24 September 2001 00:00 [Source: ICB Americas]The collapse of the most prominent icons of global capitalism is having serious reverberations in the chemical industry as share prices plummet to new multi-year lows in the wake of growing fears of a recession caused by a potential evaporation in consumer confidence.Bellwethers Dow Chemical and DuPont have been among the hardest hit, with Dow falling $3.52 (-10 percent) to $30.60 and DuPont off $3.94 (-10 percent) to $34.45 on the first day trading resumed. Others posting significant declines include Lyondell, Millennium, PPG Industries, Eastman, Rohm and Haas, Crompton, Cytec and Hercules (chart, page 9). However, by Wednesday morning, share prices rebounded slightly."Business had already been very weak going into September. Obviously the tragedy is not going to stimulate more demand, so the big change is on the macro side of the US economy," says Morgan Stanley analyst Les Ravitz. "The odds are that the consumer will back off a bit, and we may see some weakness in auto and housing data, which would lead to further declines in chemical demand.""I think the other shoe will finally drop in end markets that have been fairly resilient up to now, such as housing and construction," says Deutsche Banc Alex. Brown analyst John Moten.JP Morgan Economics now calls for a three-quarter long recession lasting through the first quarter of 2002. "Reduced US and global economic activity should exacerbate the current chemical industry slump," says JP Morgan analyst Donald Carson.Despite the negative near-term implications, Wall Street considers the massive declines a good buying opportunity for long-term investors in the chemical group."This is a bit of an overreaction. The major chemicals industry is already in the trough, and share prices already reflected that," says Deutsche Banc's Mr. Moten.Mr. Moten is reiterating "buy" ratings on Dow, DuPont, Eastman and PPG Industries. "Institutional investors were looking to see lower chemical stock prices before increasing exposure to the group, and now this is their chance," he says."The fact that the economy looks like it will be weaker for a longer period of time is sufficient reason to get more cautious on near-term earnings, which would result in share price erosion," notes Morgan Stanley's Mr. Ravitz.However, the analyst sees opportunities to pick up bargains in the chemical sector. "You should be focusing on companies with strong balance sheets and low multiples on normalized earnings," Mr. Ravitz says. Companies that fit the profile include Rohm and Haas, Dow, DuPont, Engelhard and Eastman, he notes. "In times like these, you go to the quality names."JP Morgan's Mr. Carson advises investors to wait a month or two before buying chemical stocks in anticipation of a mid- to late 2002 economic recovery. He notes that while intermediate chemical stocks strongly outperformed the market in the 12 months following heightened Middle East tensions in July 1990 in anticipation of the economic recovery in mid 1991, chemical stocks initially underperformed--declining 23 percent versus a 19 percent decline in the S&P 500.The potential for spikes in hydrocarbon raw material costs are also a cause for concern as a US retaliatory strike could threaten the flow of oil from the Middle East, notes Mr. Carson. Crude oil (WTI) has already spiked up to around $30 a barrel."Feedstocks are a wild card," Deutsche Banc's Mr. Moten points out. "While oil prices could continue higher, gas prices have fallen, and I can't see it getting worse than what we've already seen early this year."Despite its earlier reputation for being recession-resistant, the specialty chemical sector has also gotten hit hard.Banc of America Securities analyst Mark Gulley notes that specialty chemical companies most adversely affected by the aftermath of the attack include Ecolab Inc., which provides cleaning chemicals and services for the hospitality industry, and Engelhard Corp., which produces auto catalysts. "We think there could be at least a 10 percent reduction in auto production next year," the analyst says.Shares of Ecolab were down $3.85 (-10 percent) to $35 and Engelhard's shares fell $2.31 (-9 percent) to $22.05.Salomon Smith Barney analyst Gil Yang expects companies that might be most hurt from a drop in consumer confidence would be Rohm and Haas, Ferro, Crompton, Engelhard and Valspar.Companies least affected by the attack include Sigma-Aldrich and Cambrex, according to Mr. Gulley. However, even these names were not immune to the carnage. Sigma-Aldrich fell $2.77 (-6 percent) to $44.08 while Cambrex was off $2.07 (-5 percent) to $37.78."While investors will try to sort out which companies will be the most and least impacted in the weeks to come, the selling so far has been pretty indiscriminate," Mr. Gulley says.Following recent events, Wall Street will slash third quarter, fourth quarter, and 2002 earnings per share estimates just about across the board in the chemical industry. Before the attack, analysts had already begun cutting second half and 2002 earnings forecasts on indications of weak conditions continuing through early September."The big change will be in 2002 earnings estimates, which had previously factored in an aggressive rebound," says Deustche Banc's Mr. Moten."With the expected economic recovery pushed out until the second quarter of 2002, we expect to be reducing both our 2001 and 2002 EPS estimates for most of the companies we follow," says JP Morgan's Mr. Carson. "With the magnitude of the negative earnings revisions still unclear, we believe it is too early to make a valuation call on the chemicals sector."Early last week, Morgan Stanley's Mr. Ravitz cut his EPS estimates on Dow (by 25 cents to $1.75), DuPont (by 25 cents to $2), Eastman (by 50 cents to $3.25), Lyondell (by 50 cents to 50 cents) and Millennium (by 40 cents to 60 cents), as well as others.On the positive side, a potential short-term recovery in the chemical industry could be driven by inventory restocking on the part of customers worried about supply disruptions."It seems there is little inventory anywhere," notes Morgan Stanley's Mr. Ravitz. "If customers become more concerned about logistics and rebuild inventories, that could be a huge positive because demand right now is very low and there are no inventories. While we are not expecting this right now, it is a possibility."Prudential analyst Andrew Rosen-feld expects the customer inventory restocking cycle to turn up in the first half of 2002, coincident with an economic recovery sometime next year."These two events should cause a major ramp-up in chemical plant operating rates due to low system inventories," says Mr. Rosenfeld. "In our view, the inventory restocking cycle should last for at least six months, during which time selling prices should increase and margins should expand." However, he then expects the upturn to end as quickly as it began after customers have rebuilt their inventories.Mr. Rosenfeld has upgraded both DuPont and Millennium from "hold" to "buy." He also highlights Dow Chemical as his top pick, with a target price of $39.Although the uncertainty surrounding feedstocks is a concern, with WTI crude oil jumping to nearly $30 a barrel and Henry Hub natural gas continuing to decline to around $2.35 per mmbtu, the competitiveness of North American ethylene producers has improved for the moment. Another minor positive for the industry comes in the form of a weaker US dollar following the attack.
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