Intellectual Thoughts by Sanjay Panda !!!!!: Strategy- BASF, The Chemical company

Saturday, November 25, 2006

Strategy- BASF, The Chemical company

In German, it is called the Verbund. J├╝rgen Hambrecht, the chief executive of BASF, describes his company's sprawling complex of pipes, towers and storage tanks as the “ultimate business cluster”. Spread over ten square kilometres (four square miles), it is the biggest integrated chemical site in the world. At first glance, BASF's third-quarter results, out on November 2nd, did not look great. Profits plunged because of restructuring costs at Engelhard, an American producer of catalysts (as in catalytic converters) which BASF bought earlier this year. And, on the same day, BASF announced 2,000 job losses.

But the underlying trend at BASF is surprisingly healthy, given that it is an old-fashioned manufacturing company in a part of the world where heavy industry tends not to flourish these days. It more than doubled its profits between 2002 and 2005. One-off charges aside, its third-quarter results suggest the company is in line for a 20% increase in turnover this year to over €50 billion ($64 billion), with pre-tax profits up 11%. Although many industries are fleeing from Europe to less costly countries, the efficiencies of the Verbund show how a traditional business can remain highly competitive, even when it operates in an expensive place like Germany. The complex at Ludwigshafen, across the Rhine from Mannheim, comprises up to 250 individual chemical factories turning out 8,000 different products. These range from simple petroleum distillates to sophisticated nanomaterials—tiny particles which can be used to change the properties of plastics or other substances. BASF employs about 36,000 people in Ludwigshafen, where it also has its headquarters. Many travel around the site on red works bicycles, individually numbered.

range from simple petroleum distillates to sophisticated nanomaterials—tiny particles which can be used to change the properties of plastics or other substances. BASF employs about 36,000 people in Ludwigshafen, where it also has its headquarters. Many travel around the site on red works bicycles, individually numbered.

The site's legendary efficiency comes from extracting the last drop of value from every chemical reaction. It makes use of the numerous by-products from each process. At other places these are often sold or shipped from one factory to another for further processing. At the Verbund, what is left over from one process is used only a few hundred metres away to make something else. This saves BASF a fortune. Compared with having, say, 70 separate factories some 100km apart, BASF calculates its cluster enjoys annual savings of €300m ($380m) in logistics, €150m in energy and €50m in infrastructure.

For Mr Hambrecht, the Verbund represents a huge advantage in an industry in which competition is increasing, especially in Asia. So BASF is trying to replicate the benefits of its cluster, not only in other countries but also at the corporate level. Instead of splitting into lots of firms specialising in one chemical, as many giants have done, BASF is seeking to become an even bigger conglomerate.
Mr Hambrecht, who is 60, has spent half his working life at BASF, which was founded in 1865 as Badische Anilin- & Soda-Fabrik. Anilin was once important in making dyes; soda is used in glass, soaps and textiles. Today the company's products end up in goods ranging from cars to electrical goods, cosmetics, sports equipment and medical devices.

Mr Hambrecht enthuses about “the industry of industries”. Indeed, chemicals seem to be in Germany's blood. The country accounts for a quarter of the chemical industry's sales in Europe and a similar share of employment there. Germany supplies more than 12% of world exports of chemicals, the biggest single share. And the German industry spends a higher proportion of its revenue on research and development than that of any other country.In many countries, chemical factories are hardly the subject of civic pride. They are in Germany. In September an “open day” attracted thousands of visitors. Frankfurters, in particular, are proud of the huge chemical complex straddling the river Main at Hoechst, west of the city. Though Hoechst, once the local chemical giant, was absorbed into sanofi-aventis of France in 1999, its Frankfurt site still churns out polymers, pigments and pharmaceuticals. The former Hoechst headquarters, a redbrick relic of the 1920s, is an admired piece of Bauhaus architecture. Yet few sites are as efficient as the Verbund. A recent study of Germany's chemical industry by A.T. Kearney, a consultancy, found that most other production centres had big gaps in their “value chain”: raw materials and by-products had to be shipped around, at extra cost. The reasons are often historical or political. A complex at Leuna in east Germany, for example, was cleaned up at huge expense after German unification. It has never achieved its potential, even though firms such as Dow Chemical, Linde, Total and BASF have operations there. Other sites are too small or are underused, but cannot be closed for political reasons. BASF has recently been adding to its product range in a big way. In March it bought Degussa Construction Chemicals, part of a German maker of specialty chemicals, for €2.7 billion; in May it spent $470m to buy America's Johnson Polymers and in June it paid $5 billion for Engelhard, the cause of the profits crash.

Asia starts producing

Although these European and American additions bolster its business, BASF cannot ignore developments elsewhere. Ever bigger petrochemical and other downstream production facilities are being built in the Middle East. And burgeoning demand in Asia, particularly in China, is resulting in more chemicals being produced locally. Moving into developing regions can have benefits beyond lower production costs. It can allow chemical companies to get closer to both suppliers of raw materials and more potential customers. It nearly always makes sense to produce bulky chemicals, such as washing powder, where they are sold, to keep transport costs low. This puts places like China, which is a long way from the big Western consumer markets, at a disadvantage in exporting some products. But there are plenty of others to be made. Anything that can be conveniently put into a container and shipped cheaply is likely eventually to be made in Asia's low-cost factories.

Hence even BASF is having to shed businesses in which it thinks it is no longer competitive. The next to go may be a factory in Minden, Germany, which among other things makes caffeine. The Chinese now offer caffeine, which is easy to ship, to firms such as Coca-Cola at a third of the price that European factories can. Nevertheless, demand in China is so great that it will be many years before the country becomes a net exporter of chemicals, Mr Hambrecht believes. Demand across Asia is strong. Around half of future worldwide demand for chemicals is expected to come from the region. BASF already has almost 19% of its turnover in Asia, up from just 9% in 1995.

As it expands overseas, BASF is trying to replicate the Verbund concept. It has built smaller versions of the cluster in Belgium, Texas, Louisiana, Malaysia and China. The foundations of its Chinese factory in Nanjing were laid in 2001. Last year petrochemical production began there in a joint venture with Sinopec, a Chinese oil company. Mr Hambrecht, who fought internal opposition to the investment, believes that such opportunities in Asia offer European chemical companies their only chance to grow faster than at home. Chemical companies can be highly vulnerable to changes in the price of raw materials. Here too BASF hopes to gain some protection from its cluster effect. As long ago as 1969 it bought Wintershall, an oil producer. It has proved to be a useful hedge against oil-price rises. BASF is now trying to secure its lines of supply from Russia by a joint project with Gazprom to build a gas pipeline across the Baltic. It also has a share in a west Siberian oilfield. BASF was mining coal until the late 1980s, and today even that might again make sense. The company's expansion into energy seems set to continue: it recently announced plans for a joint-venture biodiesel plant in Belgium, which will use rapeseed and other organic material to produce fuel. Indeed, oil and gas provided 40% of the group's profits in 2005.

Other giants in the chemical industry have spun off various divisions to narrow the spectrum of their business . For instance, Bayer, Germany's second-largest chemical firm, listed its specialty chemical division, Lanxess, as a separate company in January 2005. Although the trend in the industry is to put new labels on bits of the business, such as “life sciences”, which includes health and food, or “coatings”, which includes paint, BASF still brands itself as “The Chemical Company”. The one business it has quit is pharmaceuticals, accepting that there is little overlap between drugs and its other products.

The diversity of its operations makes BASF unpopular with some investors because it muddies their view of the firm as a “pure play” on chemicals. Mr Hambrecht is unrepentant. He argues that conglomerates are better overall long-term performers than specialists. Through diversity, he maintains, companies can weather poor performance in one or two of their divisions. The specialist can also be more vulnerable to disruptive technology and the sudden substitution of one material for another. This is a particular risk for the chemical industry in Germany, which is highly exposed to the car business. Almost 70% of the German industry's innovations, such as smarter or lighter materials, go into vehicles. But it is harder to apply the Verbund effect in the developing field of biotechnology. A big handicap for BASF is the German government. Despite vowing in its coalition agreement last year to clear the way for genome technology, the government has since dragged its feet. Bayer is developing genetically modified rice, rape and cotton, but in America not Germany. BASF has the majority of its biotech research in Europe and believes Germany to be an excellent place for genome activities. But, says Mr Hambrecht, the government's attitude risks driving it away.

The virtue of virtuality
Perhaps the biggest danger to the Verbund, and the conglomerate-building which it encourages, is that it could lack the flexibility to cope with rapid market changes. But a variation of the concept might overcome this. This is the “virtual” Verbund; a large chemical site where a number of independent companies could voluntarily work together to achieve the same economies of scale, but use different processes as market conditions change. A.T. Kearney suggests that something like this might be done at some of the chemical sites in Germany where production capacity is underused. A European Union project supported by seven big companies, including Siemens and Degussa, is trying to get the idea going by streamlining test-production. Called Impulse, the project aims to reduce the cost and time of research and development by miniaturising test equipment. This would primarily benefit smaller, more flexible companies. The political objective is to keep jobs and factories in Europe.

Perhaps such initiatives might one day steal away some of the Verbund's advantages. But not yet. For now Mr Hambrecht, whose contract with BASF runs until 2011, is confident in the future prospects of his firm. As he jogs through the vineyards near his Rhineland home in the early morning he can indulge in thinking up new things to make.

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