chemical players. Competitors find it difficult to copy complex technology and as a result, the specialty player can continue to earn high-profit margins by selling its products.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 4:

complexity of the technology used by the entity to assess the extent of entry barriers present in the segment. The more complex the technology, lesser the possibility of re-engineering, and, therefore, lower the probability of the product becoming a commodity within a short span of time.

Specialty chemical players solve specific problems of the customers and produce high-value adding products. As a result, specialty chemical players have strong relationships with their customers and customer stickiness is very high.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 8:

In addition to investments in R&D, further barriers to entry for the specialty chemical sector come in the form of bespoke solutions and applications with long-term customer relationships which new entrants find difficult to destabilize. Specialty chemicals account for only a small proportion of the final product costs. Therefore, switching costs for customers in the specialty chemicals industry are high, resulting in reluctance to switch to realize only slight gains (customer ‘stickiness’).

Therefore, an investor would note that the key competitive strength of specialty chemical players is their R&D. In fact, the need to continuously invest in R&D is so high for specialty chemical players that it becomes almost a fixed expenditure for them.

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:

New product formulations at the customer level require constant development at the chemical company. Consequently, a company should make a commitment for a Research and Development.

An investor would appreciate that a specialty chemicals company cannot reduce its R&D spending for reporting short-term profit benefits. A reduction in R&D will have a significant impact on its competitive strengths. In contrast, the technology for commodity chemicals is mature, is widely available and more investment by commodity players in R&D may not give any outsized benefits.

Therefore, an investor would note that chemicals sector players whether commodity or specialty, need to continuously invest money in their business. The commodity chemical players need to invest a large amount of money in creating a big manufacturing plant initially and then subsequently for its expansion and upgradation. In addition, they need investments for working capital as well as safety & environment protection needs.

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.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 10:

Over the last decade, R&D expenditures as a percentage of sales (R&D expenditures/sales), in the specialty chemical industry were about 3% on average per year.

Therefore, an investor would appreciate that the business operations of chemical companies are capital intensive whether they operate in the commodity chemicals space or the specialty chemicals space.

Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors

4) Cyclicity and volatility of performance:

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:

We view commodity chemicals as a “moderately high risk” industry under our criteria, given its “moderately high risk” cyclicality and “moderately high risk” degree of competitive risk and growth…average peak-to-trough (PTT) decline in revenues of about 7% during recessionary periods since 1950…with the steepest decline (23% drop in revenues) occurring during the most recent downturn…average PTT decline in EBITDA margin of about 15% during recessionary periods…the largest decline (28%) occurring during the 1989-1992 recession.

The bulk chemical industry shows high cyclicity due to the following reasons.

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:

Industry profit margins are heavily affected by exposure to changes in input costs. Many raw material inputs experience significant pricing volatility, and commodity chemical companies have limited ability to pass on this volatility to customers because of the competitive nature of the industry.

Most of the time, the chemical manufacturing process is very energy-intensive, which makes energy costs one of the major input costs for commodity chemical players. An investor would appreciate that energy costs, which usually follow crude oil prices are very volatile in nature. As a result, high energy requirements also increase the cyclicity in the profit margins of commodity chemical players.

Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, page 4:

Some commodity chemical companies require a large amount of energy during the production process and, thus, are susceptible to fluctuations in energy prices.

Second, the prices of the final chemicals produced by bulk chemical producers depend on their global demand and supply situation and have no linkage to the cost of raw material/inputs of these chemicals. As a result, many times, bulk chemical producers are stuck in a situation where the raw material prices have increased and the final product prices have declined. Therefore, their profit margins are very volatile.

Rating methodology for the chemicals sector, Japan  Credit Rating Agency, March 2012, page 1:

Trends in prices of raw materials and finished products do not necessarily coincide, and the spread (the difference between the price of raw materials and the price of a finished product) generally tends to be unstable.

Rating methodology for the chemical sector, CRISIL, February 2021, page 10:

Bulk chemicals are pure commodities and prices tend to be very volatile, with little or no relation to the cost of production of a specific manufacturer.

The third reason for the cyclicity in the business of commodity chemical companies is the dependence of the demand for chemicals on the general economic situation in the country. In fact, the demand for commodity chemicals increases sharply during the up-cycle phase of the economic cycle and the demand declines sharply during the down-cycle phase.

Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, page 5:

Industry revenue and earnings growth generally outpaces global GDP growth during peak periods and falls below global GDP growth during trough periods.

The dependence of demand of the chemical industry on economic growth is true even for developed economies like Japan.

Rating guidelines for the chemical sector by the credit rating agency, Rating and Investment Inc., Japan, June 2021, page 5:

Demand, in other words, is influenced by the activity of the entire economy.

Therefore, an investor would appreciate that bulk chemical players witness a high cyclicity in their business performance. They frequently face boom and bust periods i.e. periods of good performance frequently follow periods of poor performance and vice-versa.

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:

Higher capital investment in bulk chemicals subjects them to more pronounced cycles compared to speciality chemicals.

Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, page 4:

Cyclical demand declines can lead to intense price competition, and lower production volumes can significantly reduce fixed cost absorption and profit margins.

In fact, the bulk chemical industry witnessed so much cyclicity linked to the economic growth of a country that at times, consumption of base/bulk/commodity chemicals is seen as an advance/leading indicator for an upcoming slowdown in the economy.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 8:

Base chemicals are a key leading indicator for potential slowdowns in economic activity, as they are used in virtually all end-markets and base chemical product sales volumes are highly sensitive to demand changes.

This is in sharp contrast to the specialty chemical players who witness a much lower cyclicity in their business performance when compared to bulk/commodity chemical players. There are many reasons for the same.

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:

For many specialty chemical producers, cyclicality can be exacerbated by volatility in energy costs or the price of raw materials, which are often commodity chemicals .many specialty producers have the ability to mitigate this volatility with pass-through provisions or value-added pricing.

Second, the raw material costs form a smaller part of the overall costs of a specialty chemicals company when compared to a commodity chemicals company. As a result, an increase in the input costs has a smaller impact on the business performance of a specialty chemical company than a commodity chemical company.

Rating methodology for the chemical sector, CRISIL, February 2021, page 10:

Speciality chemicals: Prices do not undergo cyclical changes as raw materials do not constitute a major cost.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 4:

The production of specialty chemicals typically requires limited quantities of raw materials which results in lower sensitivity to input price changes. In addition, higher feedstock prices (input prices) for several specialty chemicals are commonly automatically passed on to customers.

Instead of raw material costs, one of the key costs that specialty chemicals players is required to control is the employee costs because these companies usually have a large sales and marketing team.

Rating methodology for the chemicals sector, Pefindo Credit Rating Agency, Indonesia, November 2021, page 1:

On the other hand, specialty chemical companies are more labor-intensive and have bigger sales and customer services forces, so that controlling selling and general & administrative expenses is imperative.

Third, due to relatively lower fixed investment, specialty chemical companies are able to sustain their profitability even at lower demand/production levels. As a result, even in the economic down-cycle phases, the specialty chemical companies continue to get a certain amount of business from their key customers as well as from aftermarkets.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 4:

specialty chemicals companies face medium cyclicality risks. Specialty materials often account for a small share of production costs where those specialty chemicals are used (such as in automotive coatings) and the production of these end-products continues at lower volumes even in periods of weaker economic demand.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 8:

In contrast, we believe that the specialty chemical sector has medium cyclicality. This is because aftermarkets require lower quantities of specialty chemicals in their product processes and prices tend to be negotiated individually.

Therefore, an investor would note that the commodity chemical companies witness a high cyclicity in their business performance. The cyclicity may be externally driven i.e. induced by fluctuating demand, raw material prices etc. However, at times, the cyclicity/downturn in the industry has been induced on its own by the chemical players when the capacity additions are not planned properly.

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:

Often, companies must make decisions to add capacity well in advance of the start of commercial production. Such decisions expose these companies to uncertain demand.

Therefore, there were instances when the capacity expansion plants of multiple players became operational at the same time, which led to an oversupply in the market and led a crash of prices. An investor would remember that the commodity chemical producers work on low-profit margins and a decline in the product prices may force many players out of business.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 12:

In the past, several downturns in the chemical industry were caused by significant oversupply in the aftermath of large capacity coming online.

Most of the time, the companies attempt to reduce the cyclicity in their business by diversifying into different products, geographies etc. so that they may mitigate the impact of the downturn in any one product or country.

Rating methodology for the chemicals sector, Pefindo Credit Rating Agency, Indonesia, November 2021, page 1:

For those players, which are engaged in the commodity segment, a diversification would be a critical thing to do in an effort to reduce the cyclicality of any one product.

Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, pages 7-8:

Product, end-market, and raw material diversity are important factors for commodity chemical companies, because a narrow focus can make a company more vulnerable to cyclical pressures

Geographic diversity can offer enhanced growth prospects through exposure to developing regions with higher growth rates than more mature markets. Such diversity of sales and production limits exposure to economic or political risk in any given nation or region.

At times, the commodity chemical players diversity by producing specialty products as well to mitigate cyclicity in their business.

Key credit factors for the specialty chemicals industry by Standard and Poor’s, December 2013, page 3:

The portfolios of these large-sized corporates often include a substantial proportion of specialty chemicals operations, improving diversification and mitigating cyclicality risks to earnings.

As the raw material costs are the largest input costs for a commodity chemicals company; therefore, an ability to change the raw material as per market dynamics is very helpful to deal with raw material price fluctuations i.e. when costs of a raw material increase, then use a different raw material or use a different grade of the same raw material.

Key credit factors for the commodity chemicals industry by Standard and Poor’s, December 2013, page 9:

Companies that are able to use different inputs—whether entirely different inputs or different grades of the same material–can enhance profitability and improve their competitive positions relative to peers that do not benefit from the same flexibility.

Further advised reading: How to do Business Analysis of a Company

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:

Level of Vertical Integration: A high level of vertical integration lowers earnings volatility and protects against raw material unavailability risks and volatility in prices. Globally, there is relatively lower merchant trade in some petrochemical building blocks such as ethylene and propylene. Thus, plants dependent on external supplies of these chemicals are exposed to relatively high business risks in the form of availability and price volatility.

An investor would appreciate that most of the bulk chemical plants operate 24*7. It helps them get the maximum capacity utilization of their plants and in turn, be very cost-competitive. However, the round the clock operations of chemical plants increase the impact of the unavailability of any raw material/feedstock at any stage. This is because the unavailability of raw material may lead to the shutting down of the production line.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 3:

Feedstock Risks: Availability is particularly important, considering that most chemical companies operate continuous process plants and an unplanned shutdown can have severe cost implications.

Therefore, an investor may think that vertical integration is always a good strategy for chemical producers. However, it is not so. There are times when vertically integrated firms, which produce their raw material/intermediate products themselves become at a disadvantage to the firms that buy such intermediate products from the open markets.

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:

A high level of integration usually results in a better cost structure. However, in the event of sharp price movements in inputs or outputs, the company is exposed to adverse market circumstances. Thus, CRISIL Ratings looks into the flexibility available to the manufacturer to start from various stages in its production process in case of adverse price movements in its upstream products. The ability to market intermediate products in the event of sudden price movements in downstream products is also assessed.

Therefore, an investor would note that in the case of commodity chemical producers, being vertically integrated helps in becoming more cost-competitive, improves profitability. It also helps to avoid the unavailability of critical raw materials. However, the company needs to be flexible in its manufacturing process so that when market prices provide opportunities, then it may start the manufacturing using intermediate products or sell intermediate products without waiting for the production of final products.

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:

Rationalisation of import tariffs during the 1990s has linked the domestic market to international cycles.

From then, the prices of chemicals in India started following global prices because companies started pricing chemicals at import parity prices.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 5:

since most commodity chemicals are priced on an import parity basis, in a scenario of depreciation of the Indian rupee against the US dollar, the domestic players get a protection that partly mitigates the impact of declining import duty protection levels.

In fact, the chemicals company globally is now almost fully integrated and the companies of almost every country face global competition. The same is true for India as well as other developed countries.

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:

Duty protection and pricing: The differential between import duties on raw materials and finished products is also an important determinant of pricing for domestic manufacturers. CRISIL Ratings, therefore, analyses the movement in import tariffs and the sensitivity of margins to changes in the protection levels. This is an important aspect in the rating of bulk chemical companies.

An investor may read our detailed analysis of various chemical companies like Deepak Nitrite Ltd, NOCIL Ltd, and National Peroxide Ltd to see real-life examples of companies that benefited from the imposition of anti-dumping duties by the Govt. of India on low-priced imports from foreign countries.

7) Location of the manufacturing plants:

An investor would note that in the case of bulk/commodity chemical manufacturers, the intense price-based competition leads to low-cost production becoming the best competitive advantage. The commodity chemical players are price-takers with very low or nil pricing power.

As a result, apart from having large-integrated plants (economies of scale), the bulk chemical manufacturers also attempt to reduce their costs by way of reducing their transportation costs. It may be a substantial factor, especially for low-value adding chemical products that do not have sufficient profit margin for transportation over long distances.

Therefore, it is seen that in the case of low-value chemical products, the chemical companies attempt to make them near to their consumers.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 4:

For low-value chemical commodities such as chlor alkali products (caustic soda, chlorine, soda ash) the locational factor, among others, could play a significant role in determining the competitive advantage of a chemical entity. As the freight cost as a percentage of the landed cost to the final consumer can be high, if the product is transported from a longer distance, proximity to major end-users could impart strength to the manufacturer.

It is a situation similar to cement plants where cement being a bulky low-value adding commodity, is difficult to transport over long distances. Therefore, companies attempt to construct the cement plants at such locations where they can minimize transportation costs.

Advised further reading: How to do business analysis of cement companies

On the contrary, for high-value chemicals, the companies attempt to keep their plants near the raw-material sources to keep their input costs low.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 4:

For units producing high-value commodities, proximity to raw material sources (examples: petrochemical units located near a refinery; alcohol-based chemical units located in a sugar belt; and units dependent on imported raw materials located near a port) could impart competitive advantage via competitive feedstock costs.

In India, most of the chemical producers are present in the states like Gujarat and Maharashtra (the west coast). One of the key reasons for the same is easy access to the ports, which serve both for easy access to cheap raw material overseas (imports) and easy access to high-paying customers present overseas (exports).

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:

In addition, proximity to key end markets can have a considerable impact on transportation costs for bulky or hard-to-ship chemicals.

8) Environment and safety regulations:

Chemical manufacturing is a very environmentally sensitive process because it generates a lot of effluents, which have the potential of damaging the environment and causing pollution. As a result, the companies need to invest a significant amount of money in treating the effluents before recycling them or releasing them back into nature.

An investor would remember from the above discussion that a continued requirement to spend money to meet ever-changing environmental/pollution-control regulations is one of the reasons that make chemical manufacturing a capital-intensive process.

Chemical corporates rating methodology by the credit rating agency, Scope, Germany, April 2021, page 3:

Beyond the large capital expenditures typically required to build large-scale production facilities, further capital expenditures result from working capital and the obligations to meet safety and environmental protection requirements.

In the past, there have been many instances where chemical manufacturers have to pay penalties or shut down their operations because they failed to meet the environmental protection guidelines.

Rating Methodology for Entities in the Chemical Industry, ICRA, May 2019, page 4:

Environmental Risk Mitigation: In the past, several chemical plants have been shut down internationally or have had to pay high penalty, having failed to comply with the relevant pollution control norms.

The environmentally damaging nature of the chemical manufacturing industry became clear to the whole world during 2014 onwards when China which is the world’s largest chemical manufacturer tightened its environmental regulations and as a result, a significant number of Chinese chemical plants shut down. This was because these plants found that spending money to become compliant with environmental regulations was economically unviable. During this period, when India also increased the enforcement of environmental regulations, then many small chemical units in India also shut down.

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.

Meeting environmental guidelines is essential because, in the current times when awareness in the society about pollution-related issues is very high, any noncompliance may lead to shut down of the business of the company.

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.

Commodity chemicals are non-differentiable products; have an intense price-based competition where the manufacturers do not have any pricing power. On the contrary, specialty chemicals are niche products made after significant R&D that are difficult to replicate by competitors. Specialty chemical players have strong pricing power and earn high margins.

Commodity chemical manufacturers despite having a large market share or after being in the business for a long-time, do not enjoy any sustained advantage. They are price takers and have to focus on reducing production costs to have sustainable profit margins. Large plants with economies of scale are their main competitive advantage. Specialty chemicals need to focus on improving technology, and higher spending on R&D to solve customers’ specific problems. Lowest-cost of production may not matter much for specialty chemical players.

Bulk/commodity chemical manufacturers need to create large integrated plants to become meaningful players in the industry. Their technology is mature and widely available. Significant spending on R&D by them on commodity players may not be very fruitful. Even branding may not give outstanding results. On the contrary, specialty chemical players cannot avoid spending on R&D. Improving technology is their key for survival in the ever-changing world. R&D spending is like a fixed expense for them.

Commodity chemical players face very high cyclicity in their business performance. Their input costs and final product prices are very volatile. Companies do not have any control over both of them making their profit margins very uncertain. High fixed costs due to large plants make their profits very volatile. Whereas specialty chemicals can manage volatility by passing on increases in input costs. Customers use their products in small amounts and gain very high value from them. So, they do not mind paying a high price for specialty products. Cyclicity in the performance of specialty chemical players is much less than bulk chemical players.

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.

Rising environmental awareness has increased the cost burden on chemical players. Stringent implementation of pollution control norms has closed down many chemical manufacturing plants. Complying with updated environmental regulations involves a lot of investment and an investor should always keep it in her mind when she estimates the future investment needs of any chemical company.

Overall, while analysing any chemical company, an investor should keep in her mind the following characteristics of a chemical business.

• Pricing power: Commodity chemical players are price takers; specialty chemical players are price-setters.
• Capital-intensive: Commodity chemical players need to invest a lot of money in large-integrated plants and thereafter on maintaining/upgrading them.
• R&D: Specialty chemical players need to invest a large amount in research to survive. It is almost a fixed expense for them.
• Cyclicity: Commodity chemical players face very high cyclicity when compared to specialty chemical players.
• Regulatory protection/tariffs: Always be aware of any tariff protection enjoyed by the chemical players. Unawareness of the same may be detrimental for the investor as her investee company may lose all of its competitive advantages overnight.
• Environment protection costs: Be aware and ready to see companies spending a large amount of money on pollution control measures. This is essential if they want to continue in the business.

Also please keep in mind that over time, specialty chemicals become commodity chemicals.

We believe that if an investor focuses on these points while analysing any chemical company, then she may be able to assess the true business picture of the company.

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

I, Vijay Malik, am a SEBI-registered Research Analyst (Regn. No. INH100008364). This article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities. Investors should do their own research before making any investment decisions.

I, or my immediate relatives, do not have any financial interest in the companies discussed as on the date of publication of this article, nor do we hold one per cent or more of the securities of such companies at the end of the month immediately preceding it. I do not have any material conflict of interest and have not received any compensation or other benefits from the companies or any third party in relation to this article during the 12 months preceding its publication. I have not served as an officer, director, or employee of the subject companies, nor have I been engaged in market making activity for them.