Debating the death of commodities

23 May 2005 00:01  [Source: ICB Americas]

JPMorgan downgrades Dow, Georgia Gulf; raises DuPont, Lubrizol. Joseph Chang reports

Signs of a slowdown in the economy and falling petrochemicals and plastics prices are raising concerns on Wall Street, sending commodity chemical share prices down even further from their March highs. With the rout in stocks in virtually all industrial sectors, there is increasing debate about whether this marks the death of commodities.

“Concerns of an economic slowdown have led to a sharp decline for cyclical shares across various industries, although the current weakness in ethylene and polyethylene markets has compounded the negative sentiment for chemical shares,” says Merrill Lynch analyst Donald Carson.

JPMorgan analyst Jeffrey Zekauskas is downgrading commodity chemical stocks Dow Chemical, Georgia Gulf from “overweight” to “neutral” based on broad-based weakness in petrochemicals. This follows a recent downgrade of Nova to “neutral.” JPMorgan is also removing Dow from the JPMorgan Focus List.

Shares of Dow fell $1.14 to $43.93 on the downgrade—a 23 percent decline from its March high of $56.75. Georgia Gulf shed $1.01 to $30.18—nearly half its high of $58.75 in November 2004. Nova trades at over $30—down more than 40 percent from its high of $52.20 in March.

“The dramatic decreases in ethylene spot prices and propylene contract prices call into question the consensus idea of a soft patch in commodity fundamentals,” says Zekauskas. “Selected ethylene derivatives, including polyethylene and ethylene glycol, may suffer incrementally greater declines than ethylene itself.”

The analyst slashed his 2005 EPS forecast on Dow from $5.25 to $4.75, and his 2006 estimate from $6.25 to $5.75. For Nova, he cut his 2005 estimate from $3.60 to $3.10 and his 2006 number from $5.25 to $5.

Zekauskas also sees coming weakness in PVC, leading to the Georgia Gulf downgrade. “Following several strong years, we believe pricing and margins for PVC will begin to come under pressure in coming months due to weaker offshore demand, new Chinese capacity and falling spot prices.” He cut his 2005 EPS estimate on Georgia Gulf from $4.25 to $3.85 and his 2006 forecast from $5 to $4.

Bullish case

In spite of weakening prices, Merrill Lynch’s Carson remains bullish on the upcycle. “Post the recent 30 percent decline in commodity chemical stocks, the market seems to have concluded that the ethylene cycle is over,” he says. “However, we expect operating rates to move through the 92 percent threshold of a tight market as demand recovers in the second half of 2005 and we continue to see peak operating conditions in 2006.”

Carson maintains “buy” ratings on commodity chemical firms Dow, Huntsman and Lyondell, along with industrial gases companies Air Products and Praxair, as well as Monsanto and DuPont.

Inventory destocking is driving ethylene chain weakness, according to Carson. However, intermediate chemical margins were strong in the first quarter, he points out.

“With high operating rates for products like acrylic monomers, epoxies and MDI, price increases outstripped the sharp rise in cost for raw materials such as benzene, ethylene and propylene,” he says. “The strength in intermediates has accelerated in the second quarter as demand remains robust and raw material costs, particularly for purchased propylene, have declined significantly.”

Deutsche Bank Securities analyst David Begleiter expects that oversupplied conditions in the ethylene chain will maintain pressure on commodity chemical share prices until inventories are worked off—most likely in the third quarter. However, he expects conditions to tighten by the fourth quarter.

“While the ethylene chain has corrected severely over the past five months, further delays in Iranian ethylene capacity, likely stronger Chinese demand in the second half and relatively solid US demand gives us confidence that supply/demand balances will tighten heading into the fourth quarter,” Begleiter says.

The analyst remains bullish, maintaining “buy” ratings on Dow, Huntsman and Westlake. He sees a recipe for a mid-summer rally in commodity stock prices. “With continued strength in chloralkali, postponed capacity expansions in the Middle East and the potential for a re-vival in economic demand late in the third quarter and the fourth quarter, we believe that the commodity chemical names could see a 15 percent-plus rally in midsummer, even before the shares discount the extended peak of 2006 to 2007.”

Greenwich Consultants analyst Michael Judd remains optimistic on the upcycle in the long run. “Basically we had a mini-boom in the first quarter in terms of margins, but margins will be lower in the second quarter,” he says. “Once the inventory correction ends, we could see another run-up in prices and margins. What happens will depend on how strong demand is, and I don’t think we will go into a recession.”

The decline in commodity chemical share prices is part of an overall portfolio shift away from cyclical stocks, according to Judd. However, this is creating a buying opportunity.

“Many clients were overweight in basic materials such as chemicals, steel and paper, and have been moving back to a more neutral position because of concerns about the economy,” he says. “Investors tend to overshoot on the upside as well as the downside. So now we think these prices are very attractive for Huntsman, Lyondell and Dow.”

Specialties insulated

The specialty chemical sector has been less hard-hit than their commodity counterparts and has actually benefited from some Wall Street upgrades.

JPMorgan’s Zekauskas recently upgraded DuPont and Lubrizol from “neutral” to “overweight.”

“DuPont’s price trends have improved sharply in recent months—up 4 percent in the fourth quarter of 2004 and 5 percent in the first quarter of 2005,” says the analyst. “We expect DuPont to offset all of its raw material cost pressures in 2005 with higher selling prices. DuPont is well positioned to benefit from decreases in raw material cost pressure should they arise, given its current pricing power.”

Zekauskas expects DuPont’s EPS to improve from $2.38 in 2004 to $2.70 in 2005 and $3 in 2006 from higher prices, cost reductions and volume growth partially as a result of new product introductions.

On a valuation basis, Du-Pont’s price/earnings (P/E) multiple of 17.2x estimated 2005 earnings compares favorably to a peer group average of 18.4x, notes the analyst. Based on his 2006 projections, shares of Du-Pont at over $46, trade at a P/E of 15.5x versus an average of 16.5x for its peers.

Zekauskas finds Lubrizol attractive on both an absolute and relative valuation basis. The stock, at over $37, trades at a P/E ratio of 13.8x his 2005 estimate versus 17.7x for its peer group, and 12.2x his 2006 estimate versus 15.8x for its peers. He estimates Lubrizol’s EPS will rise from $2.46 in 2004 to $2.70 in 2005 and $3.05 in 2006.

“We also recommend shares of Lubrizol based upon the outlook for its businesses,” Zekauskas says. “In our opinion, volumes for both lubricant additives and specialty chemicals will be soft but that prices will continue to be resilient. Should raw material pressure abate, Lubrizol will have an opportunity to expand gross margins materially.”

Fulcrum Global Partners analyst Frank Mitsch is raising estimates and reiterating a “buy” rating on specialty/commodity hybrid Eastman Chemical. The analyst is boosting his 2005 EPS estimate from $6 to $6.30 and his 2006 forecast from $6.50 to $6.75 based on strong earnings potential from both specialty Eastman businesses and the commodity Voridian businesses.

“Following our tire-kicking tour of Kingsport, we come away more confident in the sustainability of the terrific first quarter results,” says Mitsch. “Prices continue to move higher and margins are following.” The analyst is also raising Eastman’s price target by $3 to $63. Shares of Eastman trade at around $58.

In the Eastman division, an emphasis on raising prices faster in response to higher raw material costs is apparent, while in the PCI intermediates business, prices are increasing down the chain with upstream capacity facing tightness, notes Mitsch. The specialty plastics unit is demonstrating pricing power, fibers is finally growing and the IntegRex PET plant is being constructed ahead of schedule.

As of the middle of last week, the chemical sector has staged somewhat of a comeback, with commodity and specialty shares up between 2 to 5 percent off of recent lows.





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