Market outlook: Wisdom of winners

04 January 2013 11:23  [Source: ICB]

What can we learn from top-­performing chemical companies? If one of the central goals of any company is to generate returns for investors, then the best performance measure is total shareholder return (TSR), or stock appreciation plus dividends. To see how this principle applies in the chemical sector, we analysed the long-term TSR performance of globally listed chemical companies.

 
Specifically, we looked at the companies that make up Bloomberg's Global Chemical Industry Index and studied the 130 that have complete TSR data for the period from 2006 to 2011. Next, we analysed those in the top quartile to identify any common success factors. In addition, for 77 of those we could also analyse how much value these top performers created over the last 20 years, to assess the longer-term sustainability of their successes.

What's so special about outperformers, and how can others benefit from those insights? We found several common threads.

1. Wide disparity top to bottom:
Over the past five years, firms in the top quartile generated total shareholder returns of 31% annually, versus 7% for the average performers and -9% for bottom quartile firms. Such out-performance is rarely seen in other industries. The No. 1 chemicals value creator is from China, Hengyi Petrochemical, with an average annual TSR of 59% since 2006.

2. Long-term, sustainable performance:
Most of the top quartile firms over the past five years were also out-performers in the 5-7 years before. And in the 1990s, those firms were average performers - meaning that during the largest stock market bubble in history they did not fall into the trap of overvalued equity, irresponsible merger and acquisition deals, and hubris. In other words, recent superior performance in the chemical industry seems to be the result of a longer-term sustainable strategy and of coherently managing for superior profitable growth.

3. Superior profitability and high growth:
In general, the two ways to create value for shareholders are to grow the top line and increase profitability (as measured by earnings before interest, tax, depreciation and amortisation [EBITDA] margins or return on investment [ROI], factoring in the cost of capital). Top-performing companies were strong in both categories, posting annual revenue growth of approximately 25% and capital growth of about 15%. Others in the sector fall far short of this, not even achieving half of this growth. Surprisingly, top-performers not only realised such strong growth rates but simultaneously managed to improve their EBITDA margin some 8 percentage points/year. They were able to drive such EBITDA margin improvement even though they started from a higher baseline, with 2006 EBITDA margins that were already above average. As a result, they managed to improve their ROI from 17% in 2006 to almost 30% in 2011. These companies aren't just getting bigger but operating more efficiently - a rare sight in other industries.

4. Top performers manage expectations:
Typically, EBITDA market multiples (market cap divided by EBITDA) reflect expected top-line growth and expected changes in profitability. Top performing chemical companies show EBITDA multiple growth of around zero between 2006 and 2011, where others show declining multiples. This indicates that superior-performing chemical firms manage market expectations much better and deliver on their promises. Mid- and bottom-performing firms overpromise and do not deliver, leading to decreasing EBITDA multiples and thus lower market valuations.

5. On average, large firms slightly outperform their smaller peers:
Over the period we studied, large companies posted TSR that was three to four percentage points higher than that of their smaller peers, on average. This could be due to economies of scale and market power, making large firms less vulnerable to changing dynamics in individual markets. However, both the best and worst-performing firms are all relatively small, indicating that such firms have greater freedom to shine or stumble.

6. Focused firms outperform:
The TSR for focused, non-diversified, chemical firms is nine percentage points higher year-over-year than that of diversified companies. This indicates that focussed firms are more internally coherent, resulting in more synergies, more management focus, and potentially larger scale in their selected markets.

7. No top European firms:
Our findings show that firms that operating in growing markets, mainly in Asia-Pacific, create the most value for shareholders. The Top 10 consists of three Chinese companies, three in the US, two Korean firms, one in Mexico, and one in India. In the aggregate, they realized an average yearly TSR between 34-59% over the past five years. For European firms, strong performance seems far more difficult, on average. One reason is that many European chemical companies have started to expand in new growth markets relatively late. Looking at regional markets collectively, the average annual stock returns for companies from southeast Asia and South America are about 20%, versus 12% for US firms, 7% for European competitors, and -9% for Japanese chemical companies. (In fact, the bottom 10 performers were all Japanese, with an average annual TSR ranging from -11% to -17%).

LESSONS TO BE LEARNED
In terms of improving future performance, what does all this tell us, and what can chemical firms learn from their longer term successful peers? We think there are four principle lessons.

First, strive to raise sales and profitability simultaneously. This combination has been perceived as extremely difficult, and firms therefore focus on one or the other. However, new strategic approaches enable chemical firms to structurally reduce costs while simultaneously strengthening core capabilities and knowledge, and making the long-term investments needed to reach expanding segments or regions.

This is especially challenging for European and US firms, as they must reduce costs in their home markets in order to improve margin performance. However, only companies that can successfully build such multi-faceted capabilities will win in the chemical market.

Second, manage for cash and capital to realise profitable growth. This means that performance should not be assessed with traditional metrics such as revenue growth, EBITDA margin, cash conversion, or return on sales. Instead, chemical companies should measure ROI and change in economic profit (or EVA). To avoid significant measurement error, invested capital for chemical companies should be measured by gross assets, not book value, in order to correct for differences in asset age. By using ROI and EVA as a basis for performance management and as a basis for a forward-looking control framework, chemical firms are better positioned to maximise cash generation and capital returns.

Third, manage market expectations and deliver on your promises. Capital markets don't like surprises, negative or positive. Communicating strategic ambitions and financial objectives clearly, and delivering on investor promises, distinguishes top performers from the pack. That also requires internal steering on future returns and prospective cash flows.

Finally, consider size when defining comparison peer groups and setting TSR targets. Bigger firms have more-stable and somewhat higher returns than their smaller peers - but also fewer opportunities for superlative performance. So managers must carefully select the competitive set that they use to gauge performance, not only based on portfolio but also based on comparable size. In addition, they should factor in the size of their company when setting TSR targets.

Sustainable superior TSR performance is for the few, not the many, and size should be taken into account. But it can be done.

Kees Cools is a partner in Booz & Company's Amsterdam office and a professor of corporate finance at the University of Groningen kees.cools@booz.com

Marco Zuijderwijk is a principal in Booz & Company's Amsterdam office focusing on strategy development and corporate finance for the energy and chemical industry

The authors are highly indebted to Lars Langhout, Ernst Salet and Jorik Schröder for their research assistance.


Author: Marco Zuijderwijk and Kees Cools



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