Chemical Industry Financial Performance Trends: Are you in the Top Quartile?

Improving, but Still Not at Pre-Recession Levels

We advise several Chemical firms as part of our business transformation consulting services practice.  We decided to start a continuing review of the financial performance of firms in our practice areas.  Our objective is to explore the relationship between Business Transformation and financial performance.  We are operating under the belief that business transformation has a positive correlation with increasing enterprise valuation, stronger competitive performance, and correspondingly higher stock performance.  We will explore these ideas in this and subsequent articles.

Every company has its own story, and certain trends tend to vary by industry.  So, our research data are summarized by industry, as are these articles.  We hope that readers will find it easier to relate to the summary conclusions if they are influenced or driven by industry-specific data.   This article and series will be focused on the Chemical Industry, as defined by how companies identify themselves to NAICS industry codes.  Our data are for companies listed as public companies in the United States, which means we do not include companies with divisions in the US but listing on overseas exchanges.  Also, we have not included companies who are more broadly included in petroleum or petrochemicals, as their chemical operations are usually not identified as separately listed companies.  We will address those companies in our Oil, Gas, and Petroleum industry analysis.

The Chemical Industry is sizeable industry segment: in excess of $200B in Total Assets, over $180B in annual Revenue, $22B in industry Net Income, and over $11B in annualChem Industry Summary capital investments.  We found that the 2nd and 3rd quartiles contain some of the largest industry participants and on average they have significant competitive room for improvement in enterprise valuation, asset turn overs, and Return on Assets compared to 1st quartile performers.  Chemicals is a diverse industry, with significant dependence on global economic growth patterns and the related manufacturing sector cyclical trends.  Given these significant external factors, it is imperative to seek every cost and expense efficiency to achieve competitive operating margins AND return on assets – or pay the price by trading at a discount to higher performing peers for an extended period of time.

Bigger is Not Necessarily Better

Our database includes 95 chemical companies who publicly report quarterly and annual financial data in the United States.   We subscribe to the ValueSource data service, and we update our data on a quarterly basis.  Our analysis was based on annual financial data, as reported and captured by ValueSource for the most recent annual financial reporting period for each company.  We further grouped the firms into four quartiles, and compared their performance to the other quartiles as well as the average for the industry.

Z-ScoreWe used a statistic called the Z-score to assess and rank companies based on their financial health.  The statistical measure includes income statement and balance sheet ratios to develop a composite measure for each company, which is known as the Z-score.  It was originally developed by Dr. Edward Altman of New York University, and has been refined over time to become the ‘gold standard’ of financial risk assessment.  While most firms in the Chemicals industry are well above the parameters which indicate cause for concern, it is a helpful technique to rank firms into four quartiles for comparative purposes.

We will go into much more detail analyzing the relative performance of the Chemical Industry’s four quartile composite parameters.  You will discover that some of the largest market segment participants are in the 2nd and 3rd quartiles, so absolute size is not a guarantor of financial success.   The standout differentiator for higher versus lower ranking appears to be tied to investment and relative efficiency.

Now will summarize and contrast the performance of the industry in the areas of revenue and margins, asset utilization and returns, impact of prior investments and asset efficiency, and market returns and the relationship of debt.

Revenue & Margins

We analyzed data for the 95 companies included in SIC codes 2812, 2819, 2821, 2869, 2879, 2899, and 5169 (Chemicals and related companies), for their most recently Chem Revenue and Marginsreported annual financial results.  The Chemical industry is filled with household names in the private sector, including Dow, E. I. du Pont, Monsanto, Huntsman, and Ashland.  Seven firms in the industry had annual revenues in excess of $10B, with total assets between $18B and $70B.  Included in the industry are firms with long, established existence as well as new entrants in biofuels and related emerging applications of chemistry.  There are a number of smaller firms in the industry, with 29 firms each reporting revenues less than $50M annually. Average revenue per firm in the industry was $3.0B, with a relatively tight range across the four quartiles for gross margins (28.3%) and a wider range of operating profit margins (15.7%). 

Asset Utilization and Returns
Financial performance tended to track margin performance when looking at balance sheet results.  Asset Turnover (Sales/Total Assets) showed some variation across the quartiles, and Return on Assets showed significantly greater variation compared to the average firm as.  Asset Turnover ranged between 0.68 and 0.93 for the four quartiles, with an average turnover of 0.87 for the prior 12-month period.  Essentially, it took 14 months of revenue to reach the equivalent level of Total Assets for the average firm.  By contrast, the average Chemical firm had an asset turnover that was nearly 10 months faster than the Chemicals industry (see our related article on the Chemicals industry).

Chem margin and asset efficiencyReturn on Assets (Net Income/Total Assets) showed significant differences across the four quartiles when compared to each other and the industry average.  The Return on Asset performance ranged from -46.6% for the 4th quartile to 16.9% in the 1st quartile, with an industry average of 8.1%. The 3rd quartile, with some of the largest firms, had an average ROA of 2.8% — one-sixth the performance of the top quartile. 

Impact of Prior Investments on Asset Efficiency

Much of the difference in the ROA performance of the 3rd quartile is explained by the relative higher levels of Depreciation & Amortization incurred by the larger firms, thereby reducing their Net Income Margin % or bottom-line performance.  In summary, some of the larger firms in the industry are able to achieve competitive operating profit margins, before accounting for prior asset investments which are being depreciated and amortized over time.  Until customer demand  increases and assists in lifting utilization rates, Chemical firms must continue to address inefficiencies in asset utilization.  Since many of the larger firms are active in M&A, we may see continued divestitures and acquisitions to improve overall financial performance.  And, they will continue to suffer in their relative stock price performance versus their 1st and 2nd quartile competitors.

Market Value and relationship to Debt

We also looked at the market value of firms compared to their total debt book value, and found a powerful trend.  The market value of chemical firms to total debt book value ranged from 0.67 to 2.88 across the four quartiles, with an average value of 1.65.  Said another way, a higher value suggests the enterprise has a stronger balance sheet compared to lower values, presuming the firm can access the public equity markets to translate some of the ‘paper’ value into equivalent asset value.  The third quartile’s market value to debt was roughly one-fourth the top quartile, suggesting borrowing related to previous investments and less attractive profit margins combined to create an environment in which top quartile firms have significantly greater opportunity to raise funds to invest in either new lines of business, growth, or innovation.

At this point, we have taken a fairly in-depth look at the Chemical industry’s performance from top to bottom, and in the next section we will move on to an assessment of risk levels and summarize our findings.

Risk Levelschemical market value and risk

A value of 0.67 in the 4th quartile suggests the market value of a firm’s public equity is about two-thirds the level of debt of that firm – very risky and represented by their Z-score of astronomically low Z-scores.  Firms with a Z-score less than 1.81 are perceived to be distressed, with a high risk of bankruptcy (or acquisition targets with discounted valuations) in the next 12-18 months.  The 3rd quartile had an average Z-score of 2.91, which is considered to be close to the top of the ‘Grey’ risk zone.  These firms have some elevated credit risk, however their market value to debt is approximately 3X so they do have some room for additional equity if necessary.  Also, many of these firms have rather large cash balances as part of their total assets (a total of $18B+ of cash on the Balance Sheets of the 3rd quartile firms), so they should play through this somewhat fragile financial period presuming their sizable investment in new drugs successfully moves through the approval pipeline in a timely manner.


Summary

The table below summarizes the data and you can see some interesting patterns in the second and third quartile metrics as we have discussed.

Summary table
As you can see, the second and third quartile contained some of the largest firms in the industry.  While their income statement measures of efficient performance, Gross Margin % and Operating Income Margin %, were statistically quite close to the industry average, they tended to be significantly less efficient in the use of assets.  Driven by relatively high levels of ongoing depreciation & amortization of prior investment in these quartiles, they suffer with lower net income margins with correspondingly low return on assets — and lower relative public equity valuations versus their higher performing peers.

External Factors are aligned for improved 2013 Financial Performance, how to take Unnecessary Risk out of the Future

C-level executives are increasingly turning to Business Process Management (BPM) to take unnecessary risk out of their business and to create more sustainable and agile business models across the enterprise.  Why do we say so?

Cap Gemini recently completed a survey of C-level executives and the survey reported 45% of the respondents they now place more emphasis on BPM within their organizations.  The research highlighted functional impediments to BPM adoption, and some concerns that BPM is viewed strictly as an IT matter.  48% of those responding identified IT as a barrier to more effective process improvement.  In addition to IT being perceived as a possible barrier to BPM initiatives, 46% of the respondents identified a lack of change readiness or change willingness at their organizations.

Looking at the broader industry trends, US firms should benefit from some or all of the following external factors: projected global economic growth and manufacturing growth in 2012, decline in natural gas prices relative to global oil prices has improved the global competitiveness of the US petrochemical industry, and improving relative public market performance versus major broad indices.  These external factors, plus internal efforts to improve operating efficiencies and lift utilization rates may drive another positive year compared to the weak results of 2008 and 2009.

We know, based on our own consulting practice, that many prominent chemical firms have some business process improvement initiatives underway.  We also know these initiatives tend to be funded from IT, and while some non-IT functional areas are involved, there has yet to emerge a strategic commitment to BPM as a way of life across all functions and organizational levels at most firms.  We believe a top-to-bottom commitment to continuous Business Transformation across all functions is a strategic imperative, and in addition to improving enterprise valuations it will also reduce risk.

Value of BT to ROI and Enterprise Value

We introduced a new term in the last section: Business Transformation.   We view Business Process Management as just one element of a comprehensive set of tools, methodologies, technologies, and training needs which collectively fall into the larger category of Business Transformation.  We employ our Confiance Transformation Framework℠ (CTF) to advise and assist clients with their Business Transformation Initiatives.  Using the CTF at a Chemical Industry client, we worked with them to identify and implement process changes within 4 months in excess of 100% Return on Investment.  Also, we recently launched Confiance University, (www.confianceuniversity.com) our cloud-based content platform we are building out with our partners to bring all relevant content together for our clients and professionals who are committed to Business Transformation.   We believe this will accelerate the acceptance and adoption of Business Transformation by private and public sector organizations, and we intend to provide testing and certification so individuals with different roles and responsibilities may mutually learn and use common approaches to improve performance.

We know organizations that are embracing Business Transformation and are expanding BPM initiatives across more than their IT organizations.  They are experiencing positive ROI outcomes – both within the Chemicals industry and in other industry verticals.    One of our clients has used BPM methods to save several million dollars per month in one of their lines of business.  In a second line of business, the client applied BPM to reduce the speed of design by two weeks – time is money.  And in a third line of business, they used BPM techniques to create a common global process model, identify differences between the “As Is” and the “Desired” models, and improved collaboration across several SAP design centers.  Again, let’s look at the Cap Gemini study for some additional insights.  98% of their respondents reported a positive ROI outcome on their BPM initiatives, and 55% reported returns of at least 2X their initial investment.  BPM makes sense, and cents!

Confiance Transformation Framework & Business Transformation

In our previous blog posting, we referenced the Confiance Transformation Framework℠ and the powerful business improvements results achieved at one of our clients in excess of 100% ROI’s.

To learn more about Business Transformation and how to get started, please view our webinar on the Confiance Transformation Framework.  See how the Confiance Transformation Framework can help your organization with an in-depth discussion and case study.

About Confiance

Confiance is a global provider of business transformation solutions for commercial and government organizations. The company provides a comprehensive approach to Business Process Management, Enterprise Architecture and Service Oriented Architecture through a combination of consulting, education and technology that allows organizations to be more efficient, agile and improve service to customers and citizens. Confiance is recognized by its Global 500 and government agency customers as a trusted partner that helps implement change in order to achieve business results. Confiance’s customers include Alcoa, Bank of America, Bose, GE Commercial Finance, Kraft, State of New York, U.S. Army, Vodafone and Wyeth. For more information visit: www.confiancegroup.com.