Specialty chemicals are the new frontier

10 October 2011 00:00  [Source: ICB]

The Chemicals Industry Group at PwC has recently undertaken a study of the chemicals industry in China in collaboration with the Economist Intelligence Unit.

Their findings are shortly to be published in a white paper. Key highlights from the study are set out below.

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The early movers of the multinational corporations to China arrived decades ago, but were typically focused on China as a source of low-cost manufacturing for export and did not put a lot of value on demand from the China market itself. The market is unrecognizable from what is was then, and domestic demand in China has a direct and significant impact on the strategies set in global boardrooms of all major chemical companies.

Construction, car manufacturing, computers and cosmetics: each of these sectors is thriving in China, and each relies on chemical inputs. China is already the largest market for some chemical products and accounts for more than one-half of Asia's chemical sales. At current rates of growth, China will surpass the United States within the next few years to become the world's largest chemicals market.

Multinationals, whether already established in China or assessing the market as new entrants, can take advantage of general growth trends to boost sales. They are facing intense competition from Chinese producers and this is severely impacting pricing, and thus, margins.

Many of the global players have a strong footprint in China already and their strategies tend to focus on two areas: increasing manufacturing capacity for existing products partly through mergers and acquisitions, but mostly through factory expansions in their existing joint ventures or wholly-owned operations.

Secondly: diversification into new product areas - especially specialty chemicals - through innovation and M&A.

Many multinationals already have a series of companies in China that they have established or acquired covering different geographies and products. Those are typically of a relatively small scale initially, but as they mature, there is a second wave of investment in new facilities that can be many times larger than the original operations.

FOCUS ON HIGHER MARGINS

Chemical companies are therefore looking to higher margin areas of activity and the fast-growing specialty chemicals segments. Sales in this area are dwarfed by sales of base substances, but they are growing exponentially and multinationals have technological advantages for many of these product types over their local competitors.

Chinese producers have the same vision of the future significance of specialty chemicals as many of the multinationals do, and so a race is emerging with domestic producers. Multinationals are striving to grow sales of specialties before the Chinese catch up. But the Chinese are focusing on innovation, and are also acquiring foreign companies that hold valuable intellectual property and manufacturing know-how they can use in China.

Gaps in the product suite or geographic coverage can be plugged by M&A, but there is a lack of Chinese domestic producers in higher value product areas, so a strategy based on acquisitions alone, without dual emphasis on growing innovation capabilities, is unlikely to succeed.

China's 12th Five-Year Plan, published in March 2011, has some key factors which will help shape the future direction of the chemicals industry in China.

Areas of activity that are "on plan" can expect greater success in terms of government support and regulatory approval.

Strong themes include the focus on more energy efficiency and reduced environmental impact. The plan also highlighted seven strategic emerging industries and four of these have direct or tangential links to the chemical industry: new materials; new energy: new energy automotive; and energy saving and environmental.

Competition in China is especially intense along the highly industrialized and urbanized Eastern seaboard, which accounts for 80% of China's current GDP.

There is still considerable growth expected in the less-developed central, northeastern and western areas. The government has specific strategies in place to encourage growth in these areas and spread China's wealth westwards.

A core element is to encourage urbanization as a means of growing domestic consumption given the higher spending power of urban versus rural workers. This is expected to drive demand across sectors requiring chemical inputs from construction to consumer goods.

People issues also are having a profound impact on business strategy in China. This applies to every sector and chemicals are not immune from the shortage of talent - particularly in experienced management - and the impact that it is having on wage inflation and staff turnover.

Talent is a key item for boards of directors in China as the shortage of talent and high turnover inhibit growth and increasing costs' impact margins. Competition and salary levels in central and western China are lower and local markets for chemical products in these areas are growing. The conurbation of Chongqing, for example, houses 30m people.

ENVIRONMENT DRIVES CHANGE

Changes in environmental and energy efficiency standards in China also are having an impact. Polluting and energy-intensive processes are being targeted and the clear message is to upgrade or close down.

This is driving some M&A activity but also is an opportunity for multinationals, particularly where value may be in the target's distribution networks and customer relationships rather than the existing manufacturing facility.

Tighter regulation can increase costs and the need for good controls over business activities, but it is also creating demand for new "cleaner" products in the broader industrial manufacturing sector that require chemical inputs, so there is a positive side to this trend.

In the past, foreign-owned enterprises enjoyed preferential tax treatments compared with domestic companies. Although those were phased out at a national level a few years ago, opportunities for favorable tax treatments still exist. Certain local provincial or municipal government policies in China are designed to attract foreign companies that are willing to establish development hubs and bring intellectual property onshore.

Some of these policies, including corporate tax incentives and logistics support provided by dedicated chemicals-sector zones, such as theNanjing Chemical Zone encourage partnerships and acquisitions that will enable the local production of higher value-added products. This moves China up the value chain and helps upgrade manufacturing processes. Intellectual property (IP) rights protection has long been a headache for any multinational operating in China, and it's a particularly sensitive issue in the field of innovation. Chemicals companies that are expanding R&D operations, or even distribution chains, need to reconsider how they enforce intellectual property protection.

This requires continuous personnel training and regular contact with government enforcement institutions.

The Chinese government has taken steps to improve IP protection. In February 2011, it clarified the patent law Implementing Regulations of the Patent Law of China. Efforts already may be making an impact. According to a survey by the US-China Business Council, about 40% of its 220-plus members have reported improvements in IP protection each year since 2006.

As the environment matures, traditional strategies pursued over the past two decades in China will no longer apply. To remain successful, experienced companies should:

• Re-evaluate sector market and distribution strategies, particularly within the commodity space. Competition will intensify as Chinese companies mature and globalize. There are opportunities to expand capabilities into the specialty sectors, where experience is vital.
• Develop human capital. Mature multinationals must develop talented middle management and leadership qualities in their staff.
• Take advantage of China's drive to localize IP development and align your China strategy with the 12th Five-Year Plan. If structured properly, companies can reap numerous benefits from establishing R&D capabilities in China.
• Evaluate China's place within an expanded pan-Asian supply chain. Many companies are rethinking their organizational and process structures so they can expand into other emerging Asian markets more efficiently.
• For multinationals new to the Chinese chemicals market, there is still ample opportunity to be successful. Before moving forward, companies should be sure to:
• Develop a thorough entry or expansion strategy. Select portfolio areas where the organization possesses solid knowledge and IP and use it as a lever for organic and inorganic growth.
• Evaluate target companies for potential joint venture and acquisition plays. This is a long-term process that requires active fostering and development of relationships. Understand the competition, as well as the Chinese companies that are in ancillary specialty categories used as additives in current product lines.
• Put the right type of leadership in place on the ground. Poor leadership can set back strategies. It is important to strike the right balance between domestic and foreign leadership and implement talent development programs to position local staff for future growth and leadership positions.

Author: Malcolm MacDonald

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