Speaker: Andrew Liveris, Business Group President, Performance Chemicals
Event: INFORMEX
Location: New Orleans
Date: 02/25/2003

Link to SLIDES

Thank you. It’s great to be here in New Orleans at Informex. This event has become the premier industry gathering of buyers and sellers of contract services in the chemical and pharmaceutical industries …and I’m honored to be your keynote speaker.

It’s also great to be in New Orleans right before Mardi Gras. This city, which is energized any time of year, is truly electric now. You might be interested to know that on this very week in history -- in February of 1827 -- the first public celebration of Mardi Gras began, as students paraded through the New Orleans streets in masks and costumes.

But also during this week in history there was another milestone event that is more pertinent to our topic today. In 1954, the Salk Vaccine for polio was given for the first time to children in Pittsburgh, beginning the virtual eradication of this debilitating disease in developed nations.

Imagine if we were gathered here today in 1954. Chances are that many of us would have friends and loved ones stricken by polio – using crutches or in wheelchairs for life.

Sadly, polio is still endemic in seven countries in the world, and the W.H.O. and companies like Aventis today continue the work that Salk began.

In 1953, Jonas Salk was asked who owned the patent to his new polio vaccine. He answered … "The people. Could you patent the sun?"

Clearly, Salk had a remarkable generosity of spirit. And that generosity of spirit seems all the more remarkable today in our world where the invention process is dominated by commercial considerations. It makes you wonder… if Salk invented the vaccine in this decade, could he have answered in the same way?

But this seeming conflict between the altruistic application of science and medicine, and making a fair profit, is not a modern phenomenon. In fact, for centuries there has been that dynamic tension between the philanthropic and the practical.

SLIDE 2:
Back in the 16th century, it was Paracelsus, a Swiss physician who was among the first to apply chemistry in medicine, who said … "The true use of chemistry is not to make gold but to prepare medicines." He was surely a man ahead of his time, because back then turning base metals into gold was every chemist’s favorite pursuit.

Today we know that the work of chemistry to cure illness and prolong life is perhaps the noblest application of our science. At the same time, we live in a world where it’s expected – and practical – that we not only use chemistry to prepare medicines, but make a bit of profit along the way.

And so each of our companies tries to find a way to turn Paracelsus’ "either/or" proposition -- gold or medicines -- into an "AND" proposition. How do we prepare medicines…or other chemically derived products…and make gold?

And that brings us to the 21st century. Whether your company is a contract manufacturer of chemicals for agriculture, pharmaceuticals, personal care products or fine chemicals, we all seek to find that sweet spot: meeting customer and societal needs, and sustaining a profitable business. That’s why we’re here at Informex this week.

SLIDE 3:
The topic of my remarks today is, "Has outsourcing fulfilled its promise?" Rather than keep you waiting on the edge of your seats for the answer, let me give that to you now. Yes. And no.

It’s a basic rule of business that all simple questions have complex answers … and vice versa.

In fact, the way you answer this question depends on who is asking whom. Do we answer from the point of view of ourselves, the suppliers? From the point of view of the customer? Investors and shareholders? … because what’s good for one stakeholder may not be good for another.

For example, the shift of fine chemicals production to India and China is good for customers because of a lower cost of manufacture, and it’s good for Asian suppliers, but bad for Western European suppliers who can no longer compete in that sector.

Some of our customers have found outsourcing to be a very good deal. Others have not, and have pulled their manufacturing back in house.

Investors, in turn, have received a fair return – some above market rates, some below – but their returns probably did not match their high hopes brought about by the hype in the custom processing sector in the go-go ‘90s.

In fact, there is no simple answer to the question of whether outsourcing has fulfilled its promise. So in the next few minutes, I’d like to share my view on which parts have fulfilled their promise, and which have not …which are destined to continue in a positive direction … which will not … and why.

Then at the end of my remarks, we’ll have time for Q&A … so you’ll be able to share with me what YOU think the answer is to this question, and why.

SLIDE 4:
Let me ease into my topic today by starting with a look at the state of the chemical industry. Then I’ll give you my take on the custom processing sector of our industry, and analyze further the question of whether outsourcing has fulfilled its promise.

Then I will make some predictions about the future of this sector of the industry. Hopefully you’ll find these a bit provocative and perhaps controversial. I hope so.

It’s no secret that the chemical industry is in tough shape right now. Dow is now the largest chemical company in the world, and I can tell you we’re facing some of the worst conditions since the 1970s and early ‘80s.

Poor economic conditions – which are affecting every industry – are coupled with uncertainty in energy prices, resulting in a "war premium" on oil and feedstocks. Also the gas price in the US now seems to have moved to a range above $4…$2 gas in the US is a distant memory. Combine that with continued over-capacity and supply/demand imbalances … and you have a formula for a long, deep trough.

SLIDE 5:
Some have said this confluence of negative factors – all swamping us at the same time – could be called "the perfect storm." Now, you could call it that … except if you saw the movie, "The Perfect Storm," you know that the boat sinks! And we obviously don’t want that to happen.

And I don’t think it will. But our industry does need to take action, and each of our companies needs to show leadership, if we are to restore our profitability and growth as an industry.

SLIDE 6:
Let me set the stage by showing you some data that illustrate the multiple economic challenges we are facing.

First, macroeconomic conditions have been at cyclical lows, both domestically and internationally, with stagnant GDP rates. Note that the upswing in 2003 is a forecast.

SLIDE 7:
Industrial production – which is a much more meaningful indicator of growth to companies like ours – is also at historical lows.

SLIDE 8:
And in the chemical industry, operating rates have been on a downward slide since the late 1980s, with today’s conditions at the worst in two decades.

SLIDE 9:
Not surprisingly, this has created strong downward pressure on pricing, with the Trade Price Index in 2002 now the same as it was in 1984. And look at the slope of the line since 1995!

SLIDE 10:
…. And as the next slide shows, this has resulted in a powerful margin squeeze.

SLIDE 11:
Couple this with rising and volatile hydrocarbon costs, and you have the makings of a Perfect Storm. … A truly gruesome scene. … A time of extreme challenge.

A key question is: how will we restore profitability and growth to the chemical industry?

SLIDE 12:
Leadership – by every company across our industry – is needed. We must change.

Today, because of our past performance, investors view our industry as stagnant, low-growth, low-innovation, and irrelevant to their investment dollars. While none of us likes this perception, we can’t argue that it’s undeserved. The chemical industry has not been making money.

We must take control of our destiny and steer our industry out of this perfect storm, to regain investor confidence. The boat cannot be allowed to sink.

How can we do that?

• For the first time ever, we MUST be disciplined on capital. Don’t build more facilities until capacity utilization and supply/demand balances improve. This has been happening in a defacto way for several years now … but we must maintain that discipline.
• Improve productivity, reduce costs. This must be continuous and never ending.
• Continue portfolio adjustments and consolidation. Our industry still has too many players and too many non-competitive assets.
• Strengthen R&D and innovation for value growth. I’ll come back to that topic in a moment.
• Differentiate through customer-focused strategies. Learn to treat our customers in differentiated ways – as retailers and other industries do – to maximize profitability and loyalty across the entire value chain.

We must rebuild investor confidence via better governance and achieving our financial results. We can re-attract investors through less cyclicality, greater free cash flow, lower debt and true organic growth. This, by the way, will help us attract the best and the brightest as employees too!

Now there are those who would say that there is little or no growth left in the chemical industry. They’d lead you to believe that the chemical industry has essentially stalled out in terms of innovation.

They say that as a mature industry -- with the forces of competition, commoditization and consolidation fully at work -- the chance for growth above GDP rates is remote.

SLIDE 13:
That is a viewpoint that I strongly disagree with. I believe that there is plenty of growth left in our industry, and I’ll tell you why.

My optimism is rooted in a deep passion for the power of chemistry. Chemistry is the enabling science. It fuels our modern world. Virtually every significant advancement of the twentieth century – from safe drinking water to modern medicine – was made possible by chemistry.

As we stand on the edge of a new century, I can see every reason why chemistry can continue to play an equally dominant role in advancing modern life. The potential is there…it is up to each of us in this room to seize that potential and turn it into value.

Consider the growth that is possible from using the power of chemistry to meet the new and emerging needs of society.

SLIDE 14:
Consider these facts:

• First, the world’s population continues to grow, putting stress and strain on health care, food, water and energy resources.
• Second, half of the world’s population live in just six countries – India, China, Pakistan, Nigeria, Bangladesh and Indonesia – all struggling to develop their economies and raise the standard of living for their people; and
• Third, compounded annual growth rates for GDP in China and India alone over the next ten years are expected to be more than double that of the developed economies of North America and Western Europe.

Our industry can put our significant scientific and technical weight behind finding new, sustainable solutions to unserved human needs. It’s what we do. Chemistry plays a lead role in developing more abundant crops, safer water supplies, cheaper medicines and more energy-efficient solutions.

Many of these growth opportunities lie at the boundary where the chemical industry and the pharmaceutical industry overlap. The market discontinuities that lie in this space are what have driven growth in pharmaceutical outsourcing, as well as growth in biotechnology as a new enabling science.

SLIDE 15:
Now let’s take a look at the state of the custom processing sector.

SLIDE 16:
The concept of outsourcing what others can do faster, better and more economically still has tremendous merit. In fact, outsourcing can be a great help in terms of helping both the chemical and pharmaceutical industries get out of the ruts we find ourselves in.

How? Well, for one thing it could allow more efficient use of capacity. If companies can shut down non-competitive manufacturing assets by using more contract manufacturing, this could help alleviate some of the supply/demand imbalance and improve operating rates.

Also, when outsourcing works well, it allows companies to spend their resources on innovation, rather than on development or manufacturing infrastructure that already exists elsewhere. In other words, it can enable the growth that will help us out of the doldrums of today.

And of course there is also the opportunity to lower the costs of today’s products, making them more competitive. Even if you cannot drive growth right now, this strategy can help protect the business you have.

SLIDE 17:
Clearly, part of the promise of outsourcing has come true…it’s a big industry all by itself, and still growing.

The total market for outsourced development and manufacturing services in the chemical industry is estimated at around $80-90 billion annually.

Most agree that the aggregate growth rate is in the neighborhood of 8-10% per year overall… but this can be misleading because, as you know, each end market has its own growth rates, drivers, trends and value proposition.

The pharma sector is by far the largest, making up about two thirds of the value. The other sectors are typically grouped together as "other fine chemical" or "non-pharma" because they tend to have similar drivers and value propositions.

Now I won’t bore you with a description of how each segment behaves, because all of you are better experts on that than I am.

But I do want to share with you my viewpoint – from where I sit – of who the winners will be in the future.

What will separate the winners from the rest? And which of our companies will still be here in 10 years?

SLIDE 18:
On the chemical or non-pharma side, a number of trends have been in play for several years.

We have an over-crowded field with many competitors, and consolidation continues as custom processors buy up one another’s assets.

This consolidation is much needed – to take out non-competitive assets, reduce overhead, offer customers more breadth of capability and increase supplier leverage. Consolidation will and should continue among custom processors.

The relentless push by customers for cost reduction also is driving more production to Asian countries such as India and China, which have well educated workforces that can do the same quality work more cheaply.

Likewise, customers are learning that efficient transportation and logistics are important in keeping costs low.

Customers have strong leverage in this sector, which has resulted in falling profitability. Fine chemical companies are now returning below the replacement cost of capital in non-pharma end-market.

SLIDE 19:
As a result, to win on the chemicals side, you will need to:

• Be lowest cost to serve
• Use processing expertise to reduce steps or converting batch processes to continuous
• Offer broad solutions, technology breadth
• Protect customers’ intellectual property
• Have financial staying power and flexibility
• Have supply chain leverage and skill
• Be agile
• Have a "timeshare" mindset

By this last point, I mean that we are owners of assets selling a service, just as an owner of a resort sells a timeshare – the right to use a particular room or property for a certain number of weeks at a certain pre-set price.

We need to know our customers very well and identify how our capabilities can fit their needs. Then we use our best-in-class productivity to get maximum use of our assets while meeting those customers’ needs – just like a timeshare resort.

SLIDE 20:
Now let’s turn our attention to the pharma side of the industry. Of course, this side is equally complex, and I don’t want to spend too much time summarizing what you already know.

But I do want to highlight some interesting aspects of the pharma segment, as they have implications for our question of who the winners will be.

Of course, one way to look at the pharma side is traditional small molecule pharmaceutical ingredients, versus large molecule or biopharmaceuticals.

SLIDE 21:
Here are just a few of the differences, and as you know, they have very different growth rates and profitability.

The traditional small-molecule side is maturing, with growth at 6–8%. This segment has been particularly sensitive to the slowdown of the pharma industry’s pipeline. While the prospects are solid long-term, we need to recognize that the field is crowded and competitive, customers are primarily cost-driven, and they have a lot of leverage. This segment will not return to the high-growth, high-margin era of several years ago. This is a natural consequence of the maturing of this industry segment.

On the other hand, the large molecule side is high-growth and high-profitability. There are few players, high barriers to entry, and high barriers to switching suppliers. Pricing is based on the value add we provide to the customer, rather than supply/demand.

SLIDE 22:
Let’s look at some of the fundamentals around this sector’s growth.

Biopharmaceuticals are a growing proportion of the total pharmaceutical market. They have numerous advantages over small-molecule APIs, including greater functionality and selectivity.

Biopharmaceuticals have a 20% compound annual growth rate, versus traditional APIs with an 8% CAGR.

In the past five years, the number of new biopharma approvals has increased five-fold. In spite of a small decline in the past year or so, we see this trend continuing.

But will the exponential growth of biopharmaceuticals – and their related manufacture – continue forever?
Sadly, no.

SLIDE 23:
The maturity curve tells the story. Every sector of an industry naturally moves through a maturation curve … as a life cycle.

Any new market that meets with success and growth will eventually reach a point where that level of rapid growth moderates to normal growth and eventually slow growth or even decline. The speed at which this happens can vary widely.

In order to revitalize growth in a mature industry, you must innovate. This applies to the outsourcing field in a number of ways.

First, the chemicals side of custom processing is more mature – and therefore less profitable and lower growth – than the pharma side. It has to innovate to survive.

Likewise, within the pharma side, the traditional small-molecule segment is more mature than the large-molecule segment, and finds itself with the same predicament.

SLIDE 24:
Maturity curves also can illustrate how new technologies run through a life cycle as well.

To continue to grow, a company will need to make constant, targeted investment in new technologies.

The good news is that a number of factors in the large-molecule segment are slowing the maturation of the segment – such as the high barriers to entry and switching. This is why the large molecule segment continues to have appeal for those companies who have the resources to compete in it.

SLIDE 25:
Therefore the winners in pharma outsourcing will be …

• Those with financial resources and flexibility
• Those with excellent regulatory capabilities and track records
• Those who collaborate and effectively find the best solution to their customers’ needs
• Those with breadth and depth of capabilities
• Those who are chosen for the short list of suppliers by the ever-consolidating pharma companies.

SLIDE 26 & 27:
And who will the winners be? What will it take to win?

It’s more than a list of reactions you can do. You will need a distinctive competitive advantage. You will also need breadth and depth of capability, as well as alliances to fill niches that you cannot deliver.

You will need small and large molecule capabilities … and that will take significant financial resources to perform.

You will need regulatory expertise.

You will need to have staying power – and be ready to invest much more.

And you need the right culture: agile, and focused on customers for win-win solutions.

Who will these winners be? Hard to say for sure. The only thing we can say is that they will not be the same names we see today.

SLIDE 28:
Take a look at the top players today, based on sales.

Who will the top players be in 2008?

SLIDE 29:
Here is a bold prediction … just our view from where we sit.

These seven companies have the breadth and depth that I mentioned earlier, and the financial strength to make the investments needed to grow.

At Dow, we have been making strategic investments to build on our breadth and depth -- acquiring Chirotech, Mitchell-Cotts, Haltermann, ANGUS and Collaborative BioAlliance … making new investments in oligonucleotides, plant-based production, microbial and mammalian cell capabilities … and forming alliances with numerous niche players. We expect to be one of the major players in this field for the long haul. The other companies on this slide can buy me a glass of wine later!!

SLIDE 30:
Now, you may be wondering, what about the small players? Isn’t there still a role for them?

In fact, the more direct question is…

"Will small niche players have a disadvantage?" The answer for the majority is yes … because they lack breadth and depth … and they lack financial resources and staying power to keep up with the investments needed in the sector.

Think about this: The typical member company of SOCMA has sales of around $40 million, and fewer than 200 employees. Compare that with the cost of entry into new technologies such as mammalian cell … which costs hundreds of millions. Companies this small don’t have the resources to keep up with the ever-shortening life cycles of these technologies.

SLIDE 31:
But some small niche players can survive and thrive…by specializing or collaborating. These niche players will have to be smart enough to be narrow and deep in a technology that turns out to have high impact and value-creation … because not all technologies will offer the value-creation potential to sustain a company’s growth.

Here are some companies who have defined a targeted strategy to serve a specific niche. A focused strategy in a value-creating niche is the first step, along with an approach to collaboration and alliances.

But it’s clear that there are NOT enough niches for all the small companies that exist today. If you’re a small or medium-sized player, you will need to decide with whom you want to form alliances. Which of the top 5-10 players that you want to be aligned with?

SLIDE 32 & 33:
So let’s return to our question of whether outsourcing has fulfilled its promise …

My answer is… for the most part, yes. The five-year spurt was terrific. But as we know, growth won’t continue at that pace. There have been too many entrants into small molecule pharma segment, and that sector is now rapidly maturing.

We will never return to the accelerating growth rates of the early phases of these markets. To think that the normal industry maturity curve does not apply here is erroneous logic. We must acknowledge that the industry is changing. Riding out the storm is not enough. We must change our strategies to adapt to these maturing markets.

As I said earlier, where technologies and markets mature, we can create more value growth -- through productivity improvement and cost reductions, and at the same time we can innovate to create new mini-curves of growth. I’d predict that two of those areas where we’ll see mini-curves of high growth will be (1) where companies can add value by taking out costs from the total value chain, and (2) the promise of biotechnology.

SLIDE 34:
So perhaps the more important question to ask is …will outsourcing fulfill its promise in the future?

My answer is … again yes.

We see a lot of opportunity out there … for companies with breadth and depth of capabilities … who partner with the right customers and alliance partners, and who truly understand their customers and the value chain … and who choose the right technologies to invest in.

But it’s not going to be easy. It will be up to each of our companies to find out where those sweet spots will be.

To survive and grow, our companies must change and adapt to turn these opportunities into value creating businesses.

How will you have to change and adapt?

SLIDE 35:
Santayana said … "In a moving world, re-adaption is the price of longevity."

Our industry is a rapidly moving one. The companies that have the staying power to constantly adapt and re-adapt to change in their sector will be the winners. And they will be the ones who will see outsourcing continue to fill its promise from the heady days of the ‘90s, through the consolidation period, to the new growth period.

Thanks for listening. I wish everyone a very successful meeting here at Informex. Now I believe we have some time for questions.