Strategic Choices for ABC Chemicals

Tony King, the global President of ABC Chemicals, was contemplating the future of the business.
ABC Chemicals was in the business of Polyurethane (PU) Chemicals and had been running very
successfully for more than 60 years. The business had been part of a European company called
English PLC, a pioneer for many chemical technologies including some man-made fibers and
synthetic yarns. Along with Old Chemical Company, it was also a pioneer in Polyurethane (PU)
chemicals, a highly versatile material. The business was acquired by ABC Corporation of the US
around the turn of the century.

ABC Corporation, a US headquartered global company, was started by Mr. Robert Punter in 1970
as a small chemical business. Up until the late 1990s, the company grew mainly through
leveraged acquisitions within North American region. Mr. Punter had a reputation for buying
businesses cheap during industry down cycle and then reaping the benefits during the industry
upcycle. Around the turn of the century, the company acquired the Polyurethanes (PU) business
and few smaller businesses from English PLC. The acquisition turned ABC Corporation from a
regional company to a global company with operations in more than 40 countries spread across
all major regions of the world. ABC Chemicals, became the largest business of ABC Corporation
contributing to about 40% of the group sales and about half of the profits. The acquisitions, while
doubling the topline of ABC Corporation, put pressure on the capital structure of the company as
its debt servicing requirements increased substantially.

In the next industry down cycle in 2002-03, ABC Corporation found it difficult to service the debt.
Punter family had to get cash infusion from a private investor by parting significant shareholding
at quite a low share price, to save the company from becoming bankrupt. The industry cycle
improved from 2004 onwards. With financial performance improving, ABC Corporation decided
to improve its capital structure with an IPO on the New York stock exchange. The IPO was
successful and allowed company to reduce its debt and improve the capital structure. With the
share price looking reasonably good, the private investor who had earlier infused capital, cashed
out soon after.

The stock exchange listing also brought various SEC requirements to be fulfilled by ABC
Corporation. Like all listed companies, the company’s stock price got linked to quarterly
performance, the guidance for next 1-2 years including its strategy and investment plans. The
company also had to be careful about its cash flow situation and capital structure to withstand any
industry downcycles.

Since the ownership change of the business about 15 years ago, Tony had seen competition in
the business change quite dramatically. A Chinese entrant and the possibility of technology
licensing by an Asian player was threatening to change the oligopolistic structure of MDI based
PU industry. It was also evident that investing billions of dollars in new plant capacity every 5-6
years, as was done by English PLC, will not be possible due to a more leveraged capital structure
of ABC Corporation. Tony was thinking what products, end markets and industry value-chain
activities should ABC Chemicals participate in going forward.
The Polyurethane (PU) products and end-markets

Global PU market was estimated to be around USD 50 billion in 2015 with growth rates around
1.4-1.5 times GDP growth rates.

Polyurethane is made by mixing two chemicals, one from the Isocyanate group and the other from
the Polyol group (Refer to Annexure-1). Isocyanates and polyols are made of many varieties. In
Polyurethane products, more than 90% of the Isocyanate products consist of two basic varieties
of Isocyanates, MDI and TDI. Most of the polyol used was of the polyether polyol variety. A
Polyurethane customer would buy two components, one isocyanate and one polyol formulation,
mix them with controlled conditions (temperature, pressure and ratios of the two components),
and pour the mixed liquid chemicals in a fixed shape mold or cavity, where the mixed chemicals
would convert into solid within a few minutes.

Within the three main product types, MDI has been the fastest growing due to its continuing ability
to replace traditional materials such as rubber, wood, glass wool etc. (Refer to Annexure-2). MDI
growth is estimated at 1.6-1.7 times GDP growth rates whereas TDI growth is around 1.1-1.15
times GDP growth rates. While MDI is used in all the above applications, TDI can only be used in
comfort foams and non-foaming applications. Besides TDI also finds a large application in
mattresses and bedding industry where MDI has very limited use. As polyols are the other side
of the two component PU system, their growth rates are dependent on MDI and TDI applications.
It is anticipated that their growth rates are around 1.3-1.4 times GDP rates.

Due to the versatile properties of PU, it is used in a variety of industries and applications.
Polyurethane chemicals can be broadly divided into following applications and industries (Refer to
annexure-2):

i) Rigid thermal insulation foam for refrigerators and freezers

ii) Rigid thermal insulation foam for cold stores, temperature-controlled buildings, industrial
fluid pipelines and storage tanks etc.
iii) Flexible comfort foam for automotive and furniture seating
iv) Flexible comfort foam for mattresses
v) Binding resin for composite wood products such as OSB, MDF and particle board
vi) Rubber-like foam for footwear soles
vii) Intermediate chemicals for specialized coatings, adhesives and other non-foaming
applications in many industries

In all these end-markets, the growth of PU depends on growth of end industries and on the ability
of PU to substitute other materials in the market applications. For example, in footwear
applications, data suggests that only about 7-8% of global footwear production uses PU as a
soling material. However due to its light weight and high-performance features, PU has been
gradually going up in the penetration in this application. That means PU in footwear can grow (a)
on the back of growth of footwear production, (b) due to increase in % of footwear being produced
with PU as the soling material.
Thermal insulation in buildings is expected to have high growth in future mainly due to concerns on
energy security which in turn was leading to energy conservation legislation mainly in developed
countries. Energy efficiency regulations had been largely adopted in the US, EU and Japan for
industrial and commercial buildings. Now the focus was shifting to residential buildings. In the last
decade, even Chinese Government had been driving towards energy efficient buildings. Due to such
regulations, building code experts had introduced (a) greater use of thermal insulation in buildings and
(b) use of more efficient thermal insulation materials. All of these factors are very favorable to growth
for PU, particularly MDI and polyols.

The wood binding applications were also seeing good growth as composite wood products help in
reducing deforestation (composite wood products use less wood than full wood or plywood).
Composite wood products include OSB (Oriented Strand Board), MDF (Medium Density Fiberboard),
Particle board etc. These boards are used as structural wood and in interiors for home construction
and furniture.

Automotive and refrigerator applications were undergoing modest growth. In refrigerators, PU is used
as the thermal insulation material in the cabinet and doors to keep the refrigerator insulated from
external environment. As PU is already being used in all the refrigerators being produced, therefore
there is no possibility for growth due to substitution of other materials. Growth primarily depends on
growth of refrigerator production growth.

In automotive, PU is used as comfort foam in seats, seat backs and head rests. For these applications,
PU has already achieved 100% penetration. PU is also used in other applications in cars such as
steering wheel, gear knob, carpet underlay, roof liners etc. However, the use of PU in these
applications is more in higher end cars and less in lower end cars. So, the growth of PU is driven by
growth in car production and to a smaller degree due to substitution of other materials by PU in non-
seating applications. PU is also used in seating application in other vehicles such as motorbikes,
scooters, bicycles, commercial vehicles, bus coaches, train coaches etc. The car manufacturers have
stringent quality requirements and expect suppliers to invest in long term product development effort
for new vehicle models to be launched under confidentiality and exclusivity arrangements. But once
established, they do not change their suppliers very easily.

In footwear application, PU is used in only about 8% of footwear as the soling material. This is primarily
due to the fact that PU is a relatively more expensive material compared to most other soling materials.
Improved purchasing power of consumers over the years has increased the use of PU to around 10%
from a much lower percentage. The customer needs are quite varied in footwear. For example, the
ladies fashion segment of the market needed customizations in quick time as the designs changed
every year. Every design change would require modifications in the PU formulation. On the other hand,
men’s formal shoes and sports shoes required high performance. Similarly, the safety shoes (used for
industrial and institutional market) market demanded high performance with special features such as
chemical resistance.

The non-foaming applications in coatings and adhesives have slightly better than GDP growth rates
driven by substitution of traditional materials and superior properties of PU in selected applications.
The applications require a diverse range of MDI products and polyol formulation. Though the quantities
required by individual customers is not very large but the diversity of coating and adhesive applications
requires a diverse range of MDI products.
Value Chain and Differentiation

Both MDI and TDI are intermediate products in the chemical industry. The manufacture of both
TDI and MDI requires main petrochemical feedstock (Toluene and benzene respectively),
supplied by large petrochemical companies (Refer to Annexure-3). Typical investment for a world
scale MDI or TDI plant is close to USD 1 billion. Between the two main isocyanates, TDI is sold
and used, mainly, as one product grade. On the other hand, roughly half of MDI is sold as one
product grade, the other half is sold in hundreds of grades as a lot of customization is possible for
MDI depending on the end application and properties desired.

The base polyether polyols are broadly of 15-20 varieties. However, these polyols are further
converted into thousands of customized polyol formulations by adding various ingredients. Polyol
formulations are ready-to-mix products by end customers. In brief, while customization (and
hence differentiation) is highly limited with TDI, MDI customization can take place in several
different ways. Polyols and polyol formulations can also be customized in most of the applications.

The supplies of PU chemicals were done in two manners by PU chemical suppliers. In the first
case, suppliers would supply the Isocyanate (MDI or TDI) separately and polyol or polyol
formulation separately. The meant that customers were free to buy polyol from a different supplier
and Isocyanate from a different supplier. Such a supply would be called a “component” supply.
Whereas the other method involved supplies of a customized MDI along with the corresponding
polyol formulation (in the required proportions of mixing) to the customer. Such a supply was
called “System” supply. For such supplies, customers would not be able to source polyol from
one supplier and isocyanate from a different supplier. Typically, applications in automotive and
footwear would fall in that category.

Polyol costs are controlled by Propylene Oxide (PO), the main raw material for polyether polyols.
Polyol manufacturers who were not backward integrated into Propylene Oxide had uncertain
control over PO supply security and cost. Punter had acquired a propylene oxide manufacturing
unit and was self-sufficient in its PO needs. However, over the years its polyol capacity was
becoming inadequate as it had not invested in polyol capacity for many years. Typical capital
costs for a world scale PO plant were in excess of USD 1 billion whereas polyol plants needed
investments to the tune of USD 100 million. Polyol formulation plants could be put up for
investments ranging from USD 10 to 25 million.

From market sector point of view, over the years, the refrigerators market had become
undifferentiated along with the composite wood products market. The cold chain market and other
thermal insulation applications had a mixed bag of differentiated and undifferentiated markets.
Automotive and footwear also offered opportunities for customization as each OEM or brand
owner has its own specifications and hence requires different material specification for each of
their models. In the Composite Wood Products (CWP)) applications too, there were few
possibilities of differentiation, mainly from a service perspective.
Competition

ABC Chemicals was one of the four leading global manufacturers of Polyurethane (PU)
Chemicals in the world. The other global competitors were “The Big Chemical Company”, “The
Old Chemical Company” from Germany and “The Yankee Chemical Company” from USA. In
addition to these global players, there were other regional players in Asia and Europe. Most of
these regional players were limited to one or two of the three main PU product groups (MDI, TDI
and Polyols). ABC Chemicals’ main product mix had significantly high focus on MDI with much
smaller manufacturing capacity for polyols and no manufacturing capacity for TDI (Refer to
Annexure-4). In a clear departure from what other global PU companies were doing, the erstwhile
British company and ABC Chemicals had strategically decided to exit TDI business in mid 1990s.
Instead, they focused on MDI based PU business by investing in MDI capacity and supporting
that by minimum but essential investments in polyols & polyol formulations to support their
differentiated systems sales. The strategy had so far paid-off well by generating good returns over
the industry cycle.

MDI manufacturing technology worldwide was limited to only six manufacturers; four global, one
Japanese and one Korean company. However, since the turn of the century, competitive
landscape changed with the entry of a Chinese company called Wenbao. The company
developed its own MDI manufacturing technology and very quickly built-up the manufacturing
capacity to match the big four. The rapid growth of Chinese MDI market also helped them to
increase and fill-up their capacity quickly. Wenbao used economies of scale and presence in the
largest and fastest growing market in the world to become a cost leader. Gradually Wenbao also
started to build its presence by selling its products in other geographies in the world. But Wenbao’s
abilities in international (outside China) manufacturing and in differentiated products (MDI variants
and polyol formulations) were unproven.

Traditionally ABC Chemicals had played at both ends of the MDI market. Cost leadership with
world scale plants and process technology in upstream MDI manufacturing, as well as driving
differentiation through its product technology and customized solution approach in downstream
applications. The company was particularly known for its ability to work with customers to help
them develop customized solutions for their market. Some examples of these customized
solutions included Nike Shox for basketball shoes (2000 Sidney Olympics), spray foam for “Bird’s
nest” (2008 Beijing Olympics), spray foam thermal insulation for single family wooden homes in
Japan in the aftermath of 2011 Tsunami.

Issues to be addressed

The leading position enjoyed by ABC Chemicals in MDI related PU market was coming under
pressure as Wenbao continued to put pressure on pricing and margins, especially in more price
sensitive and component markets. Pursuing a MDI market share driven strategy also required the
MDI manufacturers to invest large capital every 5-6 years. ABC Chemicals had also not invested
in its base polyol capacity for a long time. This had led to a situation where ABC Chemicals had
to start sourcing some of its growing polyol requirements, for system sales, from other polyol
suppliers. This was not a great situation to be in, as polyol formulations were a significant part of
ABC Chemicals’ strategy of differentiating itself through system sales (MDI variants along with
polyol formulations).

The business leadership team had been communicated by the corporation that it would not be
investing such large capital every 5-6 years in MDI manufacturing plants. With the changing
landscape and the capital constraints, the business leadership team had to decide

1. What product balance should it pursue in the future (MDI, TDI, PO and Polyol)?
2. Which applications should ABC Chemicals focus on?
3. Where in the value chain should ABC Chemicals compete? Should ABC Chemicals
continue to drive market leadership in MDI manufacturing or should it focus on
downstream applications?
4. How could the business fund the MDI capacity expansions, if any?

Annexure -1

How are Polyurethanes Made

Isocyanate
Polymeric MDI Polyol Formulation
Pure MDI Base Polyether or Polyester
MDI Variants +
MDI Mixed Isomers Additives
TDI

Polyurethane
Rigid Foam
Flexible Foam
Elastomeric (Rubber-like) Foam
Non-foam PU, eg., Adhesives
Thermoplastic Urethanes (TPU)
 Type of PU Demand Demand Product split Number of Customer Customer Threat of
Industry Growth drivers
application 2010 (kt) Growth MDI TDI Polyol Additives applications size needs substitutes
Thermal Construction growth, Substitution due Low to
Construction 3130 2.4 53% 0% 36% 11% Many Mixed Diverse
insulation to Energy legislation, energy savings medium
Thermal Refrigerator growth, no substitution
Refrigerators 1410 1 53% 0% 36% 11% One Large Same Low
insulation potential
Automotive growth, substitution in non- Low to
Comfort Foam Automotive 2000 1.1 16% 25% 54% 5% Many Large Diverse
seating applications medium
Growth of modern high-end office and Low Low to
Comfort Foam Furniture 1500 1.2 8% 22% 65% 5% Few Mixed
home furniture, substitution Diversity medium
Annexure-2

Mattresses & Growth of bedding market, Low

Bedding 1000 1.2 4% 26% 65% 5% Few Mixed Medium
pillows substitution due to superior comfort Diversity
Rubber-like Footwear growth, substitution due to
Footwear 676 1.2 32% 0% 63% 5% Many Mixed Diverse Medium
foam light weight and superior performance
Wood conservation, substitution Medium to Low
Wood binding CWP 480 1.8 90% 5% 0% 5% Few Medium
driven by superior interior air quality large Diversity
Others Various 2600 1.1 Superior performance 30% 25% 40% 5% Many Mixed Diverse Medium
 Annexure-3

PU Chemicals Value Chain

pMDI Seat foam,

Benzene
Natural Gas Aniline MDI Variants footwear
H2, Cl2, CO2 soles,
Pure MDI Mattress
foam,
Propylene Propylene Polyether Polyol
Formulation Thermal
Oxide (PO) Polyol
Polyether insulation
Polyols foam,
Toluene adhesives,
Natural Gas TDI coatings
H2, Cl2, CO2 Annexure-3

Customization
Capital intensity

Annexure-4

ABC
Chemicals

Yankee
Chemical Co.

Big Chemical
Co.

Old Chemical
Co.
Polyurethanes Applications
Wenbao

0% 20% 40% 60% 80% 100%

MDI TDI Polyol PO
 Annexure-5

110

100
MDI
Average margins over the cycle

90
TDI PO

80

Polyols
70

60

Size of the bubble indicates size of the market

50

40
3% 4% 5% 6% 7% 8%
Average volume Growth Rate %