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Specialism drives chemicals growth

The challenges faced by the UK speciality chemicals sector following our vote to leave the EU need to be set in context against the global structural drivers
April 13, 2017

If nothing else, the reaction to the recent triggering of Article 50 of the Lisbon Treaty suggests that our withdrawal from existing trading arrangements with the European Union (EU) will require a degree of subtlety, as opposed to a ‘broad brush’ approach. If ideology eventually gives way to pragmatism then we could get to a situation where transitional arrangements are put in place for a range of industries, but most likely those that wield disproportionate influence, particularly in terms of the jobs they support within the most influential member states – French agriculture, German automotive and so on.

In some cases, the sheer weight of technical considerations will necessitate a bespoke approach to formulating the future terms of trade. That certainly applies to the UK chemicals industry. The complex regulatory and environmental framework that underpins its ability to trade within the EU will be central to negotiations, even beyond any considerations on tariffs. Theresa May’s government has already stated that most EU legislation will remain practically intact to smooth the UK’s exit from the trading bloc. The industry itself is overwhelmingly in favour of maintaining the existing arrangements under the EU's Registration, Evaluation, Authorisation and Restriction of Chemicals (REACH) legislation.

 

The first link in the supply chain

It could be argued that a successful outcome to negotiations for the chemicals sector is critical for UK industry as a whole, as it’s effectively the first link in the supply chain for innumerable businesses up and down the country. And there are strategic considerations to take on board. An independent UK capability in chemical production is viewed as critical, not only from a commercial perspective, but also in terms of national security. (The same conjecture has been occupying minds in Whitehall in relation to the beleaguered UK steelmaking industry.) We have become particularly vulnerable because the UK’s refining capacity has been in decline for years, with attendant implications for basic, intermediate and precursor chemical production. The outlook for future trade negotiations and our balance of payments would be wholly negative if we were to become overly dependent on imports – some analysts believe we already are in terms of feedstock chemicals.

The Chemical Industries Association (CIA) calls for a trade deal that will “support many of our customer industries who are dependent on our products and services”. Bon chance, as they say in Brussels, or should that read veel geluk? Anyway, it may eventually transpire that enlightened self-interest prevails over the long haul, even though the early signs are far from encouraging – conflicting at best.

The UK chemical industry has shown solid growth in 2016 and this trend is expected to continue into 2017. The CIA believes that the combined chemical and pharmaceutical industries represent the nation’s biggest manufacturing exporter with annual sales of around £50bn. Every working day the combined sectors contribute around £60m in added value to the economy.

Taken in isolation, the contribution of the chemicals industry is comparable in scale to either the domestic aerospace or computer hardware sectors, both of which rely on it for critical industrial inputs. So, given the centrality of the supply chain issue to the wider economy, it’s not difficult to appreciate the commercial imperative to strike an equitable trade deal for the sector.

 

The value added solution

Whatever the shape of our eventual trade arrangements with the EU, it is apparent that the bulk (or ‘commodity’) chemicals market is increasingly moving away from the UK to overseas operators that can generate significant scale benefits. Germany’s BASF is the leading producer of bulk chemicals globally, although its pre-eminence may be short-lived due to the recently approved $145bn (£117bn) merger of Dow Chemical (NYSE: DOW) and DuPont (NYSE: DD). Other than those dedicated operators, there's a fair smattering of petrochemical heavyweights such as Sinopac and ExxonMobil (NYSE: XOM) in the mix.

Although Royal Dutch Shell (RDSB) is 12th in the pecking order, the UK is underrepresented at this end of the market. Instead of competing with volume producers, the domestic chemicals industry has shifted its production decisively towards higher-margin speciality chemicals, which are sold on the basis of their performance or function, as opposed to their composition.

The shift has paid off handsomely. The speciality chemicals sub-sector has delivered some of the strongest rates of growth in the UK economy in recent years. And this feeds into a broader narrative as it can be argued that the most successful manufacturers in UK industry have eschewed the volume game, in favour of a move up the value chain – perhaps an unavoidable consequence of globalisation.

With UK producers opting for specialisation, niche chemical manufacturing is thriving. According to estimates from IHS Markit, global consumption of speciality chemicals is expected to increase at an average rate of 3.5 per cent a year during 2015-20, with half of that consumption generated by four end-use industries: soap, cleaning, and cosmetics; food and beverages; construction; and electrical and electronics.

 

Structural drivers promoting specialisation

As a consequence, a number of market segments are projected to grow at an accelerated rate, including nutraceutical ingredients (nutritional supplements), cosmetic chemicals, and compounds used in the electronics industry; all three of these areas are benefiting from the rise of disposable incomes in emerging markets, particularly in Asia, coupled with the fact that per capita consumption of specialty chemicals is still very low compared with developed regions.

Demand for high-performance industrial inputs provides another catalyst for specialist demand. This can take many forms, including advanced materials engineering: the development of high added-value products such as polymer matrix composites, used extensively throughout industry for their rigidity, low weight and heat resistance.

Changes in environmental policy and tighter global manufacturing standards mean that once-peripheral disciplines are now to the fore. The rise of global trade has precipitated beefed-up strictures on the regulatory front, particularly in relation to environmental legislation. This is giving rise to increased demand for so-called green chemistry designed to eliminate the use and generation of hazardous substances.

 

Value-added approach needed

The government’s recent green paper on industrial strategy makes it clear that the UK will need to pursue a value-added approach in order to compete in global markets. More bulk production is heading eastwards, where cheap petrochemical feedstocks are available, and labour costs are relatively low. And as chemical markets mature and production is up-scaled, their products become commoditised, so innovation remains one of the few determinants of competitive advantage.

 

Three structural growth plays

Synthomer (SYNT), a supplier of lattices and speciality emulsion polymers, has driven up its reported pre-tax profit by an annualised rate of 23.6 per cent since 2012 on the back of increased industrial specification. The group has reinforced its position in the speciality chemicals market through targeted acquisitions, including a recent deal to acquire performance additives specialist Perstorp Oxo Belgium AB for €78m (£67m).

Another speciality chemicals constituent Treatt (TET) has driven up its profits by 16.6 per cent on the same basis from the structural changes under way in speciality chemicals markets, particularly the growth in personal care and nutraceutical demand. In a February trading update, the company, which produces cosmetic ingredients and fragrances for a wide range of different consumer goods, told investors that it expects full-year pre-tax profit to substantially exceed guidance, while revenue growth of more than 20 per cent is expected. The shares remain well supported, but that’s hardly surprising given the structural growth drivers and a return on invested capital of 24.6 per cent.

We think the former dynamic will provide the catalyst for Elementis's (ELM) long-term growth despite near-term challenges provided by both its chromium and surfactants segments.

The integration of the $360m SummitReheis acquisition promises to transform the scale of its personal care division. SummitReheis’ anti-perspirant business, which accounts for more than 60 per cent of sales, is the global leader in this field and has long-established relationships with consumer product companies in western markets and fast-growing Asian locales.

Price1-yr high1-yr low1-yr price change (%)5-yr price change (%)ROCE (%)P/EDiv yield (%)Market cap (£m)
Elementis286310181205411.119.52.31,332
Synthomer4794813093210224.317.02.41,635
Treatt39239216413140318.830.11.1200