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Lubrizol Presses for Profits

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Capital expenditures at Lubrizol Additives are likely to top $300 million this year and $250 million in 2013, says the companys president. Much of the money will go to construct an additives plant on a greenfield site in China, for research laboratories in Asia, and for upgrades to existing manufacturing facilities in Texas and France.

After 2013, the additive company expects to continue investing at the rate of around $200 million a year to improve its infrastructure, ensure supply security, create and commercialize new technologies, and add more capacity – largely in Asia.

Back in 2006, the Wickliffe, Ohio-based company could only have dreamed of being in a position to make such reinvestment, President Dan Sheets told the recent ICIS World Base Oil & Lubricants Conference in London. That year, the entire additives industry was on the ropes. Supply and demand were unbalanced, productivity had been battered by hurricanes the year before, and emerging markets like Asia, Eastern Europe and Brazil were crying for attention. Plus, thanks to an earlier wave of mergers and acquisitions, major customers in the lubricants industry had grown to wield a substantial amount of buying power. Between their purchasing clout and rising raw material costs, additive company margins suffered.

Lubricant and additive companies faced poor profitability in 2006, Sheets said on Feb. 24. At that point, reinvestment funds were not there.

The picture today is greatly altered, and margins have improved. Financial health is improving, he said with evident relief, and while global growth remains at a modest 1 to 2 percent level, the future looks cautiously optimistic.

Lubrizol was bought last year by Berkshire Hathaway Inc. and folded into its portfolio of industrial holdings, so it no longer publishes its financial results. However, the company and one large additives rival were publicly traded in both 2006 and 2011, and together their finances might be taken as a bellwether for the additives industry, Sheets suggested.

The two companies average operating margins doubled from 10 percent in 2006 to hit 20 percent in 2010, he noted. (While he did not name the other company, only Newmarket Corp.s Afton Chemical business fits the description.) Meanwhile, lubricant manufacturers, based again on a limited number of publicly traded companies, saw their average returns nearly triple in that same period. So together, the additives and lubricant industries appear to have lifted themselves to a pretty good place, he said.

Unique, Boutique

In terms of global volume sales, Lubrizol has seen about 1 or 2 percent compound annual growth since 2002, Sheets said. This is not a big, top-line growth kind of industry. Its a very unique business though, and I dont know another one like it. Additive companies are unique in this industry and in the specialty chemicals industry. We have to provide not only specialty chemicals and components, but formulation technology and proof of performance.

He estimated that the cost of replacing Lubrizols current infrastructure would be $4.6 billion; it requires $180 million a year in capital investment just to keep it running. This is another reason strong margins are so critical, Sheets indicated. Meanwhile, complexity is becoming the industrys biggest challenge and is compounding its need for capital investment.

Lubricant technology, for example, now sees continuous upgrades, with new engine oil specifications coming along about every two years, he said. That adds complexity, because older specifications dont go away just because new ones are introduced.

Geographically, markets are shifting too, with new customers and new OEMs, Sheets told the ICIS gathering. Security of supply has become front-of-mind for many customers, who now demand business continuity planning from suppliers like Lubrizol.

R&D remains the heart of the business, and also demands constant attention. Regulatory requirements to improve energy efficiency and reduce emissions are one example; another is the growing number of base oil suppliers. There are a lot of new base oil players, and our customers want the broadest base oil coverage they can get for their formulations – and we have to support that.

This shifting landscape requires a strong R&D pipeline, Sheets said, and is why Lubrizol evaluates 300 new essential chemistries a year. The additives industry spends nearly $250 million per year to perform industry-registered drivetrain and engine tests, Sheets pointed out, and that price tag doesnt include all the development work that precedes any engine testing. He estimated the total R&D spend for the additive industry in 2011 topped $600 million, versus about $430 million in 2006.

What If?

Another factor thats demanding more attention and creating more complexity is business continuity planning. Since the disastrous hurricane season of 2005, customers have increasingly included contingency planning in their contracts, and many enforce it by checking their suppliers, Sheets said. Major customers expect additive companies to show they have strategic relationships with suppliers, keep qualified materials on hand, and have back-up inventories available in case of disruptions.

2005 set the tone for this, Sheets later elaborated to LubesnGreases. Quite a few of our customers put real teeth into their business continuity planning after that. They want to have a back-up plan in place themselves in case of disruptions in supply, and they expect the same from their suppliers. So the addcos need documented back-up supply plans. These customers want to see documentation too; we even had some mock drills with some customers, where they threw simulated supply issues at us, and we had to show how wed manage it.

All of this is difficult and costly, especially given the 2008-09 financial crisis, Sheets said, but Lubrizol is making head-way towards the goal. In 2005, the company held about 78 days of qualified products in inventory, valued at a little over $400 million. In 2011, its inventory cushion had grown to 102 days, and was valued at almost $1 billion. This reflects both higher cost-of-goods and a deliberate decision to carry redundant inventory, which eats up a lot of working capital, Sheets emphasized.

More complexity also is seen in Lubrizols manufacturing metrics, he continued. In 2002, the average batch size of one of its additive blends was 120 metric tons and involved 10 components. Ten years on, the average batch is about 15 percent smaller, and it contains more components – up to 24 or 25 in the case of some driveline products. In part this is due to the proliferation of lubricant specifications, and customer desires to field a range of differentiated products serving multiple performance tiers. But the upshot, Sheets said, is that the plants must make, manage and store more batches to supply the same volumes.

These forces are similar to what the industry has seen in the past, but more intense and complex, Sheets said. And despite the need for large capital and R&D investments, only modest overall growth is expected, so to continue, we need to keep having the kind of return on investment that weve built up to now, he reiterated.

Planting in Asia

Additive manufacturing and infrastructure also demand investment, especially as Asia and the Middle East become major consumers of lubricants. The number of vehicles in China and India doubled from 2005 to 2009, with more to come, Sheets said, so his company must put more supply capacity in these markets.

Lubrizol is not alone in trying to rebalance its manufacturing assets to be ready for growth in Asia. Sheets noted that Afton Chemical is adding capacity in Singapore, as are Infineum and Chevron Oronite. Lubrizol is building its own new plant in the southern China city of Zhuhai, near Macau, which will begin operating in 2013. Moneys also are going to a new research laboratory in Zhuhai, and to an existing lab in India.

The Zhuhai plant will have a very careful, phased-in start up, Sheets told the ICIS meeting. The company will begin by base-loading some of its blending capacity with additives currently made at other Lubrizol plants. Transferring some business from other plants will let us quickly move closer to customers in China and the Asia region, he said.

In his interview with LubesnGreases, Sheets gave more details about these plans, explaining, Our plant in China is mostly about security of supply. We need to have assets in Asia to be close to customers. Transfer of manufacturing to the Zhuhai plant will mostly involve components and materials made at a plant in Deer Park, Texas, he added. Initially, additive components rather than full packages will be shipped from Deer Park for blending in Zhuhai, which will combine and blend the components there.

Deer Park will see no jobs lost or changed, he continued, and will have plenty to do, with no immediate big impact. And with less pressure on capacity, well be able to improve our customer response time and better serve the domestic and Americas markets.

China in the first phase will make detergents, like sulfonates and phenates. Then well look at the global supply chain and future needs, and at those components where were most vulnerable. Phase one is to come, and could include viscosity modifier solubilization and industrial lube additive packages.

In 2009, we said wed make this investment, and were doing it. We see the need to demonstrate our commitment to Asia. In 10 years more, the plant in Zhuhai will look more like an integrated additive plant, although smaller than Deer Park.

Life With Warren

Creating differentiated products, building new capacity and fielding more additive packages – its all worth doing if the additive company receives a good return for its dollars, Sheets remarked to LubesnGreases. It all adds complexity. Thats okay, we can deal with complexity as long as its worth dealing with. If its just complexity for the sake of complexity, if it doesnt add anything, then it may not be worth investing in. On the other hand, complexity can be a good thing in some cases, where its possible to achieve a competitive advantage.

The reality is, if the lubricants industry wants the addcos to be viable, we have to get the returns to support the capital and technology investments that it requires us to make. Ill point to what our CEO James Hambrick has said: Its less about prices than profitability; whats really important is the outcome on your margins.

What kind of margins would those be? Sheets declined to say, noting that his ICIS presentation gave a rare glimpse into Lubrizols life under Berkshire Hathaway. He said the acquisition made it possible for Lubrizol to fund growth independently, rather than selling itself to a larger chemical company or borrow against assets to raise capital.

All the SEC filings and published reports now have been replaced with quarterly financial summaries, delivered by Hambrick to Berkshire Chairman and CEO Warren Buffett and CFO Marc Hamburg. Daily internal governance is handled by a management advisory committee which includes Sheets as a member.

Life under Berkshire is a joy, he said. Its streamlined, its simpler, we have faster decisions on capital, and more flexibility. As for future investment, Sheets repeated, if we see a gap or need for new capacity, its likely to be built in Asia.

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