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Chemical Sector Peer Group Analysis:Relationship Between Return on CapitalEmployed and ValuationROCE %3025R2 = 0.72201510500.0 1.0 2.0 3.0 4.0 5.0TEV/CESpeciality ChemicalCommodity ChemicalDiversified ChemicalThis scatter chart shows a relatively strongrelationship between the average five-yeartrailing ROCE and total enterprise value overcapital employed for a portfolio of commodity,diversified and specialty chemical companies.There are some interesting observations tomake regarding the strength of the relationshipand how it varies by type of participant. In general,commodity companies must generate a higherROCE to achieve the same valuation (proxy forvaluation being TEV/CE). Whereas, within thespecialty and diversified sectors there is moreeven distribution reflecting many factors includingportfolio quality, scale, cyclicality and overallliquidity. Generally, companies below the curvebenefit from positive portfolio dynamics andliquidity effects, achieving higher valuations perunit of capital employed. Those above the curvegenerally suffer from a discount due to the cyclicalnature of their portfolios, scale or momentumissues and therefore require higher ROCE performanceto achieve similar shareholder value.While ROCE is influenced by the quality ofindustry structure and competitive positioning,creating a culture of Operational Excellenceallows a company to address these dimensionsof shareholder value proactively.Companies tend to be more focused on operationalimprovement and cost management in thedownward portion of the cycle. But the winnershave focused on creating a culture of OperationalExcellence with clear management frameworks andcontinuous goal-setting to achieve continuingperformance gains. The focus of programmaticefforts may change throughout the investmentcycle, but the level of effort is continuous. In thecapital investment wave, it will be important toemphasize good investment decisions, as wellas effective implementation. Optimizing theindustrial footprint, capital portfolio managementand capital project management are all importantat this phase of the industry investment cycle.There is significant opportunity for improvement.In a recent survey of 2,800 CEOs and business unitmanagers in the US, only 19% were satisfiedthat their LEAN programs (those focusing onefficient use of resources for profit generation)had delivered what was intended. We believethat the difference is adopting a culture ofOperational Excellence.Increasing throughput from existing assetsWe see significant transformation opportunitiesthat will drive shareholder value, particularlyamong the mid-sized companies in the sector.Leading companies that are focused on enhancingreturns on invested capital are focused oncontinuous and programmatic improvementaddressing the key levers impacting both thenumerator and the denominator.There are three thematic improvement areasfor holistic programmatic management: costmanagement; revenue enhancement; and capitaland asset management. While the balance offocus reflects the current state of the company,its specific opportunity areas and competitivepositioning, it also reflects positioning in thebusiness and investment cycle.As the economy improves, we expect cyclicalrecovery in housing and modest additional recoveryin the automotive sector to produce a significantrebound in chemical demand. With the chemicalsector operating near 80% overall utilization andmany companies behind the capital investmentcurve, the focus will remain on increasing throughputfrom existing assets and also bringing onnew capital investments in a timely manner.The use of Overall Equipment Effectivenessand Capital Project Management are in vogueas companies prepare for recovery. Companiesemploying leading capital project managementtechniques routinely achieve 1.5-2% higherROCE performance.Examining investment options consistentlyrequires a capital portfolio management processwith a sophisticated risk management approach.Companies employing integrated portfolio managementapproaches consistently make betterinvestment decisions. The area is a growingbest practice that is embedded in managementframeworks across most of the larger, moresophisticated chemical companies, and mid-capcompanies are employing this approach as well.Minimizing price inflation Maximizing innovationAs the economy recovers, there is a disproportionaterisk of commodity price inflation. To dealwith potential input price volatility similar to the2008 time period, many companies are shiftingto purchasing and supplier management programsfocusing on novel contracting mechanisms andsupplier management approaches.Sales analytics, pricing optimization and saleseffectiveness are critical to the creation ofmechanisms and communication to passinginput pricing through to customers in a timelymanner to reduce the profit cyclicality acrossthe value chain.Longer-term innovation is also critical to supportenhanced margins and growth. For businesses,innovation is not an end in itself. Their prime taskis to identify the right innovation, and it sometimesrequires tough decisions to be made betweendevelopment projects. Having the right processto manage innovation in a portfolio and ensuringthat the company is taking enough and the rightbalance of risks with its new product developmentinvestment is key. This requires the right levelof process structure and discipline with theright risk/benefit ratio and systematic controlof timelines and costs.Adopting a holistic approachIn summary, we believe that the winning companiesin our industry have increasingly created a cultureof Operational and Process Excellence thatembodies commercial excellence, capital andasset management, and cost management.This holistic approach leads to strong shareholdervalue performance with best practice companiesconsistently outperforming their peers. Shiftingthe focus and activity level of a holistic managementapproach is prudent throughout the business andinvestment cycle, and an important managementskill to optimize return on capital, growth andshareholder value.A version of this article first appeared on ICIS.com – the breaking online news service for theglobal chemical industry.CLOSEWORK® GLOBAL REVIEW 2012 59