The pace of change in the chemicals industry is slow. Despite a wave of mergers and acquisitions between the likes of Degussa and Hüls, and Dow Chemical and Union Carbide, the same companies have held the top ranks for well over a decade.
What is wrong with that? Nothing—if the companies earn adequate returns for their shareholders. But in reality, though the chemicals industry has performed quite well in comparison with other process industries, its relative stock market performance overall has been no better than average. And looking ahead, the traditional growth strategies of chemicals companies are running out of steam. Unless they find a new direction, they will preside over ever-diminishing growth prospects that will prompt shareholders to abandon the sector.
Over the next decade, traditional asset-based strategies will still be an important source of profit, but chemicals companies will also need to create other such sources to satisfy their shareholders’ longer-term growth expectations. Knowledge-based strategies will provide that new growth.
Chemicals now
The industry today includes three main kinds of companies. Commodity players, such as Shell Chemical and Union Carbide, produce basic chemicals and plastics. They account for a little over a third of total sales. Specialty players, such as Ciba Specialty Chemicals and Clariant, formulate chemicals to meet specific customer requirements. Such companies account for a quarter of all sales. Hybrids, including Bayer, BASF, DSM, and DuPont, have interests in many kinds of business along the length of the value chain. These companies, accounting for almost 40 percent of overall sales, dominate the industry.
It is remarkable how very few new entrants the chemicals sector has attracted and how little effect the Web has had on the incumbents
What is remarkable is how few new entrants the industry has attracted compared with other sectors and how little impact the Internet and the new economy have had on the incumbents. Essentially, the chemicals industry lacks "shapers": companies that have generated new profits by transforming the way they do business—and have seen their market valuations soar as a result. Chemicals companies still rely on traditional strategies for growth.
By traditional strategies, we don’t mean efforts to synthesize new molecules, which haven’t been a source of significant growth since the late 1960s. For the past two decades, chemicals companies have instead been trying to extract additional value from their assets. In the 1970s and 1980s, that meant a focus on functions such as sales and operations. In the 1990s, consolidation and restructuring were the name of the game—the former primarily to reap economies of scale and capture synergies, the latter primarily to realize cost savings.
Until the Asian crisis hit in 1997, these strategies served many companies well. The overall sector’s performance was in line with the total stock market’s, and companies in Europe and North America, where most of the consolidation and restructuring took place, often performed better than their counterparts in other basic-materials industries such as steel and paper (1). But the Asian crisis wiped out some $25 billion worth of annual economic profit, and confidence in the sector is low. Share prices haven’t recovered, because investors are still skeptical about the industry’s growth prospects.
Strategies for growth
It would be wrong to conclude that asset-based strategies no longer offer any potential for growth. Such strategies could clearly help Asian companies—many of which have been losing money—that have yet to begin serious consolidation or restructuring. Indeed, we believe that these approaches could generate up to $60 billion a year in additional earnings.
But in North America and Europe, where companies have responded more swiftly to the performance demands of the capital markets, the potential for further cost cutting is limited, partly because many companies have already accomplished so much and partly because further consolidation in many product segments would raise antitrust concerns. In any event, share prices have already taken into account any further expected increases in operational performance.
Strategic herding is the problem.1 A strategy that has worked for one business is commonly adopted by its competitors, making it difficult for customers to differentiate among these companies. Industry-wide cost reduction efforts lead all competitors to offer lower prices, damaging the whole industry. Of course, chemicals companies can’t ignore cost reduction efforts: they have to be made if a company is to remain competitive. But in the future, cost cutting will not be a significant driver of value creation for shareholders.
The main source of value creation in asset-based strategies will be the kind of restructuring that focuses the activities of a company more narrowly in areas where it is truly distinctive. Many hybrids are finding that they have captured all the synergies available from their different businesses. Consequently, a few are starting to focus on businesses in which they already have a leading position. Their strategy is to divest weaker businesses and to buy up assets in their core one, hoping to strengthen their operations and capture still more economies of scale.2 The potential is huge, since hybrids dominate the industry, but the savings are still finite and won’t, we believe, boost profits for more than an additional five to ten years.
Once the industry has become more focused, where will opportunities for growth lie? We think that knowledge is becoming an increasingly important part of any company’s capital. Only knowledge-based strategies can support long-term growth for chemicals companies.
Knowledge-based strategies
We have identified five different knowledge-based approaches that will help chemicals companies grow. All five entail changes in the way they have traditionally thought about their business. Many will require much less capital than traditional strategies, but each can improve performance significantly (see sidebar, "A strategic-opportunity landscape").
Revolutionize the business model
Finding better ways to do the same things is the essence of the first strategy: revolutionizing the business model. The most obvious example is the use of information technology and the Internet to serve customers better or to organize a company. Process industries have been slow to take up these enabling technologies, perhaps because the performance gains produced by the enterprise resource-planning (ERP) programs many adopted were so disappointingly small that they had no impact on stock prices. Nonetheless, automation and the electronic improvement of every step in the internal value chain can dramatically reduce costs and create a step change in corporate profitability.
Changing the business model offers other ways of creating value as well. The development of entirely new processes to make existing products could turn out to be one of the most lucrative. Biotechnology and combinatorial chemistry (the use of simple chemical building blocks to generate incredible synthetic diversity, which can later be screened for novel applications) may not lead to the production of new molecules. But over the next ten years, these techniques will probably change the way existing, commercially proven molecules are produced.
Take Archer Daniels Midland, which reduced its total production costs by more than 60 percent by replacing traditional chemical synthesis with an advanced biological-fermentation process. Although ADM produced no L-lysine as recently as ten years ago, it now has a worldwide market share of over 50 percent and an extreme cost advantage over all other producers.
Meanwhile, Symyx Technologies has become a pioneer in the use of high-speed technologies such as combinatorial chemistry. These have helped the company discover new materials for chemical and electronic applications, including catalysts for commodity chemical production and phosphors for lighting. Traditionally, new materials have been discovered through laborious and expensive trial-and-error processes. Although Symyx too relies on trial and error, the company’s proprietary technologies cost-effectively accelerate the process and therefore the discovery of materials. Indeed, the Symyx approach is up to 100 times faster than traditional research methods and cuts the cost of each experiment to as little as 1 percent of what it would cost with traditional techniques.
Mimic financial firms
The players currently reaping the greatest profits from the chemicals industry are not chemicals companies but financial firms—venture capitalists, private equity funds, and principal investors—that are adept at spotting opportunities to create value and equally adept at extracting it. A number of investment firms (including The Sterling Group, Kohlberg Kravis Roberts, and Schroder Ventures) have found that it is possible to make money by purchasing chemicals businesses and then shaking them up to increase their market value. Venture capitalists profit when biotech start-ups they have backed sell ideas to the big chemicals companies.
Managerial excellence is critical to the success of these companies. By instituting profit sharing, employee ownership, and stock option plans, Sterling, for example, spurred managers at Cain Chemical to reduce overhead by up to 60 percent and to increase operating margins by 7 percent and throughput by 25 percent. It then sold the company, reaping over $1.1 billion in profit from a $28 million investment.
Using some of the same techniques, venture capitalists push innovators to transform their ideas into lucrative businesses. Given the choice, most young innovators would surely prefer to be backed by a determined venture capitalist than by a large chemicals company with relatively sluggish R&D processes and modest compensation packages.
Financial firms are using these managerial techniques to divest the chemicals industry of talent and opportunities to create value. Yet there is no good reason for the failure of chemicals companies with strong managerial capabilities to spot and develop similar opportunities; after all, such companies have a much deeper appreciation of the value of operational improvements and technology than most outside investors do.
Chemicals companies could implement these management tactics and incentives to reduce overhead costs and eliminate internal subsidies—a significant problem in traditional chemicals enterprises, whose lack of cost and price transparency makes it difficult to identify weak businesses. Or chemicals companies could set up their own venture capital funds to encourage innovation and attract new talent. More ambitious still would be setting up funds to buy and then turn around companies in distress.
Create efficient markets
Although many chemicals are commodities, most customers deal directly with their suppliers, which means a lack of price transparency. This has often served the interests of the chemicals companies, allowing them to maintain slightly more favorable margins. But they must recognize that with the spread of electronic commerce, more transparent pricing is inevitable and that electronic markets will spring up to trade certain products—especially undifferentiated commodities. Such developments threaten to send prices tumbling. But opaque pricing schemes aren’t the only way to make money. New markets, whether in chemicals or in financial products and their derivatives, create opportunities for intermediation, risk management, and commodity trading. Chemdex, for instance, created a new link in the value chain by developing an electronic marketplace for the chemicals and life science industries. This market offers a huge range of products, simplified order processing, and professional (for instance, technical) support. In just two years, Chemdex cut its order-processing costs for buyers by 85 percent and for suppliers by 84 percent. In late July 2000, its market capitalization was $1.4 billion.
In February 1998, CheMatch.com established an on-line marketplace for buyers and sellers of commodity chemicals, plastics, and petroleum products. During its first two years, it was the locus of $125 million in chemicals transactions—testimony to its appeal to both sides. And in 2000, a number of large chemicals companies, including BASF, Bayer, Dow, DuPont, and Rohm and Haas, pledged $150 million to build an on-line marketplace for their products.
A market for trading contracts would separate the risk involved in owning chemicals assets from the risks of production and finance
Eventually, transparent pricing and trading could lead to the introduction of financial derivatives for such major chemicals products as polyvinyl chloride, low-density polyethylene (LDPE), and styrene. If a forward price curve were established for these and other products, manufacturers could time new asset investments more satisfactorily and lock in margins by giving price guarantees on both inputs and outputs. Such a market for trading chemicals contracts would help the industry separate the risk of asset ownership from both production and financial risk. A pure commodity player could, for example, lock in the price of most of its output and raw materials by purchasing forward contracts, outsource sales and logistics to specialists, and focus purely on lowering the cost of its operations.
Once financial markets for chemicals come into being, traders that disaggregate and reaggregate their own and others’ risk, as Enron does in the energy market, could become important players. Instead of making and selling chemicals, companies in the industry will use their knowledge of the market to enter the business of trading chemicals-backed financial derivatives.
Exploit hidden assets
Another strategy entails applying existing knowledge, assets, and skills in new ways. Over time, the chemicals industry has built a broad base of nonphysical assets, including brands, patents, customer information, and institutional skills. Yet only a few companies are trying to use these assets to their maximum economic potential.
DuPont, one such company, is renowned in the industry for its ability to run plants safely; it has suffered fewer lost working days from accidents than any other chemicals company. Several years ago, it decided to go into the business of teaching other companies to run safe plants. Another example is Dow Intellectual Asset Management, a "global technology center for intellectual-asset management," where a multidisciplinary team seeks licensing opportunities for the patents the company has collected over the years. As a result of these efforts, fees and royalties increased from $25 million to more than $125 million over 18 months, and huge savings have been realized from the maintenance of patents.
Widen participation in the value chain
Some segments of the chemicals industry, particularly specialty-chemicals companies, can offer their R&D and application development capabilities to new customers further down the value chain. This approach mirrors one attempted by many companies 20 years ago when they shifted their portfolios from commodity to specialty chemicals in the search for higher margins. The strategy wasn’t particularly successful then, because so many companies sought to become specialty manufacturers and the capital markets were skeptical about their growth opportunities. Now, however, companies might fare better by keeping a much stronger focus on the needs of downstream customers and delivering real value.
Dow, for example, rather than selling its rubber to producers of medical gloves, now makes its own—an example of how companies can capture some of the value that usually accrues to downstream producers using their products. Similarly, BASF Coatings no longer just sells paint to car manufacturers; it actually paints the cars of customers, some of the leading automotive companies. Using its superior understanding of the coating process and chemistry, BASF improves the quality of the cars’ paint jobs, thus raising the margins of its paint business even as the consumption of paint declines.
Forward thinking
Not so long ago, chemicals companies had no other thought than to make chemicals to sell to the next company in the value chain. The business model was built on the belief that the best assets—plants—would deliver the best value. Today, however, chemicals companies must rethink where and how they compete.
Asset-based strategies have served the chemicals industry well and could yet deliver another decade’s growth. But chemicals companies must start developing knowledge-based strategies now. Many of the approaches described here are quite alien to traditional chemicals companies, and it will take time for them to develop the requisite skills. Those companies that establish themselves as practitioners of knowledge-based strategies early on will reap a disproportionate share of the profit. And when strategic herding inevitably occurs, the knowledge-based skills of these same companies will ensure that they can change direction once again. 
About the Authors
Florian Budde is a principal in McKinsey’s Frankfurt office; Brian Elliott is a consultant in the New Jersey office; Gary Farha is a director and Rodgers Palmer is a consultant in the Washington, DC, office; Steffen Rüdiger is a consultant in the Cologne office.
Notes