SABIC Acquisition of GE Plastic

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Introduction

Saudi Basic Industries Corporation (SABIC) is a chemical manufacturing company located in Riyadh. It is one of the top manufacturing companies in Saudi Arabia and the whole of the Middle East with generated revenues that are in the region of the $40 billion mark and a workforce comprised of 33,000 personnel directly employed by the company worldwide. It was ranked by Fortune Global magazine in 2008 as the topmost chemical manufacturing company in Asia and number four worldwide. It has a range of several other manufacturing operations that include metals and fertilizers and a total of more than 20 affiliated business subsidiaries that are located all over the world. In 2007 SABIC added the most recent acquisition to its list of business divisions: the GE Plastic that it bought to a tune of $11.6 billion. With this new acquisition, SABIC is now set to diversify its manufacturing operations even further while at the same time expanding its growth. The company’s future plans include the construction of an ultra-modern iron and steel facility with a capacity to produce 1 million tons at the city of Al-Jubail by 2012 and other plans that will further increase its capital investments to $70 billion by the year 2020. Currently, SABIC is one of the most respected companies worldwide and a leader in the manufacture of petrochemical products, fertilizers and steel products.

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Background Information and Business Operations: SABIC

SABIC is a public company that was incorporated in 1976 by the Royal Decree of King Khalid and has 70% of its shares owned by the government which makes it a public company. The company was founded for the main purpose of utilizing the countries oil industry raw materials to form chemical products such as fertilizers and polymers. Immediately after it was incorporated SABIC initiated talks with major companies with a vision to form partnerships in the construction of several manufacturing plants in Al-Jubail city which would later become one of the largest industrial cities in Saudi Arabia and internationally. Such companies that SABIC sought partnerships with were Shell Oil, Mobil Corporation, Dow Chemical and Exxon Chemical.

In 1978 construction works of the company began in Al-Jubail city including the construction of other city amenities such as the airport. By 1986 SABIC had a production rate of more than 7 million tons of chemical products and was marking its ten-year anniversary since it was incorporated. It was also a milestone for the company which had now a total of 13 manufacturing plants located all over the country with future plans to add more, by this time the company had 8,319 employees on its payroll that spoke of its rapid expansion. In the years to follow the company would even expand more rapidly this time in a way that enabled it to compete in the international market. In 1988 the company opened new branches in three developed countries on various continents: Britain, the United States and Japan. In the same year, it was voted one of the most innovative and dynamic manufacturing companies in the whole of the middle east, during this year the company paid its first-ever dividend on its shares which it has just split into several pieces.

The decade leading up to 2000 saw the company attain new milestones that further proclaimed the company as the leader in the chemical industry internationally and saw the introduction of other range of new different business operations.

In 1992 SABIC groups of companies become the first in the Middle East to attain the ISO 9002 certification. In the following year, SABIC acquired subsidiary companies in Europe that were located in Germany, Singapore and Italy. In 1997 the company adopted the Strategic Business Units Systems (SBUs) in a bid to consolidate its various petrochemical products that were ever-increasing. The business operations strategy of the company has categorized the company manufactured products into seven different SBUs; Polymers, Chemicals, Fertilizers, Metals, Innovative plastics, Performance Chemicals and Manufacturing.

In July 2002 SABIC finalized another major acquisition deal of a petrochemical plant in Europe that brought onboard Royal DSM N.V German Company that was valued at $1,983 million. Two years later the company made a financial leap that could be attributed in part to the DSM acquisition in Europe; its listed share value increased by almost three folds and the net profit of that year more than doubled. Thereafter the next major acquisition occurred in 2007 where SABIC took over Huntsman Corporation of the UK to complement the German plant in supplying the European market which was one of its largest. However, it is the most recent acquisition of GE plastics that finally put SABIC at the center of the world map as a formidable player in major company acquisition deals which was by far the largest and the most costly as well. In May 2007, SABIC finally announced the acquisition of GE plastics for a record of $11.6 billion.

Specific products produced by the company include steel, butene-1, valox, verton, ethylene, fertilizer, phenol, benzene among many others. SABIC is currently one of the few Multi-dollar businesses with operational plants in more than two dozen countries with a workforce of 9,500 in its various foreign countries manufacturing plants. The most recent annual financial report of 2009 indicates that the company made $9billion net income generated by sales revenue of $103 billion. The current capital assets of SABIC are estimated to be valued at $297 billion.

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Background and Business Operations: General Electric Plastics

General Electric Company is a conglomerate of various affiliated companies based in New York that dates back to 1890. It is ranked as the single largest company in the world with 323,000 employees working on its various affiliated subsidiaries. GE Plastic is one such division of General Electric Company located in Pittsfield. It was formed as a separate division in 1930 occasioned by scientific advances made by Thomas Edison’s experiments of using plastic filaments in a light bulb. However, it was not until the 1960s that GE plastic manufacturing operations began to rapidly expand after its invention of the Patented Lexan Polycarbonate plastic product that had the unique advantage of insulation, waterproof and corrosion-resistant and which is an important component in the manufacture of bulletproof glasses and compact discs.

But GE Plastic is by no means just a divisional manufacturing company for General Electric Company. Since its inception more than 70 years ago the company has expanded its array of business operations to include research services besides its product manufacturing operations. GE Plastic has 11,000 employees working in its various branches offices worldwide in more than 20 countries. Until recently GE Plastic was one of the most profitable arms of GE Company that regularly posted net profits that grew every year.

However, as a result of the high cost of fuels, which is the major raw material of all plastic products, the company started to decline both financially and at the rate of expansion. In addition, the company was facing stiff competition from other global companies in the plastic industry that had the advantage of cheap labor such as from China. In the last quarter of the year, GE plastic dropped by a further 23% in a series of such profit falls that is now becoming a norm. Perhaps it is what effectively sealed its fate and prompted the founding company GE to float it to the market for sale.

Currently, the company’s business operations are entirely focused on plastic production of various forms and specifications. Its plastic products include polymers, composites, insulating resins, polycarbonates, semi-conductor chips, Noryl PPX among others. New additions to these plastics developed recently by the company are Ultem and Extem, both offering the advantage of withstanding significantly high-temperature levels. GE plastic business success can be attributed to the range of industries that it does business with that utilize the companies plastic products, its major clientele is in the field of healthcare, defense, telecommunications, aviation, auto and construction. On May 21, 2007, GE plastic was sold off to SABIC the company with the winning bid for $11.6 in a stiffly contested process that had attracted other renowned international companies such as Apollo Management Incorporation of US and Access Industries from the Netherlands.

GE Plastic Valuation Process

Valuation is a financial process applied to business establishments and assets to estimate Market Value or Economic Value. Business valuation estimates are required for several distinct reasons, it is mainly done during company mergers and acquisition as a prerequisite before transactions take place. Another instance when valuation is necessary is during company financial reports, investment analysis, capital assessment, calculating tax liability and litigation cases. During company acquisition business valuation is done solely to determine the approximate market price of the business, in this case, the market price of GE Plastic that SABIC was willing to pay. Most business and financial analysts estimated the market value of GE Plastic to be between $8-10 billion at the time of acquisition, indeed the final price that SABIC paid for $11.6 billion is considered to be way above market price.

However, there are other factors that determine the market price of business during valuation price besides the value of the estimated asset, perhaps the reason SABIC upped the stakes during the transactions process. Financial analysts normally apply three models during the business valuation process depending on the purpose of the process: Discounted Cash Flow Model (DCF), Relative Value Model and Option Pricing Model. Most often a combination of the three models is used to estimate an accurate market price, the Relative Value Model estimates business value through assessment of other similar business values while Discounted Cash Flow estimates business value by calculating projected earnings of the business in question.

These two models are the ones that were used by the SABIC battery of financial consultants that included KPMG, Jacobs Consultancy and Booz Allen Hamilton in the valuation of GE Plastics. It is important to mention an ideal and accurate business valuation process should scrutinize the five indicators of company stability i.e. Income Statement, Balance Sheet, Discounted Cash Flow Valuation, Ratio Analysis and Weighted Average Cost of Capital (WACC) Calculation.

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The DCF analysis is calculated using several other models, however in this case we are going to use Free Cash Flow to Equity in estimating GE Plastic future value which is the most commonly used. The process of DCF analysis is done through four major steps: predicting company revenue growth, forecasting FCF, calculation of discounted rate and fair value estimation. The 2006 annual report of GE Plastic indicated that the company had $6.6 billion in sales revenue and a net of $560 million, therefore the revenue growth for the company in the next 3 years would be as shown in the table below. First, we need to make several assumptions that the company growth rate will continue to be 10% since the 2005 revenue was $ 6 billion.

Step 1

Current year Year 1 Year 2 Year 3
Optimistic Growth Rate Revenue $6.6 Billion 10% $7.26 10% 7.986 10% 8.78
Realistic Growth Rate Revenue $6.6 Billion 10% 7.26 5% 7.623 5% 8.0

Step 2

The next thing that we need to do is to determine the GE Plastic company cash flow. Free Cash Flow is calculated by subtracting tax, investments, working capital and operational costs. Based on the 2006 financial figures of GE Plastic FCF of the company will be as shown below. The calculations will only provide approximate figures due to incomplete financial data such as the tax that the company paid and working capital during the financial year. The assumption in this step is that the company will gradually increase net investments from the current 4.5%.

Current year Year 1 Year 2 Year 3
Projected Revenue Growth-Sales Revenue 6600 10% 7260 10% 7986 10% 8780
Operating Cost Margin 90% 90% 90% 90%
Operating Costs 5926 6534 7187 7902
Operating Profit 674 726 799 878
Taxes NA NA NA NA
After Tax Profit NA NA NA NA
Net Investments % 4.50% 6.50% 7.50% 8.50%
Net Investments 300 471 599 746
Working Capital NA NA NA NA
Change in Working Capital NA NA NA NA
Free Cash Flow 374 6788 7387 8034

Step 3

This step involves calculating the discount rate of the company which is arrived at using equity value, cost of debt and capital structure. At the time of acquisition, GE Plastics had liabilities of $8.7 billion. Due to lack of complete data let assume the company paid 30% tax, 10% risk premium, debt rate of 6% and risk-free rate of 6% which is consistent with most companies in the industry. Cost of debt will be (capital structure ratio [borrowing rate (1-tax rate)] plus the cost of equity (equity ratio [risk-free rate +beta (approximated at 1) (risk premium). Substituting this with the figures gives

Cost of Debt Cost of equity
0.4 (6 x 0.7 ) 0.6 [6 + (1×10)]
1.68 + 9.6
WACC = 11.28

Step 4

This is the final step of determination of the company terminal value given by the following formula. The long-term growth rate is calculated by averaging the percentage increase of CF growth rate over the years, which is 10% in this case.

TV= Projected CF X (1 + Long-term CF growth rate
DR – Long-term CF growth rate

Substituting these figures gives us

TV= $ 8.03 X (1 + 0.1) TV= 8.833 TV= $6.999 Billions
11.28 – 10 1.28

This is the approximate value of GE Plastics according to this formula of Free Cash Flow to Equity.

GE Plastic Strategic Advantage to SABIC

GE plastics offered four distinct benefits to SABIC that provided the company with valuable leverage and strategic advantage as well. Number one was the fact that GE Plastic was located in America a region that SABIC wanted to have a foothold through market penetration; this acquisition, therefore, offered the perfect opportunity. The other point was that GE Plastic’s business operations were very similar to SABIC besides the fact that the deal would have diversified its manufacturing operations in line with the strategic business operation of SABIC that made it continue to flourish. In addition, SABIC would finally acquire patented technological innovations of GE Plastics which would be a valuable asset. Finally GE Plastic provided SABIC with an opportunity to finally penetrate the American petrochemical market in a resounding way, America is the single largest market for petrochemical products and would significantly boost SABIC’s business revenues. Indeed SABIC expects the acquisition of GE Plastics to increase the company’s revenue by a margin of more than $6.6 billion per year once it finalizes settling the immediate company liabilities.

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Shortly before GE Plastic was put on the market the company had initiated plant expansion for its Mount Vernon branch to a tune of $30 million. However by 2006 GE plastic’s net profits had consistently been dropping to a low of $674 on top of other increasing liabilities, nevertheless, the company has so far not experienced a net loss which meant that it was a sound and operational business. This and other factors made GE Plastic an irresistible business proposition that SABIC was rightly justified to acquire and which was unlikely to turn into a bad investment. It was a smart long-term business investment strategy for SABIC that unfortunately required additional capital investments in the short-term, but which offered enough returns, in the long run, to surpass its cost and contribute to the company’s growth in the future.

SABIC During the Financial Crisis

The 2008-2010 financial crisis period set in almost immediately after SABIC acquired GE Plastics. The company was hardest hit during the first phase of the crisis where it net profit earnings during the fourth quarter of 2008 financial year dropped by a whopping 95%. To make matter worse the financial crisis triggered the oil price hike that meant raw materials for the manufacture of petrochemicals was also elevated by a factor of 200%. This was in the backdrop of $10.1 billion GE-associated depreciation costs that the company had just settled. In 2009 during the first quarter the company suffered a major financial loss amounting to a net loss of SR0.97 billion while it share value was eroded by SR0.32 as a result the company failed to pay dividends to its shareholders for the first time in a long time.

SABIC, therefore, had to implement a range of measures that sought to have the company cut its costs and remain profitable and thereby avert financial losses that were imminent. The company’s first measure was a reduction in operating cost that saw several plants shut down as it consolidated its manufacturing process in its various other remaining plants. Consolidation of the manufacturing process also enabled the company to cut down on production rate as a result of a drop in demand for its manufactured products occasioned by a slow down in global economies. The company also implemented comprehensive reorganization in its manufacturing processes to be more in line with the new company’s strategic business operations.

SABIC company is guided by four principles that include: increased marketing initiatives, quality products, manufacturing processes integration and employee empowerment. Other measures that the company undertook included freezing current and future projects such as the Saudi Kayan PC unit plant until the financial crisis eased up. This was one of the most creative approaches that few companies could afford at the time and instead opted to cut costs by laying off workers en masse for the few that were still able to remain in business. In a way, the GE Plastic acquisition insulated the company from adverse financial losses that SABIC would otherwise have suffered without the advantage of a broad market base that GE Plastic offered.

SABIC also took advantage of implementing several employee training programs at the time that would later be an asset that later significantly contributed to it records profits in the 2009 financial year. The following table indicates the company’s financial performance between the period of 2006 shortly before it acquired GE Plastic up to the current financial year, note the way that the company financial growth is consistent despite the global crisis, a fact that supports the theory that GE acquisition helped SABIC endure the financial storm more effectively in a way that might not have been possible without it onboard.

Table 1

SABIC Financial Performance
2010 2009 2008 2007 2006
Sales (Riyal m) 103,062 150,810 126,204 86,238 78,254
Operating Profit (Riyal m) 18,804 38,090 41,047 30,886 29,170
Net Profit (Riyal m) 9,074 22,030 27,022 20,294 19,160
Total Assets (Riyal m) 296,861 271,760 253,731 166,589 136,950
Diluted Earnings Per Share (Riyal) 6.34 13.07 14 8.12 7.66
Number of Employees 33,000 33,000 31,000 19,000 17,000
Source: ICIS Market Intelligence (SABIC Financial Data)

Diluted earnings per share refers to the share value that the company was paying to the shareholders exclusive of dividends while the 2010 sales figures cover the first quarter of this financial year.

Conclusion

As the effects of the financial crisis subsided, SABIC posted records net profit of $9 billion in 2009 financial year that exceeded the projected profits of the company. This means the company was able to rapidly bounce back to profitability amid two major determinants that had weighed down it financial growth. Indeed the opening statement from the board of company chairman Prince Saud bin Abdullah asserts that the company was faced with monumental challenges in the past few years that were historic in nature but which also shaped the future of the company in a clear reference to acquisition of GE plastic and the financial crisis. In the wake of the GE plastic acquisition deal SABIC CEO Mohamed Al-Mady confirmed that the company would continue to pursue this line of it business strategy that had been the centre factor to it success since its inception in 1976.

Certainly the company rapid expansion can be attributed to it various acquisitions that it had pursued at key strategic locations worldwide and others at home country during it early years of it business operations. If there was any doubt or reservations by critics regarding the SABIC acquisition of GE Plastic back in 2007 at a cost that was considered by many analysts to be above the market price then those perceptions had been muted by the turn of the events. The 2010 financial projections for the company are estimated to be in the region of $6 billion net profit, a figure that even the company’s financial analyst agrees to be quite modest. If the wheels of time were rolled back to 2007 and GE Plastic put up again for sale there is no doubt that the company would fetch higher, perhaps even absurd price as a result of the acquisition scramble that would ensue.

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