Covestro moves from expansion to consolidation mode

Interview article by Will Beacham

LONDON (ICIS)–After several years of rapid capacity expansion in markets, some of which have become oversupplied, German polycarbonate and polyurethanes producer Covestro is cutting back capital expenditure and focussing instead on reducing overheads and raising its profile among investors as the group emerges from the shadows of its former parent, Bayer.

The company’s initial public offering (IPO) took place in October 2015 at a time of stock market turmoil. The parent was forced to cut the price range of the shares, reducing the amount it wanted to raise from €2.5bn to €1.5bn. It also added an extra €1bn to its balance sheet to guarantee it made investment grade from the beginning.

Parent company Bayer still owns 69% of Covestro though the free float will gradually increase as it reduces its stake. The group is currently listed on the German MDAX index of medium-sized companies with the prospect of promotion to the main DAX index in the longer term. Around 250,000 to 500,000 shares are trading each day.

According to CEO, Patrick Thomas, the company is moving from expansion to consolidation mode. In an interview with ICIS he said: “We’ve been through a massive wave of expansion and are now reducing capex levels to below depreciation. We want 4-5 years of cash generation before we consider another major expansion as we have sufficient capacity for our foreseen growth.”

Capex is currently 4-5% of sales. Over a decade the group spent €7bn in capex and returned €3.4bn to Bayer, including the crisis years of 2008/9. In 2009 the division returned over €500m to Bayer.

Around 60% of its assets are 10 years old or less, “so we are in a different place to many of our competitors.”

The company is still completing some projects in China which are due onstream in 2016 and 2017. The group is the only major player expanding in polycarbonate (PC) with 200,000 tonnes/year at Caojing in China coming online in early 2016, as the market allows. This will take Covestro’s total PC capacity in China to around 400,000 tonnes/year in China by 2017/18. 

The group sells 60% of its PC in Asia with half of that going to China and as a heavily Asian-oriented business its HQ is in Shanghai.

Caojing has total investment of €3bn and includes 500,000 tonnes/year of methyl di-p-phenylene isocyanate (MDI)) and 250-300,000 tonnes/year of toluene diisocyanate (TDI) plus the supporting chlorine infrastructure as well as hexamethylene diisocyanate (HDI) with capacity of 500,000 tonnes/year, according to the ICIS Plants and Projects database.

Thomas says: “For 2016 we have enough capacity, we have good, growth markets and we can improve a lot of our cost structures by standing alone. For example we are looking at simplifying our legal structures. We had a lot of indirect costs which can be removed as we simplify our structures.”

Covestro reduced its number of legal entities from 120 to 70 on the first day of its existence. Around 150 remote workers spread across 26 countries, and representing €1.2bn in sales, are now managed centrally from a human resources centre in Switzerland.

Freed from the Bayer shackles, the company now has the ability to move faster. For example, Covestro was able to close an MDI plant in Brazil. Under Bayer, the decision had been complicated by concerns of the CropScience business which shared the site and they were worried the move would trigger a strike.  “Decision-making is much easier without these dependencies,” he says.

As a newly listed company Covestro executives spend around 80 days per year on investor relations activities such as one-to-one meetings. 

Thomas says that during 2015 the company was the best of its peer group in terms of growth. The group has one of the highest cash yields in the chemical industry. “

"Analysts look for a decent, stable dividend. It’s cyclical but it is a solid dividend payment.”

Now that Covestro is independent, the investment community may want to drill down deeper to better understand its operating units. They may find some surprises in what is sometimes perceived to be a community PC and PU producer.

Thomas highlights Covestro’s €2bn ingredients for coatings business which, he says, is stable and resilient with a 20-24% earnings before interest, tax, depreciation and amortization (EBITDA) margin year after year. It has 4,500 customers and 2,500 products which are mainly PU derivatives such as aliphatic isocyanates. It is relatively small in terms of volumes but operates on the back of Covestro’s main MDI/TDI operations.

“Shared use of raw materials and technical expertise make it a perfect bolt-on to this business. It has a declared 47% market share in China and Germany.  These are stable, cash-generative and high margin – derivatives like these are not typically on the radar of procurement managers.”

Another lesser-known division is an optical coatings business which Thomas would love to grow as it has no obvious competitors. He says it is small and there are technologies that could be added to it.

He claims Covestro is doing some serious, clever chemistry in areas such as automotive refinish such as self-repairing paint where the group invented a memory coating technology. Covestro supplies many of the world’s largest coatings groups such as PPG, AkzoNobel, BASF and Sherwin Williams.

“We could buy technologies to add to other bits of the business and we expect to see a lot of small companies with interesting inventions over the next couple of years,” adds Thomas.  

Covestro also has a €2.5bn polyols business which is stable and cash-generating. PO is made and consumed locally through a 50-year PO JV deal with LyondellBasell and the propylene-PO margin is very stable. The company is No 2 behind Dow. 

PC is almost a €2.5bn business for Covestro with strength in car headlamps and car parts. Optical storage has declined to under 10% of this market and has been oversupplied. EBITDA margins had declined to around 5-6% but they have now, according to Thomas, been increasing quarter-by-quarter and reached more than 20% in the third quarter of 2015.

“We’re number 1 globally with SABIC and we have a 27% market share. It’s a very concentrated market and we are achieving increasing pricing power.” 

Covestro is also closing a lot of older, smaller, production capacities as it consolidates operations. A TDI site at Dormagen (55,000 tonnes/year) has closed and its Brunsbuttel (125,000 tonnes/year) site also closed in September 2015. A new 300,000 tonne/year TDI plant at Dormagen was commissioned at the end of 2014 which, according to Covestro, reduces energy consumption by up to 60% and requires up to 80% less solvent.

The company also shut an MDI plant in Brazil and its Tarragona MDI plant (170,000 tonnes/year) will close by the end of 2017. It is supplied externally with chlorine from a mercury cell facility which is to close.

“The economics of putting in our own chlorine facility are not viable. So we are consolidating onto two major sites. We will keep this site though as it has access to a deep-sea port and is part of the biggest chemical complex on the Mediterranean coast with superb infrastructure.”

The company will put in extra hydrochloric acid handling facilities there to serve the Iberian market. Production of polyurethane and hydrochloric acid at the firm’s other facilities in Tarragona will remain unchanged. Covestro also has a PU systems house there for the Iberia/North Africa market which will be maintained.

Asked about current market dynamics, Thomas says the group saw good demand growth in PC during the first half of 2015 then Q3 slowed in China due to the stock market turmoil. Out of Q3 demand returned to normal levels.

“There were signs of destocking in Asia during Q3 driven by China where [GDP] growth slowed to under 7% in Q3. The rest of Asia showed a greater decrease. We have 15% of our sales in China which is not huge but we are seeing a slowdown there.”

Thomas says it is difficult to observe the inventory cycles because although original material production rates are available, the activity of traders is less clear. The fourth quarter in China is looking relatively normal.

He adds: “We never planned on 7% China growth; we see a realistic rate as 3-4%. There is real growth in China and year-to-date it is still growing despite the stock market correction which created a loss of confidence.”

For Thomas a bigger worry about China is access to credit because access to unofficial credit is being cut, which means that smaller firms are suffering. The company is very cautious about giving credit to customers in China.

“The rebalancing of the Chinese economy plays in our favour because it’s all about sustainability. Lightweight mobility is a key market for us,” he adds.

 Thomas says that everyone is disappointed that Brazil’s economy has been in recession for so long.

“We have a good business in Latin America but it has not yet reached its promised growth levels. Russia is the same story. India is interesting – companies like Tata are boosting industrial growth; I see India in the next wave.”

Thomas concedes that the TDI market is well oversupplied at the moment. “We’re banging along at the bottom and we don’t expect to see instant recovery in 2016. Overall this market is growing which will help it balance.”

He believes in Europe as an important market for Covestro’s materials, despite the challenges it faces. “I don’t complain about high energy costs; I invest in low energy-consuming assets. I get frustrated by an industry which sometimes sees the glass as half empty,” he adds.

The Covestro logo is colourful which, says Thomas, is in contrast with some rather grey players in the chemical industry. “We react differently, with different business models. Our industry is based on innovation and there will be whole new markets from trends such as the aging population.”

CO2 to polyols

Covestro has been developing new technology which allows CO2 to be consumed as a feedstock for polyols production. A commercial scale 5,000 tonne/year €15m production unit at Leverkusen, Germany, is now 50-60% complete with commercial production expected by the middle of 2016.

“The chemical industry has to be part of the solution – nearly all the main volumes of polyols could use this technology. I don’t want to be the only person pushing it; I’d be happy to licence it. It would be an important signal that the industry is prepared to change,” he says.