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EMEA Equity Research
Chemicals
July 2012
Chemicals
EMEA Chemicals team
Dr Geoff Haire*
Head of Chemicals Equity Research, EMEA and Americas
HSBC Bank plc
+44 20 7991 6892
[email protected]
Sriharsha Pappu*, CFA
Analyst
HSBC Bank Middle East
+971 4423 6924
[email protected]
Sebastian Satz*, CFA
Analyst
HSBC Bank plc
+44 20 7991 6894
[email protected]
Jesko Mayer-Wegelin*, CFA
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 3719
[email protected]
Yonah Weisz*
Analyst
HSBC Bank plc (Tel Aviv)
+972 3 710 1198
[email protected]
Omprakash Vaswani*
Analyst
HSBC Bank plc
+91 80 3001 3786
[email protected]
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Chemicals
Developed
Petrochemicals
Classic
Speciality
Agrochemicals
Industrial Gases
Ineos (EU)
Akzo Nobel (EU)
Croda (EU)
K+S (EU)
Air Liquide (EU)
LyondellBas ell (EU)
Arkema (EU)
Givaudan (EU)
Syngenta (EU)
Linde (EU)
Georgia Gulf (US)
BASF (EU)
Johnson Matthey (EU)
Yara (EU)
Air Products (US)
Westlake (US)
Clariant (EU)
Symrise (EU)
Israel Chem (EU)
Praxair (US)
DSM (EU)
Umicore (EU)
Alpek (LatAm)
Lanxess (EU)
Wacker Chemie (EU)
Advanced Petrochemical
(ME)
Rhodia (EU)
Mosaic (US)
Solvay (EU)
Potash Corp (US)
Celanese (US)
Arab Potash (ME)
Eastman Chem (US)
Acron (EM)
Huntsman (US)
Bagfas (EM)
PPG (US)
Gubretas (EM)
Sherwin Williams (US)
PhosAgro (EM)
EMEA Equity Research
Chemicals
July 2012
Sector structure
Monsanto (US)
Braskem (LatAm)
Industries Qatar (ME)
Methanol Chemical (ME)
Developing
Mexichem (LatAm)
National Petrochemical (ME)
Sahara Petrochemical (ME)
SABIC (ME)
Saudi Industrial Investments
(ME)
Saudi International
Petrochemic al (ME)
Saudi Fertilisers (ME)
Synthos (EM)
Tekfen (EM)
Uralkali (EM)
Saudi Kayan (ME)
Sibur (EM)
Yanbu Petrochemic al (ME)
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Source: HSBC
Restocking-led
recovery
Rising oil
prices
Eurozone
debt crisis
Lehman
18.00%
10
17.00%
EMEA Equity Research
Chemicals
July 2012
Return on invested capital for chemical stocks versus growth in European industrial production (year-on-year)
16.00%
5
14.00%
0
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13.00%
12.00%
-5
11.00%
10.00%
-10
Average ROIC (%)
Growth in EU Industrial Production (% y-o-y)
15.00%
9.00%
-15
8.00%
7.00%
-20
-25
6.00%
Overcapacity coupled with
global economic recession
Asian Credit
Crunch
Growth in EU IP (% y-o-y)
Recession
Asian-led
recovery
5.00%
4.00%
ROIC (RHS)
Source: Thomas Reuters Datastream, HSBC
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EMEA Equity Research
Chemicals
July 2012
EBIT margin versus asset turnover chart (2012e)
3.0
Honam Petrochem ic al
2.5
Formosa C hem ical and Fibr
Lanxess
Asset T urn over (x)
2.0
Arkema
Formosa Plastics
LG Chemical
BASF
Yara
C roda
Nanya Pla sticsM ex ichem
Sy ngenta
Israel C hem ic als
Clariant
DSM
Johnson M atthey
Akzo Nobel
Braskem SA
1.5
Solvay
1.0
Hanw ha Chemical
Givaudan
Arab Potash
SAFC O
U micore
Sy mrise Adv anced Petrochem ic al
K+S SABIC
Air Liquide
Linde
N ational Industrialization
Industries Qatar
Saudi Industrial Inv estments
0.5
Sahara
Yanbu Petrochem ical
National Petrochem ical Co
Inte rnational Petrochemical
Methanol C hem ic als
Saudi Kayan
Uralkali
0.0
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
EBIT Marg in
Source: HSBC estimates
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Chemicals
July 2012
Sector description
The chemical sector, particularly in Europe and the US, comprises a wide range of companies serving
various end-markets. There are four sub-sectors – classics & petrochemicals, industrial gases, speciality
and agrochemicals. Several chemical conglomerates encompass all of the sub-sectors.
Summary of sub-sector characteristics
Sub-sector
Classics and
petrochemicals
Specialities
Dr Geoff Haire*
Analyst
HSBC Bank plc
+44 20 7991 6892
[email protected]
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
__________ Companies ___________ Characteristics
Akzo Nobel
DSM
 need to keep cost base low
Arkema
DuPont
 high capital intensity
BASF
Lanxess
 tend to be price-takers
Clariant
SABIC
 cyclical; exposed to economic and supply-demand cycles
Dow Chemical
Solvay
Croda
Symrise
 generally exposed to consumer demand
Givaudan
Umicore
 high consolidation
Johnson Matthey
 low capital intensity
 product offering requires constant innovation in order to maintain margins
 natural pricing power
Industrial gases
Air Liquide
Linde
 high capital intensity
Air Products
Praxair
 long-term contracts of up to 15 years account for about 25-35% of sales
 high consolidation; big four players represent approximately 80% of the
market
 end-markets tend to be cyclical: steel, refining, chemicals
Agrochemicals
Israel Chemicals
Syngenta
 High R&D requirement, particularly in crop protection and seeds
K+S
Uralkali
 highly dependent on crop demand and farmer economics
MA Industries
Monsanto
Yara
 high capital intensity in fertilisers so low cost base is key
Source: HSBC
Transforming in search of higher margins
Twelve years ago there were 17 large-cap chemicals companies. Since then, nine companies have either
exited chemicals (for example, UCB, Bayer and Hoechst) or have been acquired by competitors or private
equity (BOC, Courtaulds, ICI and Rhodia). The remaining companies have also undergone major
transformations as they have generally exited any commodity chemicals in which they did not have a
leading position. We expect M&A to continue to play a major role in the sector.
The classic and petrochemical sub-groups have the challenge of maximising margins through portfolio
change to become either speciality players or the “best-in-class”. Classic chemical companies tend to be
large conglomerates. Speciality players, on the other hand, end to be smaller, niche producers. Over the
past 15 years, companies in the European chemical sector – Akzo Nobel, Bayer, DSM and Solvay, for
example – have been shedding businesses with low margins and returns, or where they were lacking a
market-leading position. Within the classic sub-sector, companies have adopted two strategies to improve
profitability: increasing their presence in products where they hold leading positions or completely exiting
businesses where their market share is low or where they are at a competitive disadvantage (eg no access
to cheap feedstocks). Over the past 10 years, BASF has exited low-margin commodity products such as
polyolefins and fibres (nylon) while investing in areas such as engineering plastics, superabsorbents,
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EMEA Equity Research
Chemicals
July 2012
electronic chemicals, construction chemicals, catalysts and natural products. This has caused trough
returns to increase: the return on invested capital was 7.9% in 2009 compared with 4.6% in 2001.
The industry is mostly made up of a series of global oligopolies, reflecting the fragmented nature of the
end-markets. However, companies are generally price-takers as either customers have more bargaining
power or prices are set with respect to supply-demand balances, which is particularly true for classics and
fertiliser producers. The barriers to entry are capital costs, customer relationships and technology.
Key themes
Emerging versus developed market economic growth
Historically, the industry’s end-markets have been focused in the developed world, where growth is likely
to remain below trend for the foreseeable future. However, growth in manufacturing, the upgrading of
infrastructure and a growing middle class are making emerging markets increasingly important to the
chemicals sector. The sector average exposure to emerging markets is a third of sales. However, a number
of companies in the European sector already have a more sizeable position in emerging markets,
including Givaudan (46% of sales), Syngenta (46%), Linde (43%), DSM (38%) and Yara (38%).
Commoditisation
One of the inevitabilities in the chemical industry is commoditisation. There are two broad categories of
chemicals – commodity and specialities.
Commodity chemicals prices tend to be set by public markets and are heavily correlated with input costs
and supply-demand balances. Raw material costs represent more than 65% of the overall price, customers
can easily switch suppliers, products are defined by chemical entities and the barriers to entry are low if
you have unlimited capital. There are many competitors in this category.
In contrast, speciality chemical prices tend to be driven by the value the chemical adds to the customer’s
products/processes. Raw material costs represent less than 40% of the price, it is not easy for customers to
switch suppliers as this can involve changing manufacturing processes, and there are few competitors in
this category.
However, history has shown that speciality chemicals can easily become commodities in the absence of
innovation, or as a result of end-market changes or new entrants chasing higher margins. We have seen
examples of this in plastic additives, engineering polymers and fine chemicals. In our opinion, the term
speciality has been misused by companies and should only apply to products that can sustain high
margins and growth – such as crop protection, catalysts, fragrances and some engineering polymers.
M&A
Over the past 12 years we have seen significant M&A in the sector. There have been three types of
activity: consolidation within the sector (for example Solvay acquiring Rhodia), private equity activity
(the formation of Ineos, Access Industries’ creation of LyondellBasel from two acquisitions, and Apollo’s
later acquisition of LyondellBasell), and oil and healthcare companies spinning off their chemical
businesses (for example Novartis and Astra Zeneca forming Syngenta, and Total spinning out Arkema, its
chemical businesses). We expect M&A to continue in the sector as balance sheets are healthy; currently
DSM and BASF are active buyers according to their management teams. We also expect private equity to
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Chemicals
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bring chemical companies back to the market – although this will depend on the state of the equity
markets and the macroeconomic backdrop. Over the last two years we have seen AZ Electronic Materials,
Brenntag and Christian Hansen returning to the public market.
Substitution
The threat of external substitution to the chemical industry is limited but internal substitution is a constant
threat. Internal substitution is driven by other producers looking for new end-markets as well as
customers looking for lower-priced materials, for example polyethylene being substituted for
polypropylene in packaging. Currently many companies are investigating new technologies, such as
biotechnology and nano-materials, which could result in new lower-cost or better-performing products, or
new low-cost manufacturing processes.
Sector drivers
In our initiation report (It’s Showtime: Initiating on the European chemical sector, 1 December 2010 we
introduced three sets of value drivers to help differentiate between companies in the sector and their
ability to increase and/or sustain their return on invested capital. We believe ROIC is the best metric to
reflect the returns investors can expect from the capital that management teams are putting to work to
generate future profits, particularly in the case of companies with high capital intensity. Historically, we
have found a strong link between share price performance and return on capital.
In all, we have identified 10 drivers that influence valuation, which fall into three broad categories: topline growth, ROIC expansion and leverage. We have ranked all the companies in the European chemical
sector on each driver to gain a better understanding of which are best positioned to generate sustainable,
above-average returns in the future. The categories are:
 Top-line growth: we believe the key components of sales growth are: (1) end-market structure;
(2) exposure to developing economies; (3) barriers to entry; and (4) pricing power.
 ROIC expansion: we believe the key components of returns are: (1) exposure to raw materials;
(2) degree of consolidation; (3) cost base restructuring; (4) cash conversion; and (5) foreign exchange
exposure.
 Leverage: it is particularly important to scrutinise a company’s balance sheet in times of economic
uncertainty. Leverage is also important because it allows companies to take advantage of growth
opportunities – via either organic investment or acquisitions. The components of this sub-category
are: (1) net debt/EBITDA; and (2) debt maturity.
Macroeconomics and pricing power
Top-line growth in the sector is driven by GDP and industrial production (IP). Over the past 20 years
there has been a high correlation between the performance of the European and US chemical sectors and
IP in the developed world. In the shorter term, Chinese and Asian industrial growth has become an
important driver of earnings and share price performance. Volume growth rates across sub-sectors vary
dramatically, with catalysts, industrial gases, engineering polymers and electronics growing at over 2x
GDP, but paper and textile chemicals volumes at less than GDP. We believe average volume growth rates
tend to be around 1.5-2.0x GDP. Over the past 10 years, volumes in the classic sub-sector have grown at
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EMEA Equity Research
Chemicals
July 2012
2.0x global GDP on average and 1.2x IP, specialty chemicals volumes at 1.2x global GDP and 0.7x IP,
and industrial gases at 1.9x GDP and 1.2x IP.
Historically, we have seen many cases where classic chemical companies were not able to recover higher
costs for raw materials, and margins were squeezed as a result. However, tight supply-demand balances
following the financial crisis have momentarily put pricing power firmly into the hands of the classic
players. Conversely, several consumer-related speciality companies that tend to be price setters have
struggled with the strong rise in raw materials, as their contracts often only allow for erratic price
increases. It is worth noting that the industrial gas players tend to have prices linked to inflation and the
cost of energy for the large plants (tonnage) that they operate for customers.
In Juggling in a slowdown – 4 October 2011 we discuss in some detail the relationship between volumes
and price and macroeconomic drivers, particularly GDP and the oil price.
Input costs
We estimate that 55% of the sector’s input costs, if we include energy, are fossil-fuel based. Commodity
companies are more exposed to input costs than speciality producers, as these represent more than half of
the price of a product (as much as 65%). As commodity producers strive to reduce their cost base, they
have shifted a large amount of production to the Middle East, attracted by low gas prices. In 2001 Europe
and North America accounted for 54% of the world’s ethylene production; by the end of 2010 we expect
this to have fallen to approximately 40% and the Middle East to account for 19% by 2010 compared to
9% in 2001. The other sub-sectors are less exposed to input costs and potentially have more pricing
power. Historically, in times of fast-rising input costs, the majority of the industry has struggled to pass
on price increases quickly. However, following the financial crises of 2008-09, contract lengths for
commodity/industrial chemicals were reduced, enabling increases in input costs to be passed on more
quickly. However, for companies with contracts lasting more than a quarter there is a risk of margin
compression if input costs increase quickly.
North American natural gas advantage
Prior to 2008 the view was that the US petrochemical industry was in structural decline due to high
feedstock costs, and the ratio of the crude oil to the natural gas price (WTI/Henry hub) was around 6.0x,
which is considered to be feedstock parity. However, the advent of shale gas has lowered the gas price
substantially.
Therefore the US petrochemical industry has moved to using more gas (ethane) as a feedstock instead of
oil-based naphtha, shifting the cracker slate more towards ethylene and reducing the amount of the other
two key building blocks, propylene and butadiene, which are only obtained when using naphtha as a
feedstock. This trend is expected to continue given the amount of shale gas available in the US. There are
two implications of such a shift: 1) CMAI (Chemical Market Associates) is expecting the US
petrochemical industry to be at the top of the second quartile of the cost curve, making it significantly
more competitive than the European and Asian naphtha-based producers, so the US could once again
become a major exporter; and 2) there could be a structural shortage of propylene (C3) and butadiene
(C4). This has resulted in prices for propylene and butadiene, which are key raw materials for the
European chemicals sector, increasing significantly relative to ethylene.
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In North America a number of cracker feasibility studies are under way; if all were built, this would add
7mtpa of ethylene capacity (c5% of global capacity), which would likely either be exported (particularly
to high-cost naphtha-based petrochemical regions, such as Europe and Asia) or used as feedstock for the
manufacture of chemicals.
Chemical industry to supply ‘3E’-solution
In the Energy in 2050 research report HSBC highlights that the world can only grow and have enough
energy if energy efficiency improves and the energy mix changes. Given the chemical industry’s role as an
‘enabler’, a number of companies within the sector have technology that can help with this:
 Energy mix – Syngenta, K+S, BASF (fertiliser, crop protection, seeds), DSM (biofuels), BASF,
Johnson Matthey, Umicore (fuels cells, batteries), Wacker Chemie and Umicore (exposure to solar)
 Efficiency – this comes through the substitution of metal by engineering plastics (BASF and DSM),
improved insulation with polyurethanes (BASF and Bayer), enhanced oil recovery (Linde and Air
Liquide) and high performance tyres (Lanxess)
 Environment – Johnson Matthey, Umicore and BASF (emission catalysts).
Feed the world
We expect population growth and urbanisation in the developing world to cause a rise in GDP/per capita
as well. This would increase demand for agrochemicals, particularly if we saw higher demand for meatbased protein. We note that it takes 7kg of grain to produce 1kg of beef and 4kg of grain to produce 1kg
of pork.
As the amount of arable land has remained unchanged over the past 50 years, at approximately 38% of
total land, arable land per capita has decreased by 30%, from 0.23ha to 0.16ha.
The UN’s Food and Agriculture Office (FAO) estimates that approximately 90% of the crop production
growth required to meet future demand will need to come from higher yields. The rest should come from
an increase in arable land in the developing economies.
This has prompted some governments in countries with scarce arable land and fast-growing populations
to buy or lease land in other countries. The International Food Policy Research Institute estimates that 1520m ha, valued at USD20-30bn, have been sold or leased since 2006. The biggest purchasers have been
South Korea (2.3mha), China (2.1mha), Saudi Arabia (1.6m ha) and the UAE (1.3m ha).
If the world’s future demand for crops is to be met, there is a massive need to increase production yields
through a combination of more effective agrochemicals and the use of plants modified by seed technology
to be capable of surviving in difficult environments, such as drought conditions.
Valuation
The market is focused on short-term earnings growth. It tends to value companies on a 12- to 18-month
forward earnings basis, mainly using PE and EV/EBITDA multiples, as well as sum-of-the-parts (SOTP) for
conglomerate companies. The drawback to this for chemical companies is that they have changed so much
over the past 10 years that using historical multiples might be misleading; moreover, this methodology does not
capture the future value of those companies that have invested heavily either in R&D or acquisitions.
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In contrast, a return on capital metric (ROIC or CROCI) or a discounted cash flow (DCF) takes into
account the return on all the capital that has been invested in the company historically. This is important
for highly capital-intensive companies. A DCF captures the future value of investments that have already
been made, as the key drivers of a DCF are growth in invested capital (IC), asset turn (sales/IC), profit
margin and weighted cost of capital.
European chemical sector EV/IC range of 1.2x-2.0x over the
last 20 years
European chemical sector EV/EBITDA range of 5.0x-10.0x
over the last 20 years
2.2
10.0
2.0
9.0
1.8
8.0
1.6
7.0
1.4
6.0
1.2
5.0
1.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Average EV/IC
Trend
Source: Thomas Reuters Datastream, HSBC
10
+1 StdDev
-1 StdDev
4.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Average EV/EBITDA
Trend
Source: Thomas Reuters Datastream, HSBC
+1 StdDev
-1 StdDev
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Sector snapshot
Core industry driver: European industrial production
Key sector stats
MSCI Europe Chemicals Dollar
Index
3.4% of MSCI Europe US Dollar
15%
10%
Trading data
5-yr ADTV (EURm)
1,293
Aggregated market cap (EURm)
196,522
Performance since 1 Jan 2000
Absolute
66%
Relative to MSCI Europe US
167%
Dollar
3 largest stocks
BASF, Air Liquide, Syngenta
Correlation (5-year) with MSCI Europe US
0.23
Dollar
5%
0%
-5% Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
06 06 07 07 08 08 09 09 10 10 11 11 12e 12e
-10%
-15%
-20%
Industrial Production (y-o-y)
Sector volumes (y-o-y)
Source: Thomas Reuters Datastream, HSBC estimates
Source: MSCI, Thomas Reuters Datastream, HSBC
PE band chart: MSCI Europe Chemicals Dollar Index
Top 10 stocks: MSCI Europe Chemicals Dollar Index
450
Stock rank
Stocks
400
1
2
3
4
5
6
7
8
9
10
BASF
Air Liquide
Syngenta
Linde
Yara
Akzo Nobel
Givaudan
Solvay
DSM
Johnson Matthey
Index weight
26.1%
13.9%
12.2%
10.4%
4.5%
4.5%
3.6%
3.5%
3.5%
3.1%
17x
350
300
14x
250
11x
200
8x
150
100
50
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Chemicals Dollar Index
Country breakdown: MSCI Europe Chemicals Dollar Index
Country
Germany
Switzerland
France
Netherlands
Belgium
UK
Source: MSCI, Thomas Reuters Datastream, HSBC
Weights (%)
44%
17%
16%
8%
4%
3%
3.0
19.0
2.5
17.0
2.0
15.0
1.5
13.0
1.0
11.0
0.5
9.0
2004 2005 2006 2007 2008 2009 2010 2011 2012
12M Fwd PB
12M Fwd ROE (RHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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