Discussing Specialty Chemicals with Andrew Lane and Seth Goldstein of Morningstar

In a recent post, I discussed why I think certain incumbents in the specialty chemicals space enjoy durable economic moats, and to build on that I am pleased to talk with Andrew Lane and Seth Goldstein, CFA who cover various segments of the specialty chemical sector for Morningstar.  Andrew focuses on companies in the nutrition, flavor, and fragrance industries, while Seth has a broader focus, including specialty chemicals companies in cleaning, agriculture, and lithium.

In this post we will explore some of the unique characteristics of these specialty chemicals companies and their end markets as well as discuss what has made them standouts from the broader chemicals sector and whether that is likely to continue.

LH for Andrew:  You cover the flavor, fragrance, and nutrition segments of the specialty chemicals space for Morningstar.  This seems to be a market segment in which the incumbent players enjoy very high customer switching costs.  Can you expand on this a little bit as far as why this is the case and whether you think this will persist?

Andrew:  Absolutely – in addition to intangible assets, switching costs are a key driver of economic profit generation across these sub-industries.  Flavor and fragrance companies provide specialized taste, texture, and aroma profiles for a wide variety of consumer products. If a customer were to switch suppliers, it would risk losing the highly specific characteristics a given flavor or fragrance solutions provides, potentially impairing its own brand equity. This is a particularly risky proposition for many CPG companies, given the substantial amount of their own capital they invest in building and marketing their brands. This concern, combined with the fact that flavor and fragrance solutions account for a very small portion of a given product’s unit costs of production (usually less than 2%), typically leads to sticky business relationships. Once a customer selects a specific taste, texture, or aroma solution, it is generally unwilling to switch suppliers on the basis of cost alone. The sophistication of flavor and fragrance products continues to increase as consumers demand less sugar, fat, and salt but are not willing to sacrifice taste. Typically, customers retain a flavor and fragrance provider as the sole supplier of custom flavor and fragrance solutions for the full life cycle of a given product. Accordingly, these types of companies are deeply ingrained in the supply chains of their customers, serving as key suppliers in the manufacture of well-established brands as well as development efforts for new products. Additionally, they serve this function while also maintaining control of the associated intellectual property, a key distinction that separates them from no-moat ingredients suppliers.

LH for Seth:  You cover a broader segment of specialty chemicals, including Ecolab in cleaning and Albemarle in lithium.  How would you describe the competitive landscape in these segments?  Do you think these companies also enjoy high customer switching costs and do you think they will persist?

Seth:  Our wide moat rating for Ecolab is underpinned by the high customer switching costs for its products and services. The company is able to save its customers expenses in excess of the additional cost for Ecolab’s premium cleaning products and water management technologies. These cost savings allow Ecolab to charge a higher price and maintain customers when competitors try to undercut Ecolab on price. In addition, Ecolab’s direct sales model allows the company to sell additional products and services that become an integral part of its customers operations. The more products and services that Ecolab is able to sell to a customer, the stronger its switching costs become as there is a fixed cost component to managing multiple suppliers that a customer would have to undertake in order to completely replace Ecolab. Ecolab is one of the highest quality companies under my coverage and I expect its competitive advantages will persist for decades into the future.

Albemarle’s competitive advantage in lithium stems from operating at two of the best resources globally. This allows the company to produce lithium at a much lower cost than nearly all other lithium producers in the world. As lithium demand grows from greater battery production used in electric vehicles and energy storage systems, new lithium supply will enter the market. However, when we look at nearly all of these new resources on an all-in sustaining cost basis, they have a higher production cost than lithium made from either of Albemarle’s two resources. As a result of the higher cost supply being needed to meet lithium demand, I expect lithium prices will rise over the next couple of years, which should boost Albemarle’s profits as the company expands its cost-advantaged production capacity.

Albemarle’s other two businesses, catalysts and bromine, also have sustainable competitive advantages that I expect to remain in place. The catalyst business benefits from switching costs as its catalysts are custom made for each refinery to allow a refiner to meet fuel specifications and increase yields per barrel of oil refined. The bromine business, similar to lithium, benefits from a unique resource that allows the company to produce bromine at a lower cost than nearly all other competitors globally.

LH:  The specialty chemicals space has been home to a lot of long-term ‘compounders’ such as Balchem in nutrition and Ecolab in cleaning.  How much of their long-term success is due to their competitive advantages in their niche industry versus serving an overall higher quality end market?

Andrew:  Balchem has enjoyed success stemming from the combination of intangible assets and switching costs that it enjoys across the niche markets that it serves. This has provided steady pricing power as volumes have grown. Balchem has also been successful pursuing disciplined, tuck-in acquisitions that synergize nicely with its legacy business lines.

Seth:  Ecolab’s excess returns stem from its strong customer switching costs, which allow the company significant pricing power versus its competitors. Ecolab’s success is due to the company’s focus on cleaning and sanitation and water management, which are critical parts of its customers business processes. Many of the company’s competitors compete on price, while Ecolab competes on total value to the customer, which gives the firm pricing power and allows it to fend off lower price competition.

LH:  In your respective coverage areas, how do you view the role of regulatory burdens as far as balancing an increased cost of doing business but also providing some insulation from competition by serving as a barrier to entry?

Andrew:  While stringent regulatory oversight can represent an intangible assets economic moat source that serves as a barrier to entry for would-be-competitors, it is a double-edged sword. As mentioned in the question, regulatory oversight can spur elevated compliance costs and keeps a company at the mercy of an always-changing regulatory landscape. However, while unexpected regulatory changes can cause value destruction, regulatory change often takes place in a more gradual manner. This typically allows companies subject to the underlying regulatory scrutiny to make necessary adjustments that satisfy regulators and limit an erosion of the company’s own profit streams.

Seth:  I agree with Andrew’s answer. I’ll also add that for specialty chemicals companies, regulation changes for their customers are also a double-edged sword for product demand. Regulation changes for the companies who buy specialty chemicals can create increased demand for newer products that are more environmentally friendly, or chemicals required for environmentally friendly technologies such as lithium used in electric vehicles. However, some chemicals can also be banned from use, which can destroy demand. This requires chemical producers to continually innovate their product lines based on changing customer demand.

LH:  How do you determine whether these companies are maintaining their competitive advantages and reduce or avoid the risk of having their products become more commoditized?

Andrew:  We like to say that today’s specialty products are tomorrow’s commodities. For example, high-fructose corn syrup was once a specialty product and is now undoubtedly considered a commodity. This is where R&D efforts become critical. To stay on the cutting edge of new product development, a company in the specialty chemicals space must ensure sufficient R&D reinvestment to facilitate innovation. However, a company can’t simply approve a massive R&D budget and expect to win new business.  The ROI of that R&D spend has to prove compelling.  Phrased differently, not all R&D dollars are created equal… some are far more productive than others.  Specialty companies we cover for which we’ve assigned the intangible assets moat source have typically enjoyed a favorable return on its R&D spend, thereby establishing key proprietary formulations that will drive cash flows for years to come.  This dynamic is not dissimilar to patents achieved by pharma and biotech companies.

LH:  It seems like these companies face limited risk of being disrupted by either new technologies or by foreign competitors.  Is that a fair assessment and what developments would change your view on that?

Seth:  Along the lines of what Andrew stated above, the risk of disruption from new technologies is a key risk that specialty chemicals producers face. However, for companies that are able to continuously develop the newest premium products and essentially disrupt themselves, we see less risk from the competition.

LH:  How can people get in touch with you (if you are ok with that) or read more of your analysis, etc?

Seth:  Readers can sign up for a subscription to our analysis at www.morningstar.com/products/research.


At time of publication, the author does not hold positions in any securities mentioned, though select clients of Fortune Financial Advisors, LLC, hold Albemarle.