05 January 2004 00:00 [Source: ICB Americas]Coming off years of disappointing operating and stock market performance, as well as significant restructuring, the chemical industry may finally have its day in 2004. Evidence of an upturn has been emerging in the form of strong macroeconomic indicators, and now reports of strong performance in certain chemical sectors. Share prices of US chemical companies have surged since March, even in the face of less than inspiring business trends, and now the debate is heating up over whether it is not too late to buy into the sector.
"Once again, expectations are that we'll have a better year next year than the past year, driven by better momentum in the economy and the hope for lower energy prices," says Lehman Brothers analyst Sergey Vasnetsov. "I think in 2004, we will see a decent improvement over 2003."
"In 2003, despite the slowdown in Asia because of SARS and the war in Iraq, US chemical stocks have generally performed in line with the S&P 500 and a number have outperformed," notes Morgan Stanley analyst Les Ravitz. "2003 was hardly a bad year in terms of stock performance and in 2004, we expect more of the same. Volumes in the fourth quarter were up significantly in the US and business is very strong globally as well."
Indeed, momentum in the US economy, evidenced by third quarter GDP growth of 8.2 percent, a slew of other strong economic data and some positive developments in certain chemical sectors, is spurring optimism among many on Wall Street.
The Street is clearly looking for better times in 2004 with significantly higher earnings per share (EPS) estimates across the board. The 2004 consensus estimates for Dow Chemical Company and DuPont show EPS gains of 65 percent and 31 percent, respectively, over 2003, while analysts expect a 23 percent gain for specialty bellwether Rohm and Haas Company. Others are expected to swing into the black after years of bleeding red ink (see chart, page 9).
"Off-season price increases and extended plastic converter run times are a couple of positive developments that hint at a tightening supply-demand balance heading into 2004," says Goldman Sachs analyst Robert Koort. "In our view, the upcycle should begin to be fully priced into the stocks a year from now."
Strengthening plastics volumes in Oc-tober and November coupled with lean inventories in the supply chain have resulted in a number of price increases going through, especially in polyethylene, the analyst points out. "The bottom line is that we view this is as an early sign of developing cyclical strength."
For chemical stock prices, Mr. Koort and analyst Kunal Banerjee anticipate 25 percent upside on average over the next 12 months for commodity chemical stocks Dow, Nova, Lyondell and Millennium.
The analysts see the market beginning to price in beyond midcycle fundamentals by the second half of 2004 and likely ending in early 2005. "We would prefer to exit this group by the end of 2004 or the first half of 2005 at the latest, notably before fundamental peak conditions begin to develop in late 2005," says Mr. Banerjee.
Prudential Financial analyst Andrew Rosenfeld recently raised his industry rating on the chemical group from "neutral" to "favorable" as the industry appears to be entering a period of sustained demand growth. The analyst also raised his ratings on Dow, Lyondell and Nova from "neutral weight" to "overweight."
"We forecast that demand for commodity and specialty chemicals will continue to improve in 2004, with low inventories leading to an inventory restocking cycle, lower energy and raw material prices, and the continuing economic recovery being the primary catalyst for this increase," the analyst says.
Mr. Rosenfeld emphasizes that the commodity chemical companies will be the biggest beneficiaries of the upturn. "Due to their higher operating leverage, we expect the commodity chemical companies' shares to outperform the specialty players as we head toward the peak of the cycle."
Adding to signs of an upturn, Rohm and Haas recently announced that sales and earnings were running better than expected in the fourth quarter, driven by strength in coatings and electronic materials.
However, not everyone is pounding the table to buy chemical stocks. Sanford C. Bernstein analyst Graham Copley remains firmly downbeat on the commodity chemical sector with "sell" ratings on Lyondell, Nova and Eastman.
Mr. Copley asserts that the chemical industry has been a lousy investment over the years, and explains that recent robust gains in stock prices have been driven by a sense that the economy will continue to improve.
"The economy has been improving, but not one of these commodity chemical companies have put up better numbers than expected or even raised expectations," Mr. Copley said at a recent conference (CMR, 12/15/03, page 1). "The industry has always had a ton of downward earnings revisions. Analyst estimates that come out at the beginning of the year are generally what the companies tell them to print. And based on history, you shouldn't pay any attention to them. So why would you invest in chemicals?"
Frank Mitsch, analyst with Fulcrum Global Partners, says it may be a good idea to lighten up on chemical stocks. "Valuations appear to be getting extended, with chemicals trading at 23x 2003 and 18x 2004 earnings estimates," he notes. "EV/ EBITDA is not meaningfully more comforting at 10x 2003 and 7x 2004 estimates."
And while earnings may turn out to be better than expected, expectations are already high, according to the analyst. "Alas, the Street has been overly optimistic on earnings two out of every three years," he says.
However, on the positive side, Mr. Mitsch points out that chemical stocks have outperformed the broader market as measured by the S&P 500 over 70 percent of the time from December through April.
Energy and Currency Factors
Many analysts expect energy and feedstock prices to decline in 2004, giving a boost to margins. However, natural gas and crude oil remain at elevated levels of over $6 per mmbtu and $32 per barrel, respectively.
"Quite a few energy experts are bearish on oil prices, and a significant decline in energy costs would be wonderful for chemical profits. However, I think energy prices will stay at elevated levels for a longer period of time," says Lehman Brothers' Mr. Vasnetsov. "My earnings estimates for next year assume only about a 10 percent decline in energy prices."
Ironically, a large decline in energy costs in 2004 could be most helpful to specialty and intermediate chemical producers, according to the analyst. "Their prices tend to be more sticky and, therefore, they can keep more of the profit margin expansion due to declining energy costs versus the commodity players who would likely pass on the savings to their customers because operating rates are expected to remain weak in 2004."
Sanford Bernstein's Mr. Copley notes that high natural gas prices have taken away the industry's only competitive advantage. "We have the highest cost of labor, pension, environmental liability-you name it, we've got it," he says. "It's only been advantageous to make chemicals here because of cheap natural gas. But that's gone away and it doesn't look like it's going to correct itself anytime soon."
While energy prices are a wild card, one tailwind for US chemical companies is the weak dollar. The dollar has declined 17 percent versus the euro in 2003 and many expect continued weakness through 2004.
"A weaker dollar would benefit US chemical producers both by stimulating overall US manufacturing activity, as well as providing a direct earnings benefit for producers with foreign currency denominated sales or subsidiary profits," says Merrill Lynch analyst Donald Carson.
Prime beneficiaries of a weaker dollar would include DuPont, PPG Industries, Rohm and Haas, Air Products and, to a lesser extent, Praxair, according to the analyst.
While making predictions has always been difficult, especially about the fu-ture, Wall Street is rolling out its top picks for 2004.
"I don't think there are any dirt-cheap companies in the sector anymore, but there are still some attractive opportunities," says Lehman Brothers' Mr. Vasnetsov. How-ever, he favors PPG Industries Inc.
"PPG provides a very good blend of cyclical exposure to chloralkali plus in-dustrial exposure through their paint and glass divisions," says Mr. Vasnetsov. He expects EPS to improve from $3.05 in 2003 to $3.71 in 2004, and has a price target of $71 on the stock versus around $63 today.
Smith Barney analyst P.J. Juvekar also highlights PPG Industries as his top pick for 2004, having upgraded the stock to a "buy" in late November. "With our expectation of an industrial recovery, we believe PPG's earnings are poised for a strong recovery," he says.
Mr. Juvekar adds that 2004 may be a good year for PPG to divest its chloralkali operations-a move that could bring in $1 billion to $1.2 billion.
Janney Montgomery Scott analyst Jeffrey Peck also offers PPG Industries as his top pick with a price target of $67. "The company is a free-cash generating machine and uses its cash judiciously to pay down debt, increase its dividend, and buy back stock," says Mr. Peck.
Buckingham Research analyst John Roberts has only one "strong buy" rated stock in the sector-Cabot Microelectronics Corp. He expects the company, which earned $1.53 per share in fiscal 2003 (ended September 30) to earn $2.15 in fiscal 2004 and $2.85 in fiscal 2005. His price target on Cabot Micro is $65 versus today's price of around $48.
Prudential's Mr. Rosenfeld says Nova Chemicals Corp. offers the largest potential upside. "Given our improving industry outlook and the view that we are in the very early stages of entering the cycle upturn, it is likely that the stock will trade between our target price of $29 and upside potential of $49," says Mr. Rosenfeld. Nova currently trades at around $26. He expects Nova to earn 85 cents per share in 2004 after posting an estimated loss of $1.35 in 2003.
Morgan Stanley's Mr. Ravitz highlights Dow Chemical as his number one pick. He expects Dow's earnings to jump from $1.50 per share in 2003 to $2.50 in 2004, and the stock to trade up into the high $40s, compared to around $41 today.
Greenwich Consultants analyst Michael Judd's top pick is FMC Corp. He projects FMC's EPS to rise 35 percent from $1.81 in 2003 to $2.45 in 2004 and $3.05 in 2005. He has a price target of $42 on FMC, offering decent upside from current levels of around $34.
Banc of America Securities specialty chemicals analyst Mark Gulley highlights Airgas Inc. as his top pick. "Airgas will be a beneficiary of a recovery in US industrial production and is on the prowl for more acquisitions." He expects Airgas to generate EPS of $1.10 in fiscal 2004 ended March 31) and $1.25 in fiscal 2005.
Banc of America Securities major chemicals analyst Kevin McCarthy favors Monsanto Company with a price target of $31, versus today's price of around $28. "Monsanto has the best pipeline in the industry, and growth can accelerate as ag biotech traits become a larger part of the earnings mix," he says. Mr. McCarthy expects Monsanto to earn $1.55 in fiscal 2004 (ended August 31) and $1.70 in fiscal 2005.
The top pick for Fulcrum Global's Mr. Mitsch is Eastman Chemical Company. "Eastman has numerous internal measures they can use to increase profitability, such as the restructuring of CASPI, changes in Cendian as well as the sale of its stake in Genencor." The analyst expects Eastman to earn $2.25 in 2004, versus 95 cents in 2003, and he has a price target of $42 on the stock, versus $39 today.
Merrill Lynch analyst Donald Carson has "buy" ratings on Air Products, Praxair and Monsanto.
While Sanford Bernstein's Mr. Cop-ley is bearish on the commodity chemical group, he does have "buy" ratings on Praxair, Rohm and Haas, and Millen-nium (based on breakup value).
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