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Managing specialty chemicals: Markets, margins, and innovation

1:46 PM MDT | May 6, 2013 | —Vincent Valk

Mueller: Formulations can help protect IP.
Rogerson: Chemtura not competing on cost alone.
Ungerleider: Dow’s large scale an advantage.

Strategic positioning and innovation are key components of maintaining high margins and profitability for specialty chemicals. Companies with strong research and innovation capabilities, close customer relationships, and a fine-grained view of markets and products will stay ahead of the curve, producers and analysts say.

Specialty chemical makers need to significantly improve their efforts to position their businesses to capture the tailwinds on the demand side, says Sam Samdani, senior knowledge expert in the global chemicals practice of McKinsey & Co. Markets are being reshaped by megatrends such as global demographic shifts, resource constraints, and technological change and “micro-segmenting” can identify areas that will benefit by pinpointing the best prospects for growth, he says.

Some chemical makers agree. “The advice I would give to any young marketer would be … don’t always look at the sector where everyone is fighting against you,” says Pierre Brondeau, chairman and CEO of FMC. Brondeau, who attributes this idea to former Rohm and Haas CEO Raj Gupta, notes that FMC competes successfully in the relatively low-growth food business.

What’s so special?

Many analysts, and even some producers, say that the phrase “specialty chemical” is overused. To give a crude measure of use, a Google search for the phrase “specialty chemical” turns up 1,090,000 results. A search for “commodity chemical” turns up only 72,700; “basic chemical” turns up 748,000 results. These figures are despite the fact that the biggest companies in the industry have historically been commodity chemical manufacturers, and total US basic chemicals sales were more than double US specialty chemicals sales in 2011, according to ACC.

“I think the term is overused,” says Stefan Mueller, senior principal analyst at IHS Chemical. “It is applied for things where I would question whether it is a specialty chemical. It’s applied to everything that is not commodity, and I think that’s a bit too easy.”

So, what’s the difference between a commodity chemical and specialty chemical? That it is even a question means the answer is fuzzy. Mueller says a specialty chemical “is basically something that comes with a service. It’s not just somebody hands you a few kilos or tons of a product and you do what you want with it.” Specialty chemicals are usually formulated and produced to serve a particular need on the part of a market or even a customer, and typically involve a large helping of technical service. “Companies will formulate something based on a particular situation,” Mueller says. “Specialty chemicals are problem solvers.”

Specialty chemicals tend to have medium, but highly varying, volumes—anywhere from a few hundred kilos to thousands of tons, Mueller says. They are highly customized and serve multiple markets. Innovation often focuses on application development as opposed to the development of new products, as in fine chemicals. Companies, meanwhile, are drawn to the business because it is viewed as higher margin and less sensitive to economic cycles and substitution than commodity chemicals.

But new products can become commoditized; Mueller cites vitamin C as an example. Vitamin C started out as a fine chemical, moved into specialty chemicals status and now, with capacity around 120,000 m.t./year, behaves more like a commodity, Mueller says. “It is easily exchanged,” he adds. “Today, whether you buy it from DSM or a Chinese manufacturer, it doesn’t matter.”

Brondeau says that lithium, despite going into high-tech applications such as batteries and pharmaceuticals, is essentially a commodity. FMC makes and sells lithium hydroxide, and Brondeau admits, “[T]he product made by Rockwood is just as good. You can differentiate yourself from the supply chain, you can be a bit more reliable in the product and service you are providing … but the product is the same and does the same thing.” A specialty chemical, on the other hand, involves a greater degree of innovation or specific formulations. A specialty involves “something which is unique that a customer cannot replicate the next day,” Brondeau says.

Innovation is key

Producers and analysts agree that innovation is key to maintaining that uniqueness and differentiation. “If we don’t innovate there is a strong likelihood that the products we provide will, over time, become commoditized,” says Chemtura chairman and CEO Craig Rogerson.

Many companies take a fairly broad view of innovation. FMC views it as encompassing product R&D, application development, formulation, and finding new markets for products. “The big thing for me … is the innovation cycle,” he says. “You have to go quick.” Formulation and application development tend to happen faster than developing new products. “Doing formulation and application development can help with shortening the innovation cycle,” Brondeau says.

Working together: Specialty chemical makers must often formulate products alongside customers.

To prevent commoditization, “you work in areas where formulated products are used,” Mueller says. “The formulation will protect your intellectual property in a much better way than a patent. A patent will expire and a lot of information is in the patent … [If] you have formulated products, there are a lot of things in the formulation that are very special” and difficult for competitors to replicate, he adds.

Close collaboration with customers is critical to innovation in areas like formulation and application development. “From where I sit … innovation will be driven by our customers’ challenges,” Rogerson says. Chemtura has application development centers in North America, Asia, Europe, and South America.

This closeness—often in a literal, geographic sense—is necessitated by differences in both culture and physical environment around the globe. Specialty chemicals, by definition, tend to be used in specified applications, such as Chemtura’s lubricants for wind turbines or FMC’s pectin-based food ingredients. In the personal-care business, for example, cultural differences are paramount. Taste buds differ throughout the world, so a food ingredient that tests well in the United States may not do so in India. Even in industrial specialties, where culture and taste matter less, geologic or environmental differences often come into play. “The challenges for oil and gas drilling in the North Sea, with the kind of exposure and environment you have there, may be different than in the Gulf of Mexico,” Rogerson notes.

Patents can still provide a rough guide to innovation’s big role in specialty chemicals. Dow Chemical received 400 patents in 2012, some 40% of which were granted to the company’s advanced materials business, according to Howard Ungerleider, executive v.p./advanced materials at Dow. “If Dow Advanced Materials [was] a standalone company, it would rank as one of the world’s leading innovation machines in terms of the compounds we make and the dollars we deploy,” Ungerleider says.

Indeed, patents are a source of income for Dow. “When we look at our patent-advantaged sales, we get a margin bump,” Ungerleider says. That bump can be as high as 10%, he adds. Still, Dow also values closeness to customers. “You have to have … a market-intimate, customer-intimate view so you can differentiate yourself and help your customers grow,” Ungerleider says.

Dow’s advanced materials business also focuses on enabling label claims for customers. This can include helping fabrics stay fresh, replacing fats in foods, or increasing solubility in pharmaceuticals “so that the right level of medicine gets to the right part of the body in the right amount of time,” Ungerleider says. Enabling customer claims is an important differentiator for a number of specialty chemicals markets, particularly those, such as personal care and food, that are focused around consumer products.

Ultimately, all forms of innovation and customer collaboration are crucial to staying ahead of commoditization and remaining a viable specialty chemicals business. Rogerson, Ungerleider, and Brondeau all say that commoditization is a fact of the business and cannot be resisted on its own terms. “A specific product … will at some point become commoditized,” Rogerson says. Chemtura attempts to “come out with the next version and restart the curve,” he adds. “You have to be meeting some specific need or do things more efficiently to justify starting on a new price curve.” If that is not possible “it’s a failure from my perspective,” Rogerson says. Chemtura sold its polyvinyl chloride additives business in 2009 because the company could not figure out how to make differentiated products to maintain margins in the business. The company views staying ahead of the curve as key to running any of its businesses, as it is not built to compete on cost alone, according to Rogerson.

Samdani says that in light of the housekeeping improvements in recent years he would give the Western specialty players an overall grade of B- on maintaining the industry’s general health and performance. He gives the producers a strong grade, B+, for their improved focus on capital productivity. “Producers are no longer throwing capital at problems and have become more disciplined in their M&A activity in recent years, compared to the 1990s, for example,” Samdani says.

He gives producers a C+ on how well they have oriented strategy to take advantage of market megatrends or favorable tailwinds. Most specialty players “are not doing all the things they need to do to position themselves for growth,” Samdani says. “The investor presentations have the lingo right but if you look at strategy and operations most companies have yet to capture the full potential of growth opportunities.”

He gives producers a C- grade for not being granular enough in their market segmentation, which often leads to overly static allocation of resources. “The conventional way of defining specialty and commodity chemicals is essentially applying common math to common data to yield common wisdom,” Samdani says. “Companies can do much better by devising a growth strategy that’s more granular about where to compete,” he says. They should spend more time on developing distinctive business models for sustainable advantage to create a “position of power” in the value chain. Companies can also benefit from “micromarket management” of their sales/marketing initiatives for top-line growth, he says. “We believe that most specialty players are not necessarily looking for growth in all the wrong places, but they’re too often searching for it at the wrong level of granularity,” Samdani adds.

Scale: Blessing or curse?

The attractiveness of specialties has led to a stampede into the sector, usually via acquisition, by big producers traditionally associated with commodity chemicals. According to CW research, the biggest specialty chemical producers by sales in 2011 were BASF and Dow—the number-two and number-four companies, respectively, by total chemicals sales in 2011. “All of the big producers, Dow, BASF, DuPont, … have tried to shed commodities and buy smaller, high-value, smaller-volume specialty companies,” Mueller says. This trend has been backed, over the past decade, not just by the increasing attractiveness of specialties, but by the shifting of commodities production away from higher-cost developed economies (although the shale gas boom has reversed this in the United States in more recent years).

Dow, as one of those big commodities producers that has acquired and built a big specialties business, not surprisingly sees scale as an advantage. “I do believe in this space, size matters,” Ungerleider says. The company views “critical mass” as one of its key competitive advantages, and it looks to exploit that by competing in markets where its mass can be brought to bear: “Critical mass is about our ability to deploy 12,000 people; it’s about having 40 different application technology centers around the world,” Ungerleider says. Dow’s global scale helps it reach customers and understand markets around the world, a big help to the customer-focused innovation emphasized in specialty chemicals. Dow also has a large mass of chemists sharing data and connecting lab books, enabling large numbers of experiments to occur quickly. Chemists can easily research past experiments in a given area and connect with others who have done similar research, Ungerleider says.

However, being part of a large organization can have drawbacks. “I’m still of the mind that there is a strong risk when smaller specialty chemical companies get acquired by big diversified firms,” Rogerson says. “There is a risk that they lose some of what makes them innovative.” Larger companies that are accustomed to viewing everything though the prism of cost may have a hard time adjusting to specialties, some executives say. Larger companies may also eschew or misunderstand the smaller, niche applications and markets that are critical in specialty chemicals.

It is also important for diversified chemical makers to realize that specialties require consistent investment to maintain advantage. “The chemical industry is a cyclical world, and some commodity companies that are not used to specialties will cut costs across the company in a nondifferentiated way when the cycle is down,” Brondeau says. Even in down economic cycles, specialty chemical makers must keep investing in renewing product lines, formulating, and developing new applications, he adds. Cutting costs throughout a specialty chemicals business means that products won’t be updated and will, inevitably, become commoditized at some point, Brondeau says.

Size may be more helpful in some sectors than others. Dow’s advanced materials business, for example, “touches 95% of the world’s smartphones and tablets,” Ungerleider says. Dow has strong relationships with the small number of very large customers in the semiconductor industry, he adds. Many of these customers are also growing in the light-emitting diode (LED) display space, and Dow is working with them to develop materials for use in LED. “Because we are a large and integrated company, we can transfer chemistries across multiple platforms,” Ungerleider says.

Brondeau, who helped develop what is now Dow’s electronic materials business when he was at R&H, notes that the electronics business is very competitive. “If you look at a fast-driving, highly differentiated sector like electronics, two things are going to happen. One, you will have lots of competition because every chemical company wants to get in there. Two, you will need enormous investment to respond to a growing and very appealing sector that … expects a lot from suppliers,” Brondeau says. Technology is constantly evolving in the electronics industry, and materials suppliers must invest and innovate constantly to keep up.

FMC does not compete in electronics. However, the company runs a high-margin food business with differentiated ingredients that can command high prices, Brondeau says. The food business isn’t growing as quickly as electronics, but it does require specialized chemistries and technologies in a number of areas, such as natural food. “Food and pharma will not disappear … and maybe it is easier to differentiate yourself than in, say, electronics,” Brondeau says.

Finding these niches is a good way to run a specialty chemicals business, producers and analysts say. The overall growth rate for a market doesn’t necessarily correlate to the potential growth for a company’s products in that market.

Brondeau also notes that commoditization needs to be recognized when it does occur, and that it isn’t necessarily a death knell. “There is no shame in commodities and no glory in specialties,” he says. “You could be a fantastic commodity company, or a lousy specialty company.”

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