Chemical Companies Are Going Vertical

Even if they are pure plays

Hey there, welcome to a special edition of the newsletter that I publish four times a year—chemical industry quarterly update. The naming of this issue is still a work in progress, but while the name isn’t creative it gets the point across that I’m writing about the current state of the chemical industry, which at times is like trying to write about the ocean.

Big, deep, and complex are some words that come to mind if I was just going to write this in a few words, but there are better stories between the stories that exist out there in press releases and quarterly earnings calls (yes, earnings calls are stories told by executive leadership teams) that I want to try and write about here. This is all mostly me cherry picking some interesting facts that I come across and thinking about the broader moves going on and where I think the chemical industry is headed.

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Q4 2021 earnings are coming in and while I’m not reading every transcript or listening to all the calls I’ve noticed this trend of inflation continues to occur. For very downstream players (close to regular consumers) higher prices are really influencing margins while for those who are further upstream (closer to oil) there is pricing power and an ability to capture margin. Companies like Sabic, which has some vertical integration through Aramco, posted massive gains in both revenue and EBITDA:

revenue for the fourth quarter of 2021 reached SAR 51.28 billion )$ 13.67 billion(, an increase of 17% compared with the third quarter of 2021, and a 56% increase year-on-year.

Further, Sabic made some advances in a sustainability agenda such as circular methanol (from waste) and bio-based polyetherimides (Ultem, the old GE business), which also received International Sustainability and Carbon Certification. Sabic is a good example of how a vertically integrated chemical company firing on all cylinders can really leverage their cash to “invest for the future.”

Meanwhile, a company like Sherwin-Williams started their Q4 call off talking about inflation and supply chain disruption.

“Our full year and fourth quarter were marked by industry-wide supply chain disruptions, unprecedented cost inflation and ongoing challenges related to the pandemic,” said Chairman, President and Chief Executive Officer, John G. Morikis.

Sherwin-Williams posted net losses in profitability for 2021 compared to 2020 for the majority of their business. I wrote back in the first half of 2021 that most companies were capturing record profits due to record demand. Price increases were flooding the market as capacity was being slowly ramped back up due to a record winter storm in Texas. Companies that are closest to the consumer absorb these price increases until they can pass those costs to their customers which started to occur back in December 2021 and is still on-going. 

If we look at an upstream chemical company such as Dow we can see YoY growth and profitability. Granted 2020 is a unique year to compare to, but here is the first slide of Dow’s Q4 earnings call:

Dow’s business is commoditized chemicals after the DowDuPont split (DuPont got the specialty business) and Dow’s proximity to oil and gas feedstocks has enabled them to have excellent YoY growth in both revenue and margin. Dow continues to generate cash and raise prices, which they to return to shareholders and advance their ESG goals such as their “Net-Zero” cracker in Alberta, Canada. 

Axalta Coatings Systems (yes, I’m on a coatings kick here) had similar news to Sherwin-Williams with their most recent investor presentation. Inflation has hurt their business significantly with a 41.4% reduction in EBIT when compared to 2020 and headwinds at the customers with the computer chip shortage hindering car construction. Axalta reported a 15% raw material inflation for 2021 and 24% in December of 2021 alone.

The higher up the value chain the company is I suspect profits and revenue will be a picturesque story. The further down the value chain the company is I suspect profits to have eroded even if top line revenue has grown significantly or hit new company records. These downstream companies are still absorbing the price increases from their suppliers and it is just a matter of time till those companies pass through those costs to their consumers.

I suspect CPI inflation to keep ripping upwards for at least Q1 2022. From my view here in chemicals I suspect that everyday things such as paint given my examples is going to keep going up as companies pass through cost increases to each other. Perhaps inflation tapers down a bit as demand slows due to both price increases and interest rate increases from the federal reserve. 

The Case For Vertical

If my conclusion at the end of 2021 was that the chemical conglomerate was dead I suspect that vertical integration of supply chains will be the future for 2022 and beyond. There is already some evidence of this occurring such as Bostik (an Arkema company) acquiring Edge Adhesive and Prochimir in 2021. These two acquisitions would enable Bostik to potentially start competing with some of their customers by enabling them to enter downstream markets. Since Bostik is also owned by Arkema there is some nice vertical integration of Arkema’s 

A similar situation would be if a company such as Axalta or Sherwin-Williams were to go out and acquire their upstream suppliers. Sherwin-Williams is already starting to show signs of this with their proposed acquisition of a Specialty Polymer Inc at the end of 2021: 

Sherwin-Williams also today announced another key step in positioning the Company to better serve customers by signing an agreement to acquire Specialty Polymers, Inc., a leading manufacturer and developer primarily of water-based polymers used in architectural and industrial coatings and other applications. The transaction is expected to close by the end of 2021.

I suspect as we get further into 2022 these “pure play” companies will seek to integrate their supply chains in an effort to cut costs or upgrade commodity products to become specialties. Huntsman is trying to do this with their commodities business as they move downstream towards becoming formulators. Bostik is moving downstream towards their traditional customers and Sherwin-Williams is buying their suppliers upstream.

I caution companies seeking to vertically integrate. I suspect internal quality of product will decline and overall product quality will decline as a result. Further, the volume that is being demanded is going to decline in the next few years. Right now it feels like no one has available capacity and we are all running flat out to catch up. What happens when demand slows and there is a significant amount of internal capacity that cannot be filled by these vertically integrated companies?

Tony