IPO excitement, ‘aftermarket’ abandonment?
Lee Clements is an investment manager specialising in the long term thematic and sustainable investing sector with experience across multiple asset classes. He has managed portfolios including global long only equities, long/short equities and unlisted growth stage venture capital investments, and has extensive experience in renewable energy, energy efficiency, water and waste sectors as well as oil & gas, healthcare and technology. Between 2008 and 2015 Lee was Head of Thematic Research at Impax Asset Management. He will be among the speakers at the GCV Advanced Materials Society conference on November 10th in London (details at www.gcvmaterials.com)
Advanced materials are a large and growing market which is increasingly critical to the next generation of many new technologies. However whilst this growth can make them attractive investment opportunities there are aspects of the typical advanced materials business model that make them challenging to listed equity investors.
The development and use of new materials has been one of the hallmarks of economic and technological development for centuries. Structural materials have moved from stone through bronze and iron to steel and now advanced composites. Energy generation from wood, through coal and oil, to renewables and nuclear power.
The Share of US primary energy demand from 1780-2100 – Citi Research
New technologies, driven by performance and economic reasons, are driving the demand for advanced materials which can facilitate improvements. In particular scarce natural resources and more efficient and cleaner processes are increasingly strong drivers. Regulation, consumer preference and cost also make it imperative for companies to continually develop their technologies in order to survive, in many cases through the use of advanced materials. For example the aerospace industry has used advanced composites and metal alloys to meet the challenges of emissions regulations, consumers demanding longer, faster and cheaper routes, and the demand for greater fuel economy. These continual demands make advanced materials a significant market which is expected to grow significantly over a long horizon. A recent report for the EU predicted the market for “value added materials” would grow from €102bn in 2008 to €1,099bn in 2050, a CAGR of 6%. This CAGR is ahead of most expectations of global, economic growth, which should make advanced materials a good, long term investment compared with more traditional businesses.
|Total projected value of value added materials markets: Technology and market perspective for future Value Added Materials, Oxford Research for European Commission Directorate-General for Research and Innovation, 2012|
Advanced materials are a popular investment for venture capital funds and within large industrial groups, where they can take such a long term view. According to a survey of private equity investors some of the most popular advanced materials sectors for are within the environmental and energy sectors.
|Investment willingness for Value Added Materials by sector: Technology and market perspective for future Value Added Materials, Oxford Research for European Commission Directorate-General for Research and Innovation, 2012|
Challenging business model for listed markets
Despite the widespread importance of advanced materials and investments at earlier, unlisted stages they have often proved to be challenging investments on the listed markets. There are many examples of listed, advanced material companies which have seen initial, short term performance but have disappointed over time. Second generation biofuels, OLEDs, sapphire and activated carbon have all been popular investments which have later collapsed. There are many factors behind this but ultimately listed market investors are looking for earnings growth at an attractive valuation. The more visibility there is to the earnings growth the higher the valuation they will attach to it. Advanced material business models can have very attractive investment propositions at IPO given the disruptive technological developments they offer. However they can then let down the markets when it comes to visible revenue and earnings growth leading investors to sell out and they may end up as effectively abandoned. Some of the key issues of the business models include the complexity of the chain from material to end product and the risk of commoditisation, capital costs in setting up economic scale production and the tendency to have a very concentrated customer base.
Complex Supply Chain
One issues is the complex chain between the advanced material manufacturer and the end customer, often via various sub-system developers/integrators. This is made even more complex, and the end customer relationship even more important, with the introduction of new technologies.
Overview of the Advanced Materials Systems ecosystem:Reigniting Growth Advanced Material Systems, Deloitte Global Manufacturing Industry Group, November 2012
The complexity of the chain makes it difficult for investors to assess where the value and hence profits are concentrated. The normal assumption is that the systems developers, making the end product and owning the customer relationship, will hold more of the value and face less risk of commoditisation. Deloitte analysed more than 6000 companies, splitting them into advanced material or advanced systems groups. The return on assets were similar in the early 2000’s, but post 2008 materials under performed and investors placed 1-1.5 times lower value on materials companies through the whole period.
Performance divergence between materials and systems, while market consistently rewards systems player: Reigniting Growth Advanced Material Systems, Deloitte Global Manufacturing Industry Group, November 2012
Advanced materials companies, particularly new ones, need significant capital expenditure to build plants of the scale to achieve profitability. Companies often list before their first, economic scale plant is built, due to the need for equity capital to build said plant. Despite often having contracts with large off-takers, longer time scales and inevitable delays often lead to missing revenue and earnings targets and stock prices underperforming. Most of the US second generation biofuel companies listed with great success but have significantly disappointed as investments due to challenges with building profitable production on the original timescales.
Concentrated Customer Base
Many advanced material companies are based on a new technology and to achieve scale and market acceptance they need to partner with a large customer. Whilst these collaborations can work well for both parties, enabling new, disruptive technologies, they can also create significant issues for the smaller, materials company. Lack of visibility of end product demand, pressure on pricing and the threat of a second source supplier can all contribute to the materials company being beholden to the larger partner. If there are delays or other problems this can be very detrimental. Examples include the challenges of an OLED material supplier working with a global flat panel display manufacturer, and a sapphire producer working with a large smart phone manufacturer. In the latter case, bankruptcy for the materials innovator was the eventual sad outcome.
However advanced materials can make attractive listed investments with the right business model. A good example is where they are a key, enabling consumable in a larger process, this is the classic Gillette razors vs razors blades model. Given strong barriers to entry to keep out other suppliers it can create a profitable, annuity revenue stream and attract a high valuation multiple. An example of this attractive, annuity revenue stream is in the supply of industrial enzymes which increase the efficiency of many biological processes. In enzymes for US fuel ethanol one company has a dominant market share as heavy investment in R&D has kept out competitors. This has insulated it from much of volatility in the commoditised biofuel industry and their stock has generated significant performance for investors.
In conclusion advanced materials are a large and growing market and will be a vital part of developing a new generation of technologies across all sectors. However the typical advanced materials business model can be challenging on the listed market and it is key for potential investors to have a long term view and be able to accept volatility. They must conduct significant due diligence not only to find truly disruptive material technologies but also to find the companies with business models, barriers to entry and value capture to generate long term profitable growth.