RAG-Stiftung, a remnant of the largest coal mining conglomerate in Germany, is a foundation with the primary purpose to fund ongoing mine closure costs in the Ruhr region. The asset funding these liabilities (after many years of portfolio pruning) is RAG’s 64.3% stake in Evonik Industries. Evonik is a company that houses a portfolio of chemical businesses, many of which trace their roots back to technological breakthroughs in the nineteenth century.

Ever-evolving Evonik
Following the shedding of its smaller real estate and energy holdings, shortly after its listing in 2013, Evonik embarked on a strategy from 2017 that aimed at:

• Achieving material cost savings – given that central costs were high compared to competitors due to the historically sprawling nature of the business; and

• Recasting the portfolio away from commoditised chemicals towards specialty chemicals.

Higher returns on investment – stemming from superior pricing power – are generally expected from producing specialty (as opposed to commoditised) chemicals. Specialty chemicals are, however, not well defined and management teams in chemical companies are generous in the classification of their own portfolios – given the higher market ratings investors place on specialty exposures. In addition, over long periods of time, specialty products may become more commoditised as customer specifications become standardised, competitors erode intellectual property advantages, and entrenched players build too much capacity.

Methionine
Essential amino acids help build the proteins that make up the tissues and organs of the body. They cannot be synthesized by the body and must, therefore, come from the diet. Methionine is a sulphur-based amino acid found in many proteins. It produces several important molecules essential for proper cell function and is commonly deficient in poultry and bovine diets. This makes methionine an extremely useful animal feed additive, yielding significant feed productivity (up to 23% in the case of poultry). Growing human populations, urbanisation and increasing incomes has led to greater meat consumption, and consequently, healthy methionine demand growth of 5-6% per annum in recent years.

After World War 2, in an effort to eleveate the malnutrition problems in Europe at the time, an Evonik predecessor company created the first commercial processes to synthesize methionine. This head start is now evident in Evonik’s current 40% global market share in the product.

The complicated production process and the difficulties in its transportation and storage, means that vertically integrated methionine producers such as Evonik, are advantaged. Despite this, too much supply has entered the market in recent years, leading to significantly reduced pricing power (commoditisation).

With depressed prices beginning to squeeze out non-integrated competitors and planned new capacity projects being cancelled, it appears that we are close to the cyclical trough and Evonik’s low cost relative position should benefit them in the higher price environment that is coming. Furthermore, the completion of a massive new Evonik facility in Singapore will support a 25% increase in Evonik’s capacity, replacing older high cost capacity and consequently delivering market share gains.

‘Special’ omega-3 – a sustainable prize
Omega-3, an essential fatty acid that plays an important role in maintaining a healthy body, must also be derived from the diet. An increasing human demand for omega-3 is contributing to a greater demand for fish, which is a rapidly shrinking resource. The graphic below shows the current unsustainable flow chain of omega-3 feed to salmon aquaculture.

In a collaborative breakthrough, Dutch specialist chemical company DSM, has combined its algae know-how with Evonik’s specialist large scale fermentation manufacturing technology to produce a natural marine algae omega-3 oil alternative. It is estimated that 1kg of this algal oil can replace 60kgs of wild catch fish needed to produce a similar amount of fish oil. Following a $200 million joint investment, commercial scale production has ramped up and has considerable future growth potential.

The silica revolution
Silicon (the second most abundant element in the earth’s crust after oxygen) is too reactive to be found on its own in nature and usually occurs together with oxygen, as natural silica – loosely referred to as sand. When silica is manufactured synthetically to a high level of purity and a low density, it becomes an excellent additive for improving other materials by enhancing and altering flow characteristics, increasing flexibility and strength (rubbers and silicones), reducing moisture (sachets used in food packaging), and preventing settling and caking (solutions and powders). This has led to a wide array of applications in everyday products as shown below.

Despite the abundance of the required raw materials, the manufacturing process lends itself to creating strong competitive advantages due to scale and location, manufacturing know-how, and developing new applications and niche high margin variants. Consequently, the production capacity is extremely concentrated. With over seven decades of experience, Evonik is the largest producer, with many of its factories entrenched in on-site “fence-to-fence” partnerships with customers.

Evonik’s silica business has achieved huge success in the development of new applications for its customers. An example is “green tyres”, where Evonik pioneered the research that overcame the long-standing issues with the binding of fumed silica (hydrophilic) with tyre rubbers (hydrophobic). Green tyres have lower roll resistance, meaning greater fuel efficiency, superior abrasion resistance, and wet grip. They make up 45% of global tyre sales (from 10% in 2011).

Specialist products from fresh air
Evonik also produces hydrogen peroxide, which is mostly used in traditional bleaching applications such as in the whitening of cellulose paper, and in laundry, dental and hair care applications. It is increasingly used in new growth markets such as food, cosmetics and electronics. Key inputs are hydrogen and atmospheric air. As with silica, the required complex manufacturing process lends itself to very strong competitive advantages. The hydrogen peroxide business is expected to be much larger in the mix going forward – especially post the proposed $625 million acquisition of US competitor PeroxyChem. We expect this to be value accretive due to a complementary US footprint and as Evonik’s superior manufacturing know-how is transferred to the acquired assets.

PEEK polymer performance
Evonik’s polymer business is skewed heavily to ultra-specialised, high-demand products like PEEK (‘king’ of the polymers), Nylon 12 and polymers used in composite materials. Trading at five to seven times the price of other high-performance polymers, PEEK’s temperature resistance, strength, superior chemical resistance, and light weight make it a better input than steel in many applications, including chemical processes with corrosive environments. It is also biocompatible and an ideal material for human body implants.

There are only three companies that are capable of producing high quality PEEK at scale in its resinous form. The powder form of performance polymers is even more specialised (and costly) than the resin form and Evonik has a significant cost advantage in doing this due to substantial investment over the years. Positively, Evonik is investing heavily in Nylon 12 powders to increase capacity by 40% in the face of a healthy demand from 3D printing. Nylon 12 powder has very good sintering properties resulting in excellent durability from finished 3D products.

Innovation is key
Our main concern for Evonik is that the period over which specialty chemicals become commoditised is rapidly shrinking due to:

• End demand shifting towards Asia where intellectual property is being eroded at a more rapid rate and better-quality variants are currently not as appreciated relative to developed markets.

• Large new sources of feedstock are now available in new geographies, which is quickly weakening previously entrenched location advantages.

• Research and development efforts in chemicals have yielded few new “blockbusters” in the last decade (outside of crop protection).¹

Despite this, our view is that Evonik is at an advantage in that their absolute spend on research and development is very significant (top five global spender) with increasing visibility on the strength of their future product pipeline (the omega-3 venture and the rate of new patent applications). The percentage of sales emanating from products less than five years old has started to slowly increase from 11% to a targeted 16% by 2022.

Although profitability by product line is not disclosed, we have estimated that an increasing proportion of profits are emanating from specialty products. The chart shown left indicates that:

• the commoditised methionine exposure is cyclically depressed; and

• the Plexiglass business sold in 2019 at a very favorable price and at a relatively high point in that chemical’s profit cycle.

We believe this positive exposure mix towards specialty chemicals is not fully appreciated by the market and that this provides our clients with an attractive investment opportunity.

¹ McKinsey & Company (2017)