C&EN feature
Chemical Industry's Problem:
SLOWING PROFITS A look at the past suggests an answer for the future
DR. ROLAND P. SOULE, Irving Trust Co., New York, N.Y. It is no news that the chemical industry's investment appeal has declined notably in the last decade. Leading chemical stocks still command a loyal following, but they have lost the halo that once adorned them. What adverse trends have caused these misgivings? How can management give new impetus to slowing profits? A look at the industry in long perspective suggests the cause of some of its basic difficulties as well as a possible remedy. But the latter may involve abandoning a long cherished management principle. Stock market interest is always greatest in industries that are growing the fastest. These are usually the ones that are benefiting from the newest developments in technology. The various branches of technology have not advanced with equal speed at all times. Each had its own period of ascendancy and then was superseded by some other branch. Thus, the last 100 years in this country saw the successive rise of five types of technology: 1860-80. Civil engineering period. This was the first type of engineering to be distinguished from military en100
C & E N AUG. 14, 1961
gineering. The West was being opened up, and the railroads were rising toward the peak of their importance. 1880-1900. Electrical engineering period. This was the era of Bell and the telephone, Edison and the electric light, and Hall and aluminum. 1900-20. Mechanical engineering period. These were years when the automobile and the airplane were coming into their own. Mechanization of manufacturing operations and the concept of mass production were taking hold. 1920-40. Chemical engineering period. Many formerly imported chemicals were manufactured here for the first time. Our organic chemical industry was born. Scientific methods were injected into such old arts as petroleum refining, nonferrous metallurgy, and glass, paper, and rubber manufacturing. 1940-60. Electronic engineering period. This period saw the emergence of radar and guided missiles in World War II, and of television, computers, and data processing machines.
These ascendancies were clearly reflected in the stock market. The work of the civil engineer resulted in the rise of the railroads, and in 1890 they accounted for most stocks and bonds listed on the New York Stock Exchange. In the wake of the electrical engineer followed stocks such as Western Union, American Telephone & Telegraph, and General Electric. These were among the market leaders around the turn of the century. The mechanical engineer was behind the great increase in the average manufacturing company's unit size, which occurred in the period after 1900. Bigger size resulted in public ownership. And by 1920 the newly created group of industrial stocks far outranked the rails in total market value. The chemical engineer's work was seen in a sharp rise in chemical stocks after World War I, placing them first in dollar value among the industrials. And finally, the electronics engineer became responsible for some of the most spectacular market performers of recent years. Witness the billion dollar market value of Texas Instruments, the components producer. And then
MATURITY VS. GROWTH. Investors still consider chemicals to be among the better investment opportunities. But for those seeking investment with growth opportunity, stocks of
there's International Business Machines, the systems manufacturer, with a market value of over $10 billion— slightly more than that of the country's biggest oil company, Standard Oil of New Jersey. Thus, the strong tail wind of technological innovation that once blew chemical firms along so briskly has changed direction. But what of the future? Will some new field, such as nuclear engineering, dominate the next 20 years to the further disadvantage of the older arts? Possibly, but a reading of the record indicates more strongly that no longer can any single branch tower above the overall field of technology. Instead, the coming years may be marked by a trend long in the making. That is, we may witness the further breaking down of those barriers that still exist between the present engineering arts. Chemistry and physics, once considered separate sciences, crossed their common boundary long ago. They united most dramatically in the atomic bomb and the new field of nucleonics. Also, long range missiles would have been impossible without close collaboration among the mechanical engineer for structural design,
smaller chemical companies trading over the counter offer more than those of big companies listed on the major exchanges even though the risk of loss is greater
the metallurgist for alloys, the chemical engineer for fuels, and the electronics engineer for controls. Some progress in this combining of technologies has been made in peacetime applications, but much more can be done. Here lies great opportunity for chemical management. Projecting past trends suggests strongly that companies leading in the future will be those that rely less on chemical engineering alone and more on a combination of many engineering arts. New Direction for
Research
Attempts have been made to maintain earlier profit growth rates by increased spending in chemical research. The basic concept is sound. The industry would be badly situated indeed without the new products of recent years. But too often have new products gained at the expense of the old, with the result being change rather than growth. Sales have increased only moderately, and profits even less. Technological obsolescence has become more rapid. And the typical life span of a product from high-profit specialty to low-profit staple has been shortened.
The suspicion arises, then, that the shortcoming of the chemical industry's research in the past 20 years was not its magnitude, but its direction. Two long-term trends in over-all industry, one technical and the other commercial, suggest a new direction for research. Chemical management might be wise to give these some thought. The first trend is very simple. It is away from products made from any single material—wood, metal, paper, and plastics—and toward products combining several different materials. Each material in the product best serves its own particular function so as to give highest quality at least cost. The second trend results from the first. It is a continuing rise in commercial importance of the fabricator relative to the producer. For example, in 1920 U.S. Steel Corp. had over four times the assets and nearly four times the earnings of General Motors. But in 1959 General Motors, with no stake in steel, rubber, glass, or aluminum, had nearly 10 times the assets and over three times the earnings of U.S. Steel. The rapid growth in total industrial research spending in the past 20 years AUG. 14, 1 9 6 1 C&EN
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was due largely to increased research activity by fabricating firms. Thus, in 1958, makers of aircraft, electrical items, motor vehicles, machinery, in struments, and other fabricated prod ucts accounted for over 80% of total research and development spending by industry. The remainder was spent by producers of chemicals, pe troleum products, primary metals, rubber, foods, paper, glass, stone, and clay. Neither the new raw materials of recent years—titanium, lithium, boron, and the much publicized exotic metals —nor new semimanufactured items such as glass fiber had repercussions on the stock market to compare with those of certain new manufactured products. Witness Polaroid Corp., which so successfully wedded chemis try with physics and attained a market value in excess of $1 million within the past year. Chemical firms have been slow in following over-all industry toward greater emphasis on composite con struction in technological effort.
Chemical research is still mainly con cerned with adaptation—with develop ing new products from chemical raw materials and finding new markets for the products. Formerly this was all well and good. The industry could rely on expanding sales of semifinished materials for its continued growth. But increased competition has shrunk the profit margin in such materials. And the industry must look increas ingly to more specialized products to restore its former attractive earnings picture. To the extent that such products are of a fabricated nature, so is a tech nology of adaptation less suitable. Only by coincidence would a fabri cated product made of chemical raw materials alone be both best and cheapest in its own market. Obvi ously, better end products.can be de vised by research men not committed to greatest use of their employer's ex isting raw materials. They should be free to choose from among the raw materials of other firms. The chemical industry is subject not
NEW MARKET FOR PLASTICS? Little research is done on building materials by the builders themselves, who express willingness to use better or cheaper products offered them. Such products might be of composite design, mak ing use of plastics and many other materials. Success in providing them will not only require use of varied engineering arts, but also management skills in dealing with craft unions and city governments 102
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only to those basic trends affecting all industry; it also follows certain trends peculiar to itself. It is, of course, no industry at all in a true economic sense. It cannot be defined, like the steel and copper industries, as a group of companies making a common prod uct. Nor can it be defined, like the office equipment and building ma terials industries, as a group of com panies serving a common market. The only bond tying chemical firms together is a common use of manu facturing processes that are chemical. The result is the least homogeneous of all industries. Each firm represents a different combination of products and markets. Some combinations, not so well suited as others to meet changing conditions, do not fare so well as others for reasons beyond management control. Hence, generalization on the ills and possible cures of the over-all chemical industry is subject to many exceptions in indi vidual companies. The manner of the chemical indus try's past growth is also unique. Much of this was at the expense of other industries that it invaded and, in some cases, even absorbed. This ability to expand by a somewhat cannibalistic process, even in years of poor growth for all industry, became one of the chemical industry's greatest charms for investors. It was a prinicpal reason for the high prices reached by chemical stocks and their important role in the industry's extraordinary performance after the start of the chemical engi neering era in 1920. In 1920 the chemical industry was weighted heavily by inorganics. Or ganic chemicals at the time were chiefly those derived from coal tar. The only production that could be called "petrochemical" was carbon black from natural gas. Yet from this modest start the industry expanded steadily in scope, and it greatly in creased production in almost every line. The Bureau of the Census defines the scope in its Code 28 classification as comprising not only inorganic and organic compounds and other primary chemicals. It also includes a so-called "chemical products" group. This cov ers drugs and medicines, soap and de tergents, paints and protective coat ings, naval stores, fertilizers', vegetable and animal oils, insecticides and fungi cides, toilet preparations, printing ink, and a small group of miscellaneous items.
As thus defined, the chemical industry's growth in physical units was 25Vc faster than all industry from 1930 to 1940. From 1940 to 1950 it was 56% faster, and from 1950 to 1959 it was 119% faster. But chemical prices failed to rise as much as other prices. Some actually declined. The result was that chemical sales in dollars over the entire period grew only about 40% faster than other sales. Expressed otherwise, the chemical industry accounted for about 6% of all manufacturing sales 30 years ago and about 8% in 1959. Yet at the end of 1959 the market value of Code 28 chemical stocks listed on the New York Stock Exchange was nearly $49 billion. This was 2 3 % of the total for all manufacturing companies. This high proportion of market value relative to dollar sales resulted from two features long characteristic of the chemical industry. First, higher than average profit margins enabled it to produce in 1959 about 13%? of total manufacturing profits, compared with only 87c of sales. Next, stocks of the largest chemical companies commanded higher than average prices relative to their earnings. The market action of these big companies, such as Du Pont, Union Carbide, Allied Chemical, Dow, Monsanto, American Cyanamid, and Hercules, heavily weighted the industry averages. Thus, in 1959 these seven firms alone accounted for nearly a quarter of the sales of the entire chemical industry. And the combined market value of their stocks was about half the total for the nearly 100 chemical companies listed on the Exchange. A principal cause of a high price-toearnings ratio is, of course, a high rate of growth. Between 1940 and 1959, sales of these seven firms increased a third faster than the over-all chemical industry, and all of the gain occurred before 1950. Rates of growth of individual firms and of the industry's divisions varied widely, reflecting its basic lack of homogeneity. Sales of primary chemicals rose more than those of chemical products. Among primary chemicals, organics grew much faster than inorganics. The 1920 relationship was entirely reversed, with organics growing to about 70% of the total dollar value. Within the organic group, cyclic chemicals were far outrun by the straight-chain hydrocarbons derived largely from petroleum and natural gas. Organic chemistry's main end products used to
be dyes, intermediates, and explosives; now they are synthetic fibers, synthetic rubber, and plastics. Until recently synthetic fibers ranked first in importance in the entire industry. Now plastics lead, both in dollar value and in apparent promise of continued growth. The rise of petrochemicals—raw materials and intermediates originating from petroleum and natural gas—was an outstanding phenomenon of the period. They probably accounted last year for 30% of the weight and 60% of the dollar value of all chemicals exclusive of chemical products. In Recent
Years, Slowing
Profits
The chemical industry's record of the last decade was above the average of all industry. Yet, from the investor's standpoint, that record was disappointing compared with the outstanding performance of the chemical industry in earlier years. Between 1950 and 1960 the seven biggest companies increased their gross operating
investments by an average of 2 2 1 % . But their sales expanded only 142% and their net profits 70%. And because they issued additional shares to finance their growth, earnings per common share rose by an average of only 42%. Obviously, the chemical industry lost many of the bulwarks of its high profit margins—restricted raw materials, secret processes, complex technology, and large capital needs to obtain competitive costs. Long the great invader of other industries, it was itself invaded. Some of the invasion came from foreign chemical companies, but more came from domestic firms not previously making chemical products. Some of the firms were in such improbable industries as meat packing, shipping, machinery, flour milling, and liquor. But the main invaders were the rubber and oil companies. Nearly every major U.S. oil refiner entered some part of the burgeoning petrochemical business. Four of them accounted in 1959 for more than
CHANGE IN PRODUCT POLICY. Instead of a policy of adaptation—developing new markets for its chemical intermediates and semifinished products— the company should look at consumer desires and develop new products to meet them. It should be prepared to combine other materials with its own, whatever the source. Then it should consider direct consumer sales under its own brand name, perhaps through its own sales organization AUG.
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Industrial Research & Development: Millions of Dollars
MATERIAL FABRICATORS
$2,498 1,947
Aircraft Elec. equip. & communication Wlotor vehicles & other transp. Machinery Instruments Drugs and medicines Fabricated metal products Other manufacturing industries
850 781 288 128 125 160 $6,777
Total fabricators Total fabricators Total producers
Source:
$6,777 1,467 $8,244
MATERIAL PRODUCERS Indl. and other chemicals Petroleum refining & extraction Primary metals Rubber Foods Stone, clay, and glass Paper Other nonmfg. industries Total producers
Millions of Dollars
$ 656
245 130 88 80 65 51 152 $1,467
82% 18 100%
National Science Foundation, "Reviews of Data on Research and Development," May 1960.
one tenth of petrochemical sales in this country. The oil firms were particularly formidable competitors. They .were producers of ethylene and propylene, two building blocks of the petrochemical industry; and the larger firms had research organizations as capable as almost any in the chemical industry. Moreover, complex technology was less of an obstacle even to smaller companies with only modest research facilities of their own. Contracting firms offered complete plants that would make them instantly and fully competitive in many operations with companies already in the field. And finally, the oil industry had great capital resources. Faced by a world-wide oversupply of petroleum that discouraged internal expansion, it turned eagerly to chemicals for new investment opportunity. Chemical products that were high in sales volume and profit margins particularly attracted the newcomers. As a result, many important specialty products underwent accelerated decline toward becoming staples, sold largely on a competitive basis. This transition from high profit specialty to low profit staple is nothing new in chemicals. The traditional answer has been to develop new specialties to replace the old. But increased competition is shortening the life span of many of them and lowering the return they can earn. What new synthetic fiber can be expected to fare as well in the 104
Fabricators Outspend Producers in 1958
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future as viscose rayon and nylon did in the past? The chemical industry is the biggest, and probably the last, of the socalled growth industries to expand largely through a technology of adaptation. It was able to cling so long and successfully to this policy because of the extraordinary versatility of certain of its products. Among inorganics, the elements most capable of conversion into a wide variety of salable compounds were chlorine and nitrogen. But carbon, of course, proved to be the most versatile of all in number and range of its marketable compounds. This, plus its low cost in the form of petroleum and natural gas, provided a main driving force behind the chemical industry's expansion in the past 30 years. But even petrochemicals are no longer expanding so rapidly. Their growth rate in pounds was 157c from 1950 to 1955 and 11% from 1955 to 1960. For the next five years the rate is forecast at less than 9%. Continued concentration on a policy of adaptation, however susceptible to this technology the materials may be, must ultimately meet its own law of diminishing returns. As a result of these trends, investors now view the chemical industry with mixed feelings. On the favorable side, they continue to value the downside protection its great diversity of products and markets provides. And they are confident that, even if further slow-
ing in some product groups' earnings should occur, the industry's expansion on other fronts will more than offset the loss. Viewing it as a whole, therefore, they see more attractive investment opportunities in chemicals than in many other industries. But on the less favorable side, its investment ranking over other industries has narrowed. Leading chemical companies no longer command a 30 to 50% premium in price-to-earnings ratios over the average of Dow-Jones industrial stocks. In general, this margin has been cut in half and in some cases eliminated completely. A main reason for the decline is investor doubt that big chemical firms can regain their former fast growth rate. Increased diversity retards the movement of earnings not only downward, but upward as well. Too, increased size is a handicap. It is much harder for a billion dollar company to maintain a fast growth rate by adding new products than for a firm one tenth as large. The bigger and more diversified a company becomes, the more its growth rate tends to gravitate to the all-industry average. Hence, many investors seeking highest capital gains in the chemical industry now tend to forsake the large companies listed on the New York Stock Exchange. Instead, they place their bets on some of the smaller firms in the over-the-counter market. They look for youth rather than maturity. They hope to find a company that will grow as fast as a
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limited group of products can grow in a well favored section of the industry. Such investments are frankly speculative, of course, since youth not only offers more promise, but involves more risk. Remedy
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What can give new impetus to the chemical industry—more particularly to the bigger firms that make up such a large part of it? Obviously, they cannot be made smaller or less diversified to recover their lost youth. What is needed are wider profit margins and recapture of rates of return more characteristic of past performance. If this long view of the chemical industry's position relative to other industries suggests any one course of action, it is to move its emphasis away from adaptation and more toward independent design. That move would be a shift from its traditional position as mainly a producer of intermediates and semifinished goods. It would be a shift toward a new position as a fabricator of end products, many of them branded and directly sold in consumer markets. It would be a move toward composite construction and greater use of all engineering arts. In short, it would be a move in conformity with basic trends of long standing. Consider the current situation in plastics. This is the chemical industry's most important division, and it is believed by many to hold the greatest promise of growth. Most primary plastic materials in this country are made by about a dozen large companies. These sell to hundreds of smaller satellite companies, which make the plastic materials into their final form. One difficulty with the setup is that a satellite company sometimes integrates backward and starts manufacturing part or all of its own primary plastics. Thus, often the better a customer it becomes, the more likely the chemical firm is to lose it as a customer. But there is a far more basic difficulty. By and large, the satellite firms lack financial resources, knowThow, or disposition to develop and sell plastic end products to the fullest possible extent. Obviously, it is not easy for a chemical firm to decide to go into the business of making end products based on its own materials. First, there is that long-cherished management principle
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expressed by the hoary shibboleth, "Don't compete with your own customer." The obvious answer here is don't do it unless new business to be won promises to more than offset the old business lost. And this could mean don't do it if you must enter a field already dominated by large and successful companies. Secondly, the new end product may also use raw materials made by others. The answer to this may lie in organizing a new company to be owned jointly with the other manufacturer. Finally, the new product may require selling outlets and merchandising know-how entirely lacking in the chemical firm. While these are not readily available, they can often be acquired on the outside as already demonstrated by the experience of others. Developing a new business of this type is likely to be a slow and difficult job. But the potential rewards are great. Benefits of a consumer franchise are usually reflected in higher and more stable profit margins. Branded end products are far less vulnerable than staples both to price com-
what tips the balance in your favor?
DR. ROLAND P. SOULE is a con-
sultant and former vice president in charge of research and planning at Irving Trust Co. He is BACHRACH
also
a
director
and former vice president of American Machine ir Foundry Co., and a director of International Cigar Machinery Co., Breskin Publications, and Modern Packaging Corp. He is a member of the advisory committees of Boston Capital Corp. and New York University's research division, as well as a former trustee, vice president, and chairman of the finance committee of the Chemists Club. He lectures at Columbia University s school of engineering and is author of the chapter on business finance in McGraw-Hill's "Chemical Business Handbook." Dr. Soule received his B.S. from the University of Rochester in 1917, and then went on to obtain his Ch.E., A.M., and Ph.D. from Columbia University in 1920, 1921, and 1922, respectively. In addition to the Chemists Club, he is a member of ACS, AIChE, Phi Beta Kappa, Sigma Xi, Tau Beta Pi, and Phi Lambda Upsilon.
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BARIUM CYANIDE, TECHNICAL NICKEL CYANIDE NICKEL POTASSIUM CYANIDE
J Some of the many special chemicals we manufacture. •
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petition and to obsolescence. Witness the superior performance of Scott Pa per and Kimberly-Clark in the paper industry. And look at the merger of technologically vulnerable ethical drug firms with the makers of proprietaries to get the benefits of trade-marked specialties. Du Pont has long benefited from a product structure heavily weighted by consumer items and by a company name favorably known to the general public. Recognition of the value of a consumer-oriented subsidiary was shown when Union Carbide acquired Visking, Dow acquired Dobeckmun, and Cyanamid acquired Formica. Perhaps the outstanding example of a fabricator of consumer items is Min nesota Mining & Manufacturing Co. This concern began as a producer of silica granules for sandpaper and as phalt roofing. It has evolved into an organization with a genius for develop ing and marketing consumer items made from new combinations of raw materials. And the latter originate largely outside the company. Minne sota Mining stock now commands the highest price-to-earnings ratio in the chemical industry. In the past 20 years the stock has soared in market value to an amount almost equal to that of Union Carbide, which ranks second in the industry. A look at the past in long perspec tive is sometimes helpful in planning a course for the coming years. Thus, a remedy for the chemical industry's slowing profits may be found after a diagnosis of its present condition. The prescription in broadest outline is simple. Follow the precedent of the most successful industries, and con form with those basic trends that promise to continue most strongly in the future.
REPRINTS . . . . . . of this article are available at the following prices: One to nine copies—50 cents each 10 to 49 copies—15% discount 50 to 99 copies—20% discount Prices for larger quantities on request Address orders to Reprint Depart ment, ACS Applied Publications, 1155 16th St., N.W., Washington 6, D.C.
AUG.
14, 196 1 C & E N 109
