Ultrapar Considers Entering Surfactants Market in China

Case Type: industry analysis; market entry; business competition.
Consulting Firm: Cornerstone Research final round full time job interview.
Industry Coverage: chemicals.

Case Interview Question #01314: Your client Ultra Group (NYSE: UGP) is a Brazilian chemical conglomerate that produces a wide range of chemicals. The company develops and supplies raw materials to industries in over 30 sectors including cosmetics, personal care, household cleaning and industrial, agrochemicals, paints and varnishes. It has three research and development centers, twelve industrial plants in Brazil, the United States, Mexico, Uruguay and Venezuela.

The CEO of one of the divisions of Ultra Group is concerned about the increasing production of surfactants in China. Specifically, he is concerned about the import of surfactants into Brazil, which will threaten the company’s dominant domestic market position, and the company’s primary export market, which is the U.S. In addition, the CEO is also interested in entering the China market to produce surfactants to take advantage of the low labor and material cost in China. How will you help the CEO to address these problems?

Possible Answers:

Candidate: The client is concerned about China’s threat to the company’s domestic and export markets, and also whether it makes sense to produce surfactants in China. I would like to take a step back to understand which of the three concerns is the most important?

Interviewer: Unfortunately, its revenue for surfactants is evenly split between the domestic and export market, and the company has always been wondering whether it should enter China. The CEO wants a plan to approach all three problems.

Candidate: It is unfortunate we cannot prioritize our approach, so I will focus on the three concerns equally.

Interviewer: Correct. Let’s focus on the first concern. How will you determine if his domestic market position will be threatened by China’s production of surfactants?

Candidate: I would like to benchmark the client’s cost structure of producing surfactants with the more efficient and larger Chinese surfactants producers. The cost of producing any chemical should be distributed between labor, raw materials and overhead such as the manufacturing plant. In addition, there will be transportation costs and even tariffs for the Chinese produced surfactants if it is exported into Brazil. Unless the labor and raw material cost in China are significantly cheaper, my initial hypothesis is that Chinese produced surfactants will not be a threat to the client’s domestic market.

Interviewer: That’s a reasonable hypothesis. Why do you think that Chinese labor and raw material cost are comparable to the client?

Candidate: In Brazil, I believe the client can obtain cost-competitive skilled labor as compared to China, and sourcing for raw materials throughout South America should be reasonably as cost efficient as in China.

Interviewer: Okay. Let’s move on to the second concern. How will you further determine if Chinese surfactants producer will threaten the client’s primary export market in the U.S. since both of them are exporting their products?

Candidate: I will assess the amount and growth of exports out of China for surfactants. Given the strong economic growth of China, I will assume that domestic demand is also increasing. Therefore, the amount and growth of exports will be driven by how much domestic production exceeds domestic demand, and this insight can also help to answer the third concern.

Interviewer: How will you assess the surfactants production level in China?

Candidate: Given the lack of high-quality market data in China, it is critical to look into different data sources to triangulate the result.

First, I will buy research reports from multiple local private market research companies in China who actually track both the production size and growth of surfactants from state-owned enterprises and private enterprises.

Second, I will interview the head of the surfactants association in China to cross-check the data on these market research reports.

Third, I will interview relevant senior managers of the top three to five largest private sector companies about the overall production level of surfactants and its growth rate in China. I do not think the senior management team from the Chinese state-owned enterprise will speak to an international management consultancy, even on the overall chemical production level and the projected growth rate.

Interviewer: That seems to be reasonable. How do you plan to assess the domestic demand level in China?

Candidate: In order to assess the domestic demand, it is important to assess the downstream demand for surfactants. Can I find out what products will need surfactants?

Interviewer: Let’s assume there are only three products that will need surfactants. Take the example of one of the three products. How will you estimate the demand and growth of this product?

Candidate: I will actually employ the same process as determining the production of surfactants by using the local market research firm, talking to the association for the product and interview the relevant senior management of the top producers to determine the market size and growth of the product.

An additional step will be to determine how much per unit of the product will require surfactants and extrapolate accordingly. It is also important to determine if there will be a substitute to surfactants for the product and the rate of substitution.

Interviewer: Can you calculate for me the demand for surfactants for the current year and next year based on the following table, assuming no substitution for surfactants?

Candidate: The current demand will be sum of the usage of surfactants by these three products, which will be:
15,000*0.2 + 10,000*0.1 + 20,000*0.35 = 3,000 + 1,000 + 7,000 = 11,000 units of surfactants.

The demand for next year will be:
3,000*(1+3%) + 1,000*(1+5%) + 7,000*(1+10%) = 3,090 + 1,050 + 7,700 = 11,840 units of surfactants.

Interviewer: Thanks for walking me through your calculations. What is the percentage increase for the Chinese domestic demand of surfactants?

Candidate: It is (11,840 – 11,000)/11,000 = 7.6% increase. This is a fairly aggressive growth rate.

Interviewer: Okay. What’s next?

Candidate: Once we have an estimated market size and growth for the relevant products for surfactants, we will be able to assess the domestic demand and the demand growth rate for surfactants. We need to verify the reasonable assumption that the producers in China who need surfactants will first purchase it domestically.

Interviewer: Assume that you have determined both the production and demand of surfactants in China, and found that there will be increasing exports of surfactants in the future, what will be the next step in our analysis?

Candidate: Let’s circle back to the second concern of whether the Chinese producers will threaten the client’s primary export market. Assuming their cost structure is relatively competitive and they face the same tariffs, the key differential will be the transportation cost. I will assume the transportation cost will be slightly higher for the Chinese producer than our client because China is further away from the U.S. than Brazil.

Interviewer: That’s a fair assumption. Do you think that is going to make a difference?

Candidate: I think our client can initially leverage on the cost differentiation. But assuming that the differentiation in transportation cost is minimal, the Chinese exporters of surfactants will definitely pose a threat in the near future.

Interviewer: What will you advise the client to do then?

Candidate: The client can work on deepening customer relationships while remaining competitive in price. First, the client can work harder to ensure that its delivery schedule of surfactants meets its U.S. customers’ need. Second, the client can better understand the amount of each batch of surfactants that the U.S. customers require, and deliver the exact amount accordingly.

However, given that surfactants appears to be a commoditized chemical, the price differentiation between the Chinese producers and the client should never differ significantly. An effective and deep customer relationship will not overcome a significant price differentiation for a commoditized product. Therefore, the client should definitely look into producing surfactants in China.

Interviewer: How should we determine if it is a good idea to produce in China, and how should we do so?

Candidate: Given that we have established that Chinese production has already exceeded Chinese demand, it is unlikely our client will be able to sell to the domestic demand in China if the client went in alone without a Chinese partner. Another option would be to produce in China for the surrounding export market. It is definitely not a good idea to produce in China to export back into Brazil or South America because of the transportation cost.

Therefore, unless circumstance changes and the cost of raw materials or skilled labor in China drop significantly relative to Brazil, I would recommend that our client continue to monitor China’s production, but not enter into China right now.

Interviewer: I agree. Let’s assume that the raw material cost has dropped significantly in China as compared to Brazil, and actually makes it cost effective to produce surfactants in China and transport back to Brazil and the U.S. market. What should the client do now?

Candidate: The client should consider looking for a joint venture Chinese partner with existing production facilities that will produce cost-effective surfactants for export back into Brazil given the time pressure. One key risk is that the joint venture partner may take unfair advantage of the client, given the client’s unfamiliarity with China. So the client should aim to have a majority share of the joint venture.

If the client has more time, then it may want to consider building its own factory in China to have full ownership, but the key risk factor is the unfamiliarity in obtaining the necessary permits from the local Chinese government to
build a factory focusing on a rather dangerous substance-chemical.

Interviewer: Good. Do you want to quickly sum up what we have discussed, and assume that I am the client’s CEO.

Candidate: CEO, I would like to address your three concerns.

First, you do not face a threat to your domestic market because of the comparable production cost of surfactants between you and the Chinese producers. The transportation and tariff for the Chinese-produced surfactants will make it too costly to be competitive.

Second, you do not face an immediate threat to the U.S. export market because it costs more to transport Chinese-produced surfactants to the U.S. than from Brazil. However, you have to deepen your relationship with your U.S. customers, and ensure the Chinese produced surfactants will not be significantly less expensive than yours in the U.S. market moving forward. Therefore, you must always ensure your price is as competitive as the Chinese producers for your U.S. customers.

Third, you may not want to enter China now to produce surfactants because the Chinese domestic demand for surfactants has been more than fully met, and there is no cost advantage for going to China to produce surfactants as compared to production in Brazil. That said, if it becomes much more cost effective to produce in China, then it is imperative to consider a joint venture partner in China to leverage on the more cost effective production process quickly.

Interviewer: Great. I think you did an excellent job.