Market capital, chemical companies

At the turn of the century, the German chemical company Bayer was capitalizing on a previously unnoticed chemical improvement on morphine. In 1898, Bayer began aggressively marketing heroin as a cough cure for the rampant disease of the time, tuberculosis. Heroin, a derivative of morphine, crosses directly into the brain, where it is converted immediately back to morphine. Unbelievably, it was said to be non-addictive. 

Short-term profit volatility and analysts forecasts, then, have much less impact on a company s share price than is often assumed. Capital markets have a longer-term perspective. Furthermore, in an industry like chemicals, even if we assume a continuous improvement in fundamental performance, the attempt to generate an equally continuous, volatility-free growth in profits will be virtually impossible because of structural factors like feedstock volatility, currency exposure, and seasonal effects. Chemical companies should learn to live with earnings surprises and concentrate instead on communicating a concrete long-term strategy - and of course deliver appropriately on capital market expectations, which will be correctly set on this basis. 

Perfect capital markets should see through the cycle and the reaction of valuations to purely cyclical fluctuations in the industry return on capital should be insignificant. To examine this, we again compared the actual valuation level to a fundamental predicted valuation level for commodity chemical companies. To pinpoint the effects of cyclicality, however, we used a slightly different approach. As we wanted to evaluate capital market expectations, we compared the actual valuation level with a fundamental valuation level based on perfect foresight , i.e., assuming that the capital market knew the actual development of the key value drivers for the next 8 years and evaluated this information in line with its implied fundamental value creation.4 Furthermore, we used a capital structure-adjusted market-to-book ratio instead of an earnings-based metric for the valuation level. 

In this case the key problem is that financing might be very hard to obtain in trough times, which is the only time commodity chemical companies should consider adding capacity, in theory at least. Conversely, in an upturn, financing is available more easily and there might even be some pressure from capital markets to invest in new capacity - in fact preparing the overcapacity that will cause the next downturn (see also Chapter 6). 

On average, then, capital markets follow the principles of fundamental value creation remarkably closely. Nevertheless, there are deviations, which are likely to be persistent or recurring because they are difficult to exploit. These deviations can put chemical companies at considerable risk in pursuing a strategy focused on fundamental value creation, but as we see below there are tools to help manage this risk. 

The starting point for an advanced SHV orientation is a clear understanding of the company s capital market valuation. This may appear an obvious point, but in our experience many companies rarely go beyond tracking TRS in comparison with competitors and talking regularly to analysts and I-banks. There is more to it than that chemical companies need to develop a superior understanding of the drivers of their capital market valuation and potential gaps to their own best estimate of fundamental value. 

As a further consequence of an advanced shareholder value orientation, a more targeted approach can be taken to investor relations. We feel that investor relations in many chemical companies today is predominantly aimed at providing timely, accurate, and exhaustive information to capital markets. Again, the assumption is that capital markets are perfectly efficient and will always evaluate this information correctly again, this does not match up with the real world. Behind the capital markets are investors with a wide variety of expectations and important specific investment preferences and institutional restrictions. In addition, it can be demonstrated that only a small number of investors with significant trading volume mainly influence stock prices in the short and medium term (Coyne, K. P. and Witter, J. W.). 

We therefore chose to examine the performance of chemical companies in relation to some easily measurable dimensions of their corporate activity - such as product portfolio, scale, geography, market position, and product focus. By classifying companies this way, we were able to test a number of hypotheses about what drives the creation of value, measured by total return to shareholders (TRS), market-to-book value, and pre-tax return on invested capital (ROIC). Data from the last full commodity cycle (1992 to 2003) generated surprising insights.5 ... 

Chemical companies have managed to hold their own fairly well in the capital markets over the last twenty-five years. 

Since gas players have invested cautiously despite continuous growth, they have managed to increase their capital productivity and prevent value leakage during the last five years. Compared with specialty chemicals companies, industrial gases players have shown a relatively stable market-to-book ratio over the last ten years. Current valuation levels are driven by a relatively stable operating performance and substantial growth expectations. 

Hoechst transformed its business from a hybrid chemical company into a pure Hfe science company by radically divesting over 80 percent of its portfolio, getting rid of businesses such as specialty chemicals (sold to Clariant) or chemical intermediates (spun off into Celanese). It completed the acquisition of Roussel-Uclaf and bought Marion MerreU Dow, and finally merged with the French life science company Rhone-Poulenc after the latter had also spun off aU its chemical business as Rhodia. By reinventing" itself under the brand name Aventis, it increased its Return on Sales (ROS) from 4.6 percent to 12.4 percent, a development that has recently been viewed very favorably by capital markets. 

Companies that have bought into the idea of a fairly small corporate center with limited day-to-day control should be careful not to become anorectic, however. With the critical size of a chemical compan/s market capitalization now in excess of USD 10 biUion, many companies have tended to become like conglomerates of related businesses. In order to add value (and to minimize the discount that the market puts on conglomerates), these organizations corporate centers - aside... 

If chemical companies accept the capital markets expectations as their primary performance target, then attempts to achieve production excellence - and thereby influence the biggest cost element in the business system - can only benefit them. To ensure well-rounded performance improvement, the capital market perspective should also be combined with other outward-looking measures derived... 

Fig. 16.8 Comparison of total shareholder returns and market/invested capital ratios for less cyclical and more cyclical chemical companies, 1987-98 Source McKinsey...

In 2002, Cap Gemini Ernst Young developed VCI models for the energy, utilities, and chemicals industries. About 70 of the largest United States-based companies are included in the data set after filtering for a minimum market capitalization in each industry, and for availability of data. The models ended up explaining at least 70 percent and up to 90 percent of the variability in market value in an industry. 

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