Lehman Brothers Sees Strong Year For Chemical Stocks, M&A in 2001

22 January 2001 00:00  [Source: ICB Americas]

By Joseph Chang

After taking a beating last year, US chemical stocks are poised to rebound in 2001 as investors look ahead to the next upcycle, according to the Lehman Brothers global chemical group. M&A activity is expected to remain robust in 2001 as turbulent operating conditions push companies to consolidate.

"After three peak years (1995 to 1997) and two trough years (late 1998 to 2000), the chemical industry is entering the last full year of the downcycle," said Lehman Brothers analyst Sergey Vasnetsov at the company's media briefing held in New York City last week. "Our research of the supply/demand balance calls for the second half of 2001 as a transition period, and 2002 as the first full year of the 2002 to 2004 upcycle."

Mr. Vasnetsov says the next cycle peak could look very different from prior peaks as significant consolidation among petrochemical players reduces the number of new projects and stabilizes pricing. He cites the combinations of Exxon/Mobil, BP/Amoco, and the pending merger between Dow and Union Carbide. "Both Exxon and Mobil had large crackers planned in Singapore, but now only one will be built," he says.

"Instead of one big spike like we had in 1995, you might have a few smaller peaks," Mr. Vasnetsov concludes. "The peak will last longer, but won't be as high. This steadier profit growth will go a long way in restoring value in the industry."

However, the near-term outlook is less sanguine with four to five tough quarters ahead, according to the analyst. He expects prices for olefins and polymers to slide further in 2001, and volumes to be depressed because of inventory destocking on the part of customers and a slowing US economy.

Despite the gloomy profit outlook, Mr. Vasnetsov sees a very positive year in terms of share price performance after being correctly bearish on the major chemicals group in 2000. His top picks for 2001 are Nova Chemicals (commodity), PPG Industries (diversified) and Eastman Chemical (intermediate chemicals). On Nova, the analyst has a 12-month price target of $30 and a peak target price of $50. Shares of Nova currently trade at around $19.50.

Mr. Vasnetsov notes that the commodity chemicals group is driven primarily by the supply/demand situation. "Yes, energy is important, but only on a transient basis for a quarter or two," he says. "Fundamentally, if you have a good supply/ demand situation, you can pass on price increases successfully. Conversely, if demand is not good as is the case now, you will have a margin squeeze."

For diversified chemical companies such as DuPont and PPG, he says fundamentals are driven primarily by the underlying industrial economy. "Volume growth is critical because that allows you to have high asset utilization to offset your high fixed cost base."

On the M&A front, chemical industry consolidation in 2001 is expected to remain strong. "Since the early 1990s, significant end-market consolidation, the contraction in pricing, slowing top-line growth, reduced opportunities for cost cutting, and the investor shift into the technology sector has led to chemical stocks being oversold," notes Paul Collins, managing director in the Lehman Brothers global chemical group.

Aided by depressed public valuations, the average M&A premium in the chemical industry is between 62 to 65 percent currently compared to 35 to 40 percent for other industrial takeovers, notes Mr. Collins. "This speaks to the intrinsic value of these chemical companies," he says.

In addition, institutional investor requirements for sufficient trading liquidity are putting pressure on public chemical companies--the majority of which have market caps (stock price times the number of shares outstanding) of less than $2 billion. "We hear a lot of investors say that if a chemical company doesn't have a market cap of $2 billion, they won't invest," says Mr. Collins.

"Here you have funds flowing into big cap companies, a slowdown in earnings and ultimately a reduction in P/E multiples," Mr. Collins points out. "Consequently you have an awful lot of pressure on the board as to what to do. From an M&A perspective, we will continue to see a lot of activity because of the market cap size issue."

Other trends fostering chemical M&A activity include non-chemical companies divesting chemical assets to focus on core operations and the rise of financial buyers. "Last year, chemicals was the number one sector in terms of investments by the private funds," notes Mr. Collins. "They see chemicals as a fundamentally undervalued marketplace today and will continue to be active."

Mr. Collins also sees the relatively new CEOs in the industry being less conservative and more open to exploring all options to build shareholder value in the face of difficult market conditions.

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