A Look at Raw Material Supply in the Context
of the
The two quotes illustrated below are the actual words of the owners of two different chemical businesses when discussing their raw material situation in due diligence with potential buyers. In one company, raw material costs are of primary importance. In the other, they are almost irrelevant. As such, these examples reflect opposite ends of the spectrum. In the chemical industry there are some businesses that exhibit these extreme characteristics, and many more that are somewhere in between the two extremes. In the article that follows, we will look at raw materials in the context of the acquisition of a chemical business in further detail. Raw material costs are critical - In some chemical businesses, many of which are "commodity" in nature, raw material costs are extremely important to the overall business's success of failure. In the situation depicted in the first cartoon, the owner of the company felt that his most important employee was his purchasing manager. The business was highly competitive, with customers having little or no loyalty, ready to switch suppliers for a penny a pound. In this environment, the company which can purchase its raw materials advantageously has a leg up on the competition. Raw material costs are of minor significance - The second situation depicted in the cartoon involved a 20 year old company whose owner said that his company never raised prices (to existing customers) when raw materials went up. Why not? How could this be? A specialty chemical company with high margins may have much more room to absorb raw material price increases. Such a company may also be able to reformulate to keep its costs down. And if the company is constantly developing new and improved products that the customer needs, it can price the new products such that margins are maintained or even improved. In all these cases, raw material costs are not as important. Let's look at some other situations that are between these two ends of the spectrum: Raw material costs fixed under a long-term contract? or purchased on a spot basis? - In an environment where raw material costs are unstable, the existence of a long-term contract fixing the cost of raw materials can be very helpful, or very detrimental, depending on how it is structured. In recent times, raw materials based on petrochemical feedstocks had been rising due to the large increases in the price of crude. In this environment, a company which purchases under a long term contract where prices were fixed before the run-up is in good shape, whereas the spot purchaser will have problems if it can't raise it's own prices to offset the raw material increases. Conversely, when prices are falling, the company with the long-term contract may be at a disadvantage to the company that buys on the spot market. China/Asia - The burgeoning chemical industry in China and elsewhere in Asia is having a significant impact on much of the U.S. chemical industry and correspondingly, on many U.S. chemical businesses that are for sale. In the raw material context, many companies are finding today that raw materials sourced out of China and other parts of Asia are significantly lower in price and of equivalent or better quality to raw materials previously sourced in the U.S. This is an important subject of due diligence today for many buyers of chemical businesses. A strong position with foreign sources of supply can be very important, and woe may be to the company that does not have good contacts and sources in this part of the world. Captive sourcing - Many chemical companies are vertically-integrated, i.e. a key raw material may be produced captively and "sold" or "transferred" to another part of the same company. It is not uncommon for companies to divest only a part of a vertically integrated business, keeping the captive "supplier" and selling off the downstream "customer", or vice versa. Typically here the parties will want to continue this relationship on some kind of arms-length basis as part of the deal. In this context, the type of contract the parties come up with can be absolutely determinative of the success or failure of the acquired business. Alternatively, the valuation of the business can almost completely depend on the pricing of the raw material and length and other terms of the supply contract. The chemical industry is incestuous - In many ways, the
chemical industry is a small world unto itself. A company that is
a supplier to another company may also be a competitor to that company
in another segment of its business. It may even be a customer of
that company in a third segment. While theoretically one party in
a supplier/customer relationship may have leverage, the situation
may be reversed somewhere else in their respective businesses, either
as competitors or when the supplier/customer relationship is reversed.
When doing due diligence in the raw material context, or otherwise,
it is important to keep this bigger picture in mind. Will the dynamics
of these various relationships be affected if one of the businesses
is sold? |
