Chemical Industry Stock Outlook - May 2012 - Industry Outlook

By Zacks | September 06, 2012 AAA

June quarter results mostly reflect a slow economic recovery in the U.S. and persistent recessionary conditions in Europe, leading to weakening demand for chemical products. High input costs and weaknesses across some key end-markets (such as construction and electronics) remain the major impediments to growth.

Companies in the chemicals space witnessed slowing economic activity in the quarter, largely due to the fragile economic conditions in Europe. Outlook for the U.S. economy has also suffered, though more recent data points seem to indicate some improvement.

Even the emerging markets have not been immune from global downturn. Activity in China and some other emerging economies slowed in the June quarter. The Chinese economy has been going through a rough patch as government stimulus actions have not been successful failed to staunch the slowdown, at least for now. The problems were compounded by a slowdown in exports. These issues are expected to continue to weigh on the performance of the chemical stocks in the second half of 2012.

Industry Dynamics

Chemicals are generally used to make a number of consumer goods and are also used in the agriculture, manufacturing, construction and service industries. In fact, the chemical industry itself consumes 26% of its own output. Major industrial consumers include rubber and plastic, textiles, apparel, petroleum refining, pulp and paper and primary metals.

The chemical industry, a nearly $3 trillion global business, has grown at a brisk pace for more than five decades. The fastest growing areas have involved the manufacture of synthetic organic polymers used as plastics, fibers and elastomers. The chemical industry is mainly concentrated in three areas of the world: Western Europe, North America and Japan. Europe is the largest producer, followed by the U.S. and Japan.

The U.S. chemical industry represents roughly 19% of the global chemical output and employs more than 800,000 people. It is responsible for 10% of the nation's merchandise exports, aggregating $145 billion annually. Roughly 5.5 million additional jobs are backed by the purchasing activity of the chemical industry.

The chemical industry, by nature, is cyclical and heavily linked to the overall condition of the U.S. economy. Chemical industry also touches 90% of manufactured goods, making the manufacturing industry the biggest consumer of chemical products.

There are 170 major chemical companies in the U.S. operating internationally with more than 2,800 facilities abroad. The chemical industry is among the biggest industries in the U.S., a roughly $760 billion enterprise. It has been consistently leading the U.S. economy's business cycle due to its early position in the supply chain.

According to chemical giant BASF SE (BASFY), global chemical production (excluding pharmaceuticals) rose 4.8% in 2011, backed by healthy demand from major industries. In the EU, chemical production edged up 1.6% while declining 3.1% in Japan, hurt by the March 2011 quake.

The sluggish economy took a toll on growth in the U.S. as the nation's chemical production grew a nominal 2.1% in 2011. South America and Asia (excluding Japan) witnessed growth of 4.7% and 11.1%, respectively. Growth in Asia was led by strong contributions from China.

End-Market Scenario

U.S. chemical production continues its monthly declining streak as reflected in the recently released data by the American Chemistry Council ("ACC"). The Washington-based chemical industry trade group said that the Chemical Production Regional Index (CPRI) fell 0.1% in June, following a downwardly revised 0.5% decline in May.

The U.S. CPRI, which was created by Moore Economics to track chemical production in seven regions across the nation, is comparable to Federal Reserve's industrial production index for chemicals. The ACC reported that chemical production dipped in the Gulf Coast, Midwest, Southeast and West Coast regions and was flat in the Ohio Valley, Mid-Atlantic and Northeast regions.

On a region-by-region basis, production declined across all regions except the Gulf Coast and Ohio Valley areas. On a year-to-date basis (production for the first six months of 2012 compared with the year-ago data), production nudged up 0.2%.

On a monthly comparison basis, chemical production in the Gulf Coast region, where key building block materials are produced, was down 0.4% in June. The Midwest region saw a decline of 0.2%. Productions in the Ohio Valley and Mid-Atlantic regions were flat in June. Production slipped in the Southeast (down 0.2%) and West Coast (0.1%) regions during the month while remained unchanged in the Northeast.

Output from the U.S. manufacturing sector, the largest consumer of chemical products, crept up 0.2% in June, following a 0.1% fall a month ago. Within this sector, output rose in several key chemistry end-user markets including appliances, motor vehicles, computers, apparel, structural panels, rubber products, paper and printing.

Demand for U.S. manufacturing has been weak in recent months given the ongoing European predicament and slowdown in Chinese manufacturing sector. The ACC noted that output clipped in a number of key segments including plastic resins, fertilizers, adhesives, organic chemicals and pharmaceuticals. However, production rose across many segments such as inorganic chemicals, industrial gases, consumer products, pesticides, coatings and synthetic rubber.

The decline in chemical output was also witnessed in Europe . According to the European Chemical Industry Council ("ECIC"), chemicals production in the European Union fell 2.1% year over year in the first five months of 2012. Production edged down 0.7% year over year in May 2012. Chemicals prices rose 2.7% year over year in May, led by a 4% increase in the price for basic inorganics.

Raw Material Trends

The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. Oil prices remain high despite the sub-par growth outlook for the global economy, largely owing to geostrategic reasons. BASF report states that the price of Brent crude oil rose sharply in 2011 (averaging $110 a barrel), stirred by the combined impact of strong demand and political unrest in the Middle East and North Africa.

Brent crude, which hit a four-year high of $128 a barrel in March 2012, recently exceeded $116 (highest in more than three months) on supply concerns stemming from Iran's controversial nuclear program and a sharp decline in U.S. crude oil inventories.

Price of the other key raw material, naphtha, averaged at $930 per metric ton in 2011, representing more than 30% year-over-year surge. Naphtha prices are also expected to remain elevated relative to last year's levels. The only bright spot for the industry on the feedstock front is natural gas. In fact, the price of natural gas has dropped to its lowest level in over a decade.

Over the past five years, the U.S. natural gas markets have seen a dynamic shift due to the emergence of a new source of energy, shale gas, which exists in large quantities with sources close to many big energy-intensive cities. Shale gas is not only desirable for environmental reasons, given its low carbon footprint relative to oil or coal, but is at the same time cost effective.

2012: A Balanced View

For the rest of 2012, the outlook for the global chemical industry is balanced, as the U.S. and European Union continue to contend with soft local economies while the emerging markets are expected to show higher growth in output despite the recent slowdown.

The ACC foresees moderate production growth this year followed by a stronger recovery in 2013. National chemical output is expected to slow to 1.6% in 2012 from 3.8% a year ago, and then rise to 2.1% in 2013. A rebound across most of the key end-use markets is helping to maintain the industry's contribution to the nation's economic growth.

The chemicals outlook indicates moderate growth over the next few years, depending on certain factors including strengthening domestic demand and an improvement in overseas exports. Exports climbed nearly 11% to $189 billion last year and are projected to surpass $230 billion in 2014.

While the U.S. economy is not headed toward another recession, the sovereign debt plight in Europe coupled with other economic factors poses downside risks to the U.S. economic outlook.

The ACC projects weaker growth in the European chemicals output than its earlier forecast in 2012, in part, due to increased uncertainty. Most of last year's output growth took place in the first quarter after a strong demand recovery with double-digit growth witnessed in 2010.

The ECIC, however, sees growth resuming in 2012, strengthening steadily through the year. The group forecasts 1.5% chemical industry growth this year. While developed economies, restrained by debt and stricter fiscal policies, are likely to increase chemical production at a modest pace, more rapid growth in output from the emerging markets is expected in 2012.

Asia and other emerging markets are expected to continue to lead in volume increases. Chemical makers in the emerging markets are expected to deliver a 6.2% production increase in 2012 followed by 7.5% in 2013.

OPPORTUNITIES

According to the ACC, emerging market growth and abundant shale gas should help drive U.S. chemical exports. A string of factors are driving growth in the export markets including favorable energy costs stemming from the abundance of shale gas and strong demand from the emerging markets. Affordable natural gas and ethane (derived from shale gas) offer U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock.

Further, cost-cutting measures implemented by chemical companies, such as plant closures, aggressive cost containment and production improvement initiatives, should yield industry-wide margin improvements. Cash flows derived through these actions can be used for growth.

Mergers and acquisitions offer chemical companies another means to shore up growth in this difficult scenario. These companies remain focused on exploring growth opportunities in the fast-growing emerging markets, particularly in the lucrative regions of Asia-Pacific and Latin America such as China and Brazil.

We feel that chemical companies with strong earnings quality, healthy growth trajectory and liquidity profiles are better placed in the current rickety market environment considering their ability to leverage strong balance sheet and cash flows in maximizing shareholder value in form of dividends and share repurchases or use them for value acquisitions.

Some of the key end-markets for chemical products are on an uptrend. This has been evident from the recent earnings reports of leading chemical players. E.I. DuPont de Nemours & Co. (DD), for example, put up a healthy performance in the recently reported quarter. The company saw strong performance in agriculture, food and bioscience businesses, along with its advanced materials business, which witnessed healthy results despite weak European markets. The Danisco acquisition contributed to higher sales in the quarter.

Eastman Chemical Company (EMN) is well placed to benefit from its acquisition of Solutia. The company's diversified chemical portfolio, along with its integrated and diverse downstream businesses, is driving earnings. The company benefits from business restructuring, cost-cutting measures and increased capacity additions.

We also hold a favorable view on Celanese Corp. (CE) despite the challenges it faces in Europe. We like the company's initiatives to improve margins and profits by running its plants better and controlling expenses, which should yield results through the rest of 2012. The company's strong presence in emerging markets, especially in China, will enable it to deliver incremental earnings in 2012. We are also upbeat about the prospect of its TCX ethanol process technology.

In agricultural chemical space, we like the prospects of Agrium Inc. (AGU). Fertilizer stocks like Agrium stands to gain from the U.S. Midwest drought in the remainder of 2012. The company has logged a solid second quarter and is poised to benefit from skyrocketing crop prices and overall strong fundamentals for the agriculture and crop input market. High crop prices (especially for corn) and tight grain inventories are expected to create huge demand for its nutrients.

WEAKNESSES

The global nature of the industry puts competitive issues into sharp focus. The U.S. producers have responded to competitive pressures by streamlining operations, relocating manufacturing facilities to low-cost regions closer to end-markets, and being overall more nimble and flexible in responding to market opportunities. And it is not always easy to pull this off.

Commodity price hikes, though subsiding lately, is adding to feedstock costs for many of these producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures at play. As a result, margins for a number of producers will continue to be under pressure.

Given the industry's sensitivity to the global economy, any negative current in the macro economy would be reflected in the prospects of the chemical companies. The turmoil in Europe and its impact on global growth remain sources of near-term uncertainty. Western Europe continues to pose challenges on chemical stocks due to weak demand (particularly in the construction industry) and the lingering impact of debt crisis.

Moreover, the U.S. housing sector remains a weak end-market. The domestic housing sector, a key consumer of chemicals, is likely to remain soft through the remainder of 2012. Weakness in the electronics and construction end-markets may weigh on the results in the back half of the year.

Chemical companies generate a considerable amount of revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Unfavorable currency exchange translation (stemming from a stronger dollar) dented most of these companies' results in the most recent quarter.

Chemical titan The Dow Chemical Company (DOW) was pummeled by several headwinds in the June quarter. The company's results were hurt by the beleaguered economic conditions in Europe. Softness across electronics and construction markets may continue to impinge its results in the second half. Moreover, Dow is facing challenges in Western Europe due to the recessionary conditions and expects currency headwinds to continue given the weak euro.

Air Products and Chemicals Inc. (APD) also felt the heat in the June quarter as it faced challenging conditions in Europe and Asia and unfavorable currency exchange impact. The company has reduced its adjusted earnings per share target for fiscal 2012 factoring in the currency headwinds and slower economic growth.

In specialty chemical space, PPG Industries Inc. (PPG) is expected to face greater challenges going ahead. While the company had a decent second quarter recently, it expects the European market to remain under pressure and foresees inconsistent growth in North America and Asia. Moreover, the company expects higher input costs to continue to weigh on its results in the second half. Currency exchange also remains a sore point.

Also in specialty chemical, Methanex Corp. (MEOH) posted lower-than-expected results in the second quarter. The company's production was hit by curtailment in natural gas supplies and eventually constrained revenues. Methanex remains exposed to tight economic conditions and uncertainties associated with the demand and pricing of methanol. We have downgraded our rating on the stock to Underpeform factoring in these issues.

Another specialty chemical company Valspar Corporation (VAL) is contending with the difficult global economic conditions. Unfavorable currency exchange swings hurt the company's sales in the most recent quarter. The uncertain macroeconomic backdrop, slow recovery in the U.S. and decelerating growth in China is expected to continue to impact its results moving ahead.

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