Victrex (VCT)

 

This mid-cap dominates an oligopoly

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This mid-cap dominates an oligopoly

Victrex's (VCT) chief executive chooses his words carefully, like a politician. At last year's AGM, David Hummel told me he doesn't like to talk of commoditisation. That doesn't mean rival manufacturers aren't making inroads into the market for PEEK, the super-tough polymer his company specialises in manufacturing, although an idle listener might think so.

At its AGM last Thursday, Hummel told shareholders he thinks of metal as PEEK's main competitor, as opposed, I suppose to rivals like Solvay and Evonik, two large polymer manufacturers that also produce PEEK.

Because PEEK's light, cheaper to shape, and less susceptible to corrosion, manufacturers are using it instead of metal in components for cars, aircraft, consumer electronics and a wide range of industrial products.

Is Hummel misdirecting us? Or is he just focusing on his own game? Mostly, I think, he's focusing on his own game.

Growth despite pricing pressure

Victrex's PEEK patent expired in 2000, yet the company still produces more than the rest of the industry combined. When Solvay adds 1,000 tonnes of PEEK capacity later this year, statistics published by Victrex show it will still account for about 64% of the industry's total capacity. In 2016, Victrex produced 4,000 tonnes, more than the 3,000 tonne capacity of its rivals.

Though prices are coming under pressure, particularly in markets like consumer electronics where less specialised grades of PEEK are sometimes specified, turnover at Victrex has grown from £59 million to £250 million since 2000 and pre-tax profit from £16 million to £83 million. The process of commoditisation, therefore, has been slow and not particularly deleterious.

That's probably because Victrex has not stood still. Hummel says its strategy is like running on a treadmill. The company is forever producing new grades of PEEK, and new shapes.

On the day of the AGM, Victrex announced a joint venture to manufacture brackets for aircraft, one of a series of new programmes that will involve it in producing finished or part-finished components with the aim of proving its material in new markets, stimulating demand, and increasing the value captured by Victrex from the products ultimately made of PEEK.

The competition

Races to innovate are expensive, and can degrade returns across the board, but a race may be the wrong metaphor to describe Victrex's competitive situation.

Usually, there's only one person on a treadmill. Solvay and Evonik are large diversified chemical companies, whereas Victrex is a specialist, making only PEEK, composites composed partly of PEEK, and closely related variants of PEEK also in the PAEK polymer family.

It should have all the advantages: more expertise and stronger relationships with customers, as well as more capacity. Victrex's former parent, ICI, invented PEEK and ever since Hummel and three other managers spun the company off in 1993, it's had to persuade engineers to use it instead of the metals they know so well.

When a company has such an entrenched lead, perhaps the best strategy for competitors is not to out-innovate their rival, but to feed off its innovations by supplying undifferentiated grades of PEEK.

If Victrex has competitive advantages, it should be apparent in the numbers. These are plucked from Google Finance, and only for one year, but I think they're divergent enough to tell a story:

Company Market capitalisation Operating margin Return on assets
Evonik (2015) €13.9bn 12% 6%
Solvay (2015) €11.7bn 7% 2%
Victrex (2016) £1.7bn 40% 18%

Financially, Solvay and Evonik look like quite similar businesses, unlike Victrex, which as you might expect of a specialist is smaller and much more profitable*.

After the AGM, Hummel asks me whether he's answered all my questions. He says I'm like all the analysts that come to him. They come and ask about patents. They come again and ask about competitors. They keep coming until they run out of questions.

Although I hold the shares in the Share Sleuth portfolio, I'm not there yet. When it comes to the future you never run out of questions. Victrex's move into manufacturing components makes the business more complex. Having built new chemical capacity, the emphasis is shifting to investment in tooling and manufacturing, activities it's less familiar with.

From newer grades of PEEK it expects to earn higher profit margins, but some new applications might earn lower margins due to higher manufacturing costs. The company hopes to maintain profit margins by running on the treadmill, but I can't escape the feeling that, while PEEK manufacture looks like an oligopoly dominated by Victrex, Victrex is having to work harder to find new customers and competition is a factor.

Thrusting aggressively into component manufacture, where Victrex can develop closer relationships with customers and make new developments it can protect, shows the company is adapting, which is a good, but nonetheless unsettling thing. It means success in the future will in part, be based on a strategy that is only beginning to be tested and will only be proved after a decade or more.

In parting, and I'm not prone to sycophancy, I promise, I ask Hummel if he takes great pride from the development of Victrex, which, after all, is not taking the easy but often less profitable road and diversifying out of its niche. After his marriage, and his children the company is his greatest achievement, he says, but it couldn't have been achieved without a great team**.

Maybe he could be a politician too*** :-).

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Postscript: One shareholder objected to the company's Long Term Incentive Plan, quoting a line I am sure came from an article I wrote that every letter in the acronym LTIP is a lie (Probably this one, although it could be this one. I've said it a few times). LTIPs often encourage short-term behaviour, if they're lax enough they're bungs not incentives, and they often reward luck or the skill of others and not the performance of a single executive. While I don't like LTIPs, and we must push back against their ubiquity, I take comfort in the fact that Victrex is so obviously investing for the long-term regardless of potentially perverse incentives.

*See a company tipped to prosper for commentary on Victrex's financial performance.

**Some of whom I've met and been impressed by.

***I don't mean to represent all politicians as masters of misdirection, I'm abusing a stereotype.

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Contact Richard Beddard by email: [email protected] or on Twitter: @RichardBeddard

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.