Wall Street and financial analysts give their 2009 profit outlook for chemicals

Earthquake zone

31 December 2008 00:00  [Source: ICB]

A global recession, demand destruction and asset deflation - not your usual wish list for the New Year. What do the financial pros forecast for 2009?

IT WAS a harrowing end to 2008. The financial crisis, which started in the US, triggered a worldwide economic downturn as demand fell off a cliff late in the fourth quarter. Inventory destocking is still the name of the game, from cars to chemicals to retail goods. The scary part is that nobody knows what real underlying demand will be.

Wall Street's profit forecasts for 2009 reflect some of the gloom, but more cuts may come pending fourth quarter earnings conference calls. Consensus estimates call for earnings to range from a decline of 44% to a gain of 14%.

"The fourth quarter is as bad as you could imagine, with massive inventory destocking occurring on top of weak demand and typical year-end uncertainties. It's been more severe in Asia and Europe than in the US," says David Begleiter, analyst at Germany's Deutsche Bank. "We're seeing volume declines of 30-40% this quarter - customers are just destocking their inventories and not ordering."

The destocking trend is likely to continue at least through the first quarter of 2009.

European chemical companies will also feel the pain in 2009. Paul Satchel, analyst at Netherlands-based insurance group ING likens the chemical sector to "an earthquake zone."

"The breadth and depth of the demand dislocation are profound, and we expect another round of estimate downgrades, threatening stock prices further," he says. "We see the sector as significantly at risk of a further downward correction in the next six months."

With the industry experiencing "unprecedented uncertainty," Satchel has become even more bearish on the sector, slashing profit estimates across the board. In December 2008, he downgraded Germany-based BASF, Belgium's Solvay and Dutch giant DSM to "sell" ratings from "hold."

"While we recognize that fair value for each of these companies lies well above current levels, we contend that fair value is wholly irrelevant in current conditions," he says. "Uncertainty is the key, and the operational risks are clearly on the downside."

Profitability through the first half of 2009 will be tough, says Laurence Alexander, chemicals analyst at US investment bank Jefferies & Co. "You have inventory liquidation and companies wrestling with end-market pricing dropping quickly - in some cases so quickly that they can't pass through high-cost inventory."

Dmitry Silversteyn, analyst at US-based Longbow Research, says: "The fourth quarter of 2008 and the first quarter of 2009 are going to be very very tough for specialty chemical companies. Basically, everyone is looking to finish the year with bare-shelves inventory. Over the next six months, I expect a drastic double-digit reduction in volumes for most markets."


Looking to raw materials, petrochemicals and other input prices are falling, along with just about every other asset class.

The ICIS Petrochemical Index (IPEX) for December plunged by a record 27% to 211.44, eclipsing November's record 13% month-over-month decline.

However, it could take time before specialty chemical companies to benefit.

"We're not seeing raw material prices decline meaningfully yet for specialty chemical firms, even as we see upstream petrochemical prices down sharply. It takes time - a quarter or two - for these raw material declines to filter down the supply chain," says Silversteyn.

A more stable demand environment could emerge once inventory liquidation runs its course by the second half of 2009. "And once you get to the fourth quarter, you can start to get some easier year-over-year comparisons," says Alexander.

But earnings visibility could still be cloudy over the next few months.

"We're not going to see what real demand is like until the first or second quarter of 2009," notes Silversteyn. "I don't think companies will have a very good idea when they give 2009 guidance on the upcoming fourth quarter conference calls."

Begleiter adds: "By the second half of 2009, we should return to a more normalized level of behavior and activity, even though this could be at recessionary levels."

The analyst sees earnings per share (EPS) for the US chemical sector declining by something in the order of 10-50% in 2009.


World economic activity is expected to slow markedly in 2009, according to American Chemistry Council (ACC) chief economist Kevin Swift.

"We're in a global recession with both mature and emerging markets being impacted by the credit crisis," says Swift. "Leading indicators suggest that this will continue for at least another six months."

World GDP is expected to rise by 3.6% in 2008 and just 2.2% in 2009, compared with 5.0% in 2007, before recovering to 3.8% in 2010, he says.

After peaking at 5.4% in 2004, global chemical output will rise by only 2.2% in 2008 and 1.5% in 2009, before rebounding to 3.3% in 2010, he predicts.


But all is not doom and gloom, as analysts are looking to some positive factors, such as lower raw material costs, and cost savings as companies batten down the hatches.

"Raw material prices are coming down sharply, and some price increases that have been put in place will hold or at least lag the decline in raw materials," says Begleiter. "Plus, companies are being much more aggressive in cutting costs."

In December 2008, US giant Dow Chemical announced a massive restructuring program that involves cutting 5,000 jobs (11% of its workforce), the closure of 20 high-cost facilities, the temporary idling of another 180, and divesting nonstrategic businesses.

The moves are expected to result in $700m (€484m) in annualized cost savings by 2010 and come on top of Dow's $800m in expected cost savings from its $18.8bn acquisition of US specialty chemical company Rohm and Haas with the same period.

Dow will also slash capital spending by $600m to $1.4bn prior to the Rohm and Haas merger, or $1.9bn post-merger, noted Jeffrey Zekauskas, analyst at global financial services firm JPMorgan. Also in December, US chemical giant DuPont announced 2,500 layoffs and the temporary idling of around 100 sites in a move to cut $250m in annualized costs.

In November, BASF announced it was temporarily shutting down 80 plants and cutting production at another 100 facilities.

"Companies are focusing on cash flow and taking out excess capacity quickly. This reflects the severity of the downturn," says Begleiter. "However, this is far different and better behavior than in prior cycles in terms of the reaction of chemical companies to the downturn."

However, companies should beware of going too far in terms of capacity reduction, according to Silversteyn.

"A utilization rate in the low-to-mid 80s is not the level where companies should be closing down facilities," he says. "I don't see that demand destruction is going to be significant enough to reduce operating rates below 75%, which is where you would want to see plant consolidation. Massive asset rationalization is not a viable solution to what's going on right now."


Although government-controlled ­interest rates are falling, debt financing costs are rising as investors seek higher returns for higher risk. That is also hitting capital budgets.

"Companies are adjusting to a higher interest rate environment, where projects that seemed logical at 6-8% don't seem reasonable at 14%," says Alexander. "We've seen a battening down of the hatches where people are reconsidering their capital spending plans."

The strengthening US dollar could also prove to be a major headwind for US companies in 2009.

"The foreign exchange translation impact is going to be negative for all US chemical companies on the top line," says Longbow's Silversteyn. "Some will suffer more, while some will be insulated to some extent if they have manufacturing facilities abroad where they're buying raw materials and selling the products."

US-based fine and specialty chemicals firm Sigma-Aldrich, which had been seeing a benefit of 5-10 cents/quarter from positive foreign exchange impacts over the past two to three years, will now be facing negative effects of similar magnitude as the dollar strengthens, notes Silversteyn.


The outlook for 2009 is more severe than the previous cyclical downturn that ravaged the chemical industry in 2001-2002, says Swift. "We are facing significant uncertainty and unprecedented events," he adds.

The last major downturn for the chemical industry was in 2001-2002. In 2001, DuPont's earnings per share (EPS) fell by 56%, while Dow's ­earnings fell by 72%, notes Begleiter.

However, some analysts believe profit declines could be less severe this time around because of the higher specialty components of their portfolios as well as cost savings. Plus, balance sheets are generally stronger than in the last cycle downturn and companies are focused on cash flow generation.

"In the 1990s, about half the companies were free cash flow positive," Alexander points out. "But now heading into this downturn, it is about 90%. The industry appears to have managed the cycle a bit better."

Most companies have paid down debt and have not splurged on capital spending during the upcycle. Debt/capital ratios in the specialty chemicals sector are at a "very manageable" 20-30%," notes Silversteyn.

"In 2001, we were coming off a decline in the US industrial economy since 1998 and there was an increase in asbestos litigation, but we had the benefit of a weaker US dollar," notes Alexander.

"This time around, we have capacity utilization dropping and it feels more like the early 1980s or the early 1990s rather than the 2001 slowdown in terms of the severe retrenchment of end market demand."

But Silversteyn sees the potential for a deeper downturn this time around as the consumer fails to step up to the plate.

"This is new territory for most of us in this business. The 1970s would be a better proxy for this environment," he says. "In 2001-2002, the consumer was still spending.

The industrial slowdown was temporary and it was almost like an inventory correction. This time, the consumer spending won't bail us out."

And those looking for a big rebound in demand will be disappointed, according to the analyst.

"We still see flat to slightly down demand in 2010. It will be 'death by a thousand cuts' in the coming years, with the only silver lining being lower raw ­material costs," he says.


While there is no doubt that 2009 will be a tough year, investors can still make money. Wall Street is rolling out its top stock picks - the ones that can weather the storm and even thrive amid the downturn.

Chemical stocks tend to move up early in an economic recovery, as orders for product are filled quickly, says Begleiter. "The stocks tend to bottom at the depths of a downturn and investors want to own these very early in the upturn."

Alexander adds: "As soon as the credit markets start to ease, we should see a sharp shift on the part of investors toward overweighting the chemical sector. But right now, equities are hostage to the bond market."

Chemical stocks were hammered in 2008, and none more so than the highly leveraged companies.

"Investors have negative tolerance for leverage right now - hence the sharp declines in Rockwood and Celanese shares," says Begleiter. "But neither have capital structure issues - no near-term debt maturities and reasonable room within their covenants. I don't see any companies in serious threat of default."


Begleiter tips US-based Celanese as his top pick for 2009. "Celanese sits at the lower left corner of a very steep acetic acid cost curve, and that will enable it to earn a 15% return on capital in its core acetic acid business even in the depths of a recession," he says. "That's a unique situation and stock has been oversold."

The analyst expects Celanese's EPS to fall by more than half from $3.17 in 2008 to $1.50 in 2009. His target price for the stock is $15.

Alexander highlights US industrial gases company Airgas as his top pick for 2009.

"There's a long-term story here of improving returns on capital and the company has recurring revenue from cylinder rental fees," he says. "And to the extent they see a slowdown, they have automatic stabilizers in their business in terms of cutting overtime and other costs. Plus, they could benefit from a broad-based infrastructure stimulus package in the US."

Alexander expects Airgas to earn $3.40 per share in fiscal 2009 (ending March 2009) and $4.00 per share for fiscal 2010 - impressive growth in this environment from the $2.68 per share earned in fiscal 2008. The analyst has a price target of $48 on the stock.

"As the industry gets toward the end of the downturn, investors will focus on secular growth themes such as aerospace, energy, infrastructure and transportation," he says.


Silversteyn's best pick for 2009 is specialty chemicals and soda ash firm FMC.

Silversteyn expects FMC to earn $4.50 per share in 2009 and $5.50 per share in 2009 on higher soda ash prices, and higher sales and margins in its agricultural chemicals and specialty chemicals franchises.

"With superb operating performance expected in 2009 in soda ash, pesticides and biopolymers and lower share count driving even faster EPS growth, FMC stock deserves to be trading at 10-12 price/earnings," he says. Silversteyn has a $60 price target on FMC.


Frank Mitsch, analyst at US financial services firm BB&T Capital Markets also has FMC as his top pick, with an even higher price target of $85.

"FMC continues to outperform ­expectations and is one of few companies still expected to report improved year-­over-year results in the fourth quarter of 2008 and beyond," says Mitsch. "We also expect to see further share repurchases, given the strong cash flow and undervalued stock price."


Satchell's sole recommendation in the sector is Germany-based industrial gases firm Linde.

"We see industrial gases as the beacon of resilience as visibility in the chemical ­sector declines," he says "Long-term contracts and a consolidated market help maintain stability."

Satchell expects Linde to earn €6.84 per share in 2008 and €5.46 per share in 2009, and has a price target of €71 on the stock.


Analyst Firm Stock E2008 EPS E2009 EPS Price* Target
David Begleiter Deutsche Bank Celanese $3.17 $1.50 $11.74 $15
Laurence Alexander Jefferies & Co. Airgas $3.40** $4.00*** $35.91 $48
Dmitry Silversteyn Longbow Research FMC $4.50 $5.50 $46.22 $60
Frank Mitsch BB&T Capital Markets FMC $4.55 $5.25 $46.22 $85
Paul Satchell ING Linde €6.84 €5.46 €56.92 €71

NOTE: *As of the close of December 10, 2008. **Fiscal 2009 ending March 2009. ***Fiscal 2010 ending March 2010



Consensus earnings per share estimates

E2008 EPS E2009 EPS % Change Stock price* P/E (2009)
Dow Chemical $2.64 $1.98 -25% $19.52 9.9
DuPont $2.91 $2.39 -18% $26.55 11.1
Celanese $3.26 $2.36 -28% $11.74 5.0
Nova Chemicals $0.48 $0.37 -23% $4.22 11.4
Huntsman $0.32 $0.18 -44% $5.72 31.8
Eastman Chemical $4.92 $3.72 -24% $29.99 8.1
Rockwood $1.93 $1.51 -22% $9.48 6.3
Nalco $1.14 $1.31 15% $11.54 8.8
Cytec Industries $3.77 $3.52 -7% $22.07 6.3
PPG Industries $4.99 $4.89 -2% $44.75 9.2
FMC $4.46 $5.09 14% $46.22 9.1
Albemarle $2.58 $2.64 2% $20.85 7.9
Valspar $1.61 $1.81 12% $17.24 9.5
Arch Chemical $2.27 $2.19 -4% $24.66 11.3
Ferro $1.29 $1.44 12% $7.70 5.3
Lubrizol $4.47 $4.60 3% $36.06 7.8

NOTE: *As of the close of December 10, 2008


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