Wall Street Projects Big Profits in 2005

03 January 2005 00:01  [Source: ICB Americas]

Commodities expected to post stellar gains. Joseph Chang reports.

What a year! Following years of famine, the chemical industry is finally starting to feast on fat profits—a gift wrought by years of underinvestment mingled with a strengthening global economy led by the US and China. After a great recovery year in 2004, Wall Street sees a profit bonanza in 2005 with commodities remaining tight and pricing power working its way down to the specialty names.

“We’re looking for a very good year in 2005 following very strong fundamentals coming out of 2004,” says Lehman Brothers analyst Sergey Vasnetsov. “Even in conditions of moderate GDP growth, 2005 will be a very big step up in terms of earnings and cash flows.”

“With 2004 showing us that yes, there is life in chemicals, 2005 and 2006 are really going to show some very stellar performance,” says Fulcrum Global Partners analyst Frank Mitsch. “Santa will bring us terrific profitability in 2005, and chemical equities will continue to outperform.”

Commodity chemical companies are expected to post huge profit gains in 2005, with Dow Chemical up 56 percent, Georgia Gulf 61 percent, Westlake 55 percent and Eastman 33 percent. The more leveraged names such as Lyondell (+389 percent) and Nova (+155 percent) are anticipated to record exponential growth. On the specialties and diversified side, leading companies DuPont and Rohm and Haas are expected to post very decent gains in the range of 18 percent.

Stock prices have reflected the strength and expected further profit gains in commodities, with equities posting their strongest gains in at least eight years. As of December 27, Dow is up 23 percent on the year, Georgia Gulf 68 percent, Nova 74 percent and Lyondell 67 percent. Gains have been more muted on the specialties side.

Upcoming fourth-quarter earnings should be robust for the commodities group. “With ethylene and chloralkali margins reaching new highs in December despite the typical seasonal slowdown, we believe the fourth quarter will be a very strong one for commodity chemical companies,” says Deutsche Bank analyst David Begleiter.

While commodities have been the story of 2004, Smith Barney analyst P.J. Juvekar is taking a more positive stance on the specialty chemical sector in 2005 as the companies start to see nascent pricing power.

“We see a ‘hand-off’ from commodities to specialties over the next six to 12 months, during which we expect both sectors to outperform. Eventually, commodities will run out of steam,” says Mr. Juvekar. “We see distinct similarities with the last peak and relative performance of each sector from 1993 to 1995. Specialties are likely to catch up with commodities in 2005.” On that theme, the analyst recently upgraded DuPont from “hold” to “buy.”

Mr. Juvekar notes that at the run-up to the last peak in 1995, commodity stocks began their move in late 1993 and peaked relative to the S&P 500 in late 1994. Specialty chemical stocks severely underperformed during this period, only coming to life in late 1994 and catching up with commodities over the following 12 to 18 months (see chart).

While turning bullish on specialties, Mr. Juvekar also remains positive on commodities. “We still think there is one more leg up in Dow, Lyondell and Nova based on the falling dollar and continued tightness in supply-demand fundamentals.”

Deutsche Bank’s Mr. Begleiter maintains that while there typically is a staggered beneficial effect for specialties as companies down the chain recoup margins, “that does not mean you should be running away from the commodity names. As long as industrial demand remains strong, you can buy the commodities and then also the specialties.”

Mr. Begleiter points out investors that sold Dow’s stock back in 1994 to 1995 after a strong run-up to the peak missed further significant gains in the years ahead. “Industrial production didn’t slow down and Dow shares kept going higher,” he says.

After rising from below $15 (split-adjusted) in the recession of 1990 to around $25 in 1994, Dow pulled back to $20 by late 1994 before embarking on a string of gains to reach around $45 by 1999—all this despite the fact that the petrochemical cycle had peaked in 1995.

Starting the new year, fundamentals are going strong for the chemical industry. “We’re clearly entering 2005 with higher margins, and more importantly, high momentum, which we do not believe will end anytime soon,” says Fulcrum Global’s Mr. Mitsch.

The analyst notes that while crude oil prices have been falling, ethylene spot prices have risen from 32 cents per pound in October to 45 cents today. Chloralkali has also been strong with caustic soda prices up 150 percent year over year and chlorine up 60 percent. “We expect to see very high ECU [electrochemical unit] levels through 2005, given the 100 percent operating rates and lack of new supply.”

“We’re heading into the new year with very strong demand and no sign of a significant slowdown,” says Deutsche Bank analyst Laurence Alexander. “While we may see soft year-over-year comparisons in the first half of 2005, it now looks as though we could get a renewed acceleration in the economy in the second half of 2005 from a combination of strong global demand and the benefits of the weaker dollar.”

Banc of America Securities analyst Kevin McCarthy recently boosted 2005 earnings per share estimates on Dow, Lyondell, Nova, Eastman and Westlake based on recent strength in ethylene pricing. The analyst is also bullish longer term.

Merrill Lynch analyst Donald Carson believes the coming cycle peak will be stronger than the last one in 1994 to 1995, rivaling the 1988 to 1999 peak. However, he points out that Wall Street’s consensus profit estimates for 2005 and 2006 appear more reflective of the brief 1994 to 1995 upturn.

“We believe that earnings estimates are still too low for most commodity chemical names,” says Mr. Carson. “Ethylene glycol margins have been above ’88-’89 peak levels recently, and chloralkali margins will likely be at record levels next quarter. Ethylene and polyethylene are on the cusp of a significant increase in margins as nameplate operating rates approach the historical 93 percent threshold of a sold-out market.”

While pricing momentum could slow or reverse if energy prices continue to fall, margins will likely accelerate, according to the analyst. “With supply-demand balances tight, prices are likely to decline much less than feedstock costs,” says Mr. Carson. He expects ethylene, polyethylene and chloralkali profitability to remain robust through 2006.

While the mood for 2005 is generally bullish, some are expressing caution. “While almost everyone is building in a relatively high economic growth rate into their models, it’s worth noting that in past periods where we had high oil and commodity prices, there has been a slowdown in the economy,” says Fred Petersen, president of Millwood, N.Y.-based consultancy Probe Economics. “Margins in 2005 should show an improvement over 2004, but volumes and how far this cycle goes will depend on the economy.”

Goldman Sachs analyst Robert Koort, who recently downgraded Dow from “outperform” to “in-line,” cautions on the risks of broad-based enthusiasm for commodities seen today.

“Our checks of the market suggest widespread admiration for the turnaround underway and the expectation for an exciting peak in 2006,” says Mr. Koort. “Over the last few months, the tone of our conversations with investors has very quickly evolved from trying to confirm an uptrend to a more excited discussion of just how high the peak could be and why the cycle might be different this time.”

The analyst notes that the current mood is a remarkable reversal from 18 months ago when most everyone was fixated on the loss of global competitiveness for the US petrochemical industry, the migration of manufacturing out of the US, the threat of plastic imports, asbestos worries and questions on Dow’s ability to continue to pay its dividend.

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