Changing Picture - We witness now the realization of the most severe global crisis since sixty years. Initially centered on the housing and real estate markets, the downturn expanded into the banking and financial sectors before reaching the real economy and the chemical industry. Many analysis were done recently to understand the causes of the crisis, whereas now comes the sobering task to assess its consequences on chemical distributors and their suppliers. This article analyzes the new economic and financial scenario and specific challenges and opportunities faced by chemical distributors.

Producers' Turmoil

Last year, most chemical manufacturers experienced considerable decreases in raw material prices as well as significant drops in demand for their products. As most asset values busted, the disposable incomes of various segments significantly decreased and are likely to remain deflated over a long period of time. In January, news of the bankruptcy of Tronox and of the U.S. arm of the third global chemical producer LyondellBasell hit the whole industry. The LyondellBasell bankruptcy represents a write off for the banks of over 10 billions dollars. Both companies were affected by demand and margin drops as well as by very high debt levels.

Simultaneously, the financial crisis and the decline in oil prices forced the collapse of the KDow joint venture concluded earlier between Dow and Kuwait Petrochemicals. This turnaround left Dow in quandary with limited resources to complete the generously valued Rohm and Haas acquisition. During the last few months, the Hexion, Huntsman, LyondellBasell, Dow, Rohm and Haas demises marked the end of easy credit availability and leveraged buy outs.

Overall, the recession will lead to the restructuring of many industrial sectors, including the chemical industry. This will bring a new industrial outlook in industries where chemicals are used like paints and coatings, building, automotive, paper and polymer processing. It is now clear for distributors that dependence on a few large suppliers or on a few customers can be very precarious under the present circumstances. Finally, in relation to slow or negative industrial growth rates, producers and distributors will have to adapt their sales to shrinking industrial demand and declining markets.

Private Equity In Reflux

Private equity firms own most leading European chemical distributors. Their inroads in the sector expanded significantly to reach last year an overall European industry market share above 30%. Private equity investments in chemical distribution have specific characteristics not evidenced in other sectors, namely: higher ownership rotation, shorter holding periods, only secondary or tertiary exits and increasing leverage levels. Secondary or tertiary placements entail a major drawback: namely the formation of a speculation bubble where the company values increase a lot and bear no relationship anymore with the financial reality. Since secondary placements are unlikely to be completed now and IPO's may not be on the agenda before 2012 or 2013, we can only expect some M&A distressed opportunities to emerge soon.

This table illustrates well the new financial challenges faced by private equity, at times when acquisition multiples fall. It is considered that the equity value of a company is equal to its enterprise value (EV) minus its debts. The EV is assumed by private equity to be an EBITDA multiple. Most transactions were dealt in the recent past on the basis of multiples between eight and 10. In the future, they will be dealt on the basis of multiples between five and seven which will significantly penalize their equity values. Consequently, the current strategy of most private equity owned distributors aims at trying to preserve the value of their equity investment by eventually growing sales and EBITDA to compensate the inevitable decline of acquisition multiples which is a challenging, if not unattainable goal.

The chemical distributor model remains a powerful engine of value creation in the supply chain between producers and end-users; however the conflicting interests of private equity, bankers and insurers faced with the decreasing performance of their investments, create many uncertainties in the sector.

Private equity faces new regulatory rules which impose that they assess annually the price of the companies they own, based on their market value and not anymore on the original cost of their investment. By some calculations, the actual losses created by goodwill impairments could exceed 30%. Therefore, private equity is now mostly sticking to what they have, trying to optimize the value of their investments, avoid equity injections and wait for better times.  

Distributors' Challenges

Chemical distribution, even when confronted with a difficult environment, remains a flexible and entrepreneurial industry sector. This point is illustrated with innovative examples in the area of Reach implementation and information technology processes implementation.  

2008 was the Reach implementation beginning year marked with the completion of the pre-registration process for higher volume products above 1000 MTPA and hazardous chemicals below 100 MTPA. The iterative registration process proved to be more costly and tedious than anticipated, since it includes comprehensive information about product handling, downstream uses and formulations. During the next two years, final registration within specific product consortia will take place.

Reach implementation is a bigger challenge for specialty chemical distributors who rely on overseas imports from USA, China and India. They often have to cover the registration costs on behalf of their overseas suppliers without being sure of recovering these investments on the market. Reach is now creating two types of European distributors based on distinct competencies, namely importers and domestic distributors.

Reach restricts domestic distributors to freely import buy chemicals from Asia. Consequently, there will be a small number of specialized companies able to manage increasingly complex import activities that will purchase larger volumes, either for their own account or on behalf of other distributors or resellers.

Information Technology Inroads

Due to the sector complexities, information technology penetration into chemical distribution took more time than in other sectors. Initially, the adoption of adapted enterprise resource planning (ERP) systems by most distributors was driven by reporting, internal costs and margin management. Then it gradually moved into internal and external information exchanges. Impressive developments took place in the area of customer management processes like supply chain integration, procurement outsourcing and vendor managed inventories. Telemetry systems are used by bulk distributors to monitor their customers' stocks and this gives them some mutual benefits. Customers pay for what they consume and don't have to monitor their tank levels anymore. Distributors can also flexibly plan their customer shipments.

Distributors managing single sourcing contracts become purchasing agents for their customers. They provide a full range of chemicals and related services to their larger chemical users in the chemical and other related industries like paints and coatings, automotive or pharmaceuticals. As a result, chemical users decrease their purchasing costs by buying from a single source, reduce administration, lower inventory levels and simplify the management of used drums and pallets, returnable containers and spent chemicals. Information technology systems became process facilitators in the management of these complex and varied activities.

Chemical distribution is facing now major challenges and opportunities. Their most significant test lies in their ability to resolve complex financial and credit issues. Distributors with reduced indebtedness, strong balance sheets and a sound strategy are in a better position to benefit from the market recovery. It is safe to assume that the chemical distribution picture after the downturn will be different from what we observe now.