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Cash Coating Helps Rohm & Haas

Odette Galli

There still may be legitimate reasons to question the current industrial recovery, but those doubts seemed to be seriously tested last week. The latest economic indicators and recent remarks from Federal Reserve Chairman Alan Greenspan appear to support the view that all systems are go when it comes to U.S. economic growth. That's why economically sensitive stocks may grab the spotlight again, particularly as second-quarter earnings season begins soon.

Specialty chemical company Rohm & Haas (ROH Quote) is one example. The company has broad exposure to the very industrial, construction and electronics end markets that are now demonstrating strong vital signs.

Protective Coat

When the company reports its second-quarter results next month, sales could be as robust as they were in the first quarter when they jumped 14%, 7% of which was organic. And with profit improving on higher volumes and a disciplined approach to capital spending, Rohm & Haas is likely to generate strong cash flow this year that will be used to improve its balance sheet and return money to shareholders in the form of a higher dividend.

Rohm & Haas shares already sport an above-average yield of 2.6%. This is likely to give the stock strong support, even though its current valuation of 19 times the consensus earnings estimate of $2.05 per share for this year is above its historical average of 18.

Last week, companies such as Rohm & Haas got a big lift from numerous sources that lent support to the argument that the industrial sector was on solid ground. For one thing, during Chairman Greenspan's testimony before Congress, he sounded unequivocally optimistic about the prospect for continued economic growth.

This was further supported by data such as that for industrial production, which jumped 1.1% in May, the biggest monthly increase in six years and an acceleration from the 0.8% rise in April. The May level was the first time the index had clawed its way back above its prior peak in June 2000.

Likewise, capacity utilization rose to 77.8%, its highest level in three years, from an upwardly revised level of 77.1% in April. And industrial production at high-tech-related industries grew 3.5% in May to levels that are 30% above last year. This is particularly important to Rohm & Haas, because nearly 20% of its sales are tied to electronics.

In fact, the news on the electronics front just keeps getting better for Rohm & Haas. According to a recent story in the Taipei Times, global chip sales are expected to rise 24% this year -- the first year that all major applications for chips will experience growth since 1999. Earlier this month, Intel (INTC Quote) said that its second-quarter sales were likely to come in at the high end of its original forecast, and the book-to-bill ratio for North American toolmakers was 1.11 last month, indicating that orders are coming in at a healthy level above sales.

Rohm & Haas has a leading position in materials used in printed wiring board assembly, semiconductor manufacturing and packaging and finishing. According to a recent presentation to investors, Rohm & Haas' sales into those markets have increased at an 11.7% compound annual rate since 1995, compared with nearly 8% for the market overall. And its profit margins in this segment are among its highest as well: In the first quarter, electronic materials produced an EBITDA margin of 21%, compared with the companywide margin of 17%.

Weak Spots

But a number of troublesome issues are likely to emerge during second-quarter conference calls with chemical companies such as Rohm & Haas. For one thing, oil prices remain stubbornly high, and the gap between Rohm & Haas' raw material costs and the prices it charges probably widened quite a bit in the second quarter from the $14 million difference reported in the first quarter.

Second, with the debate over the sustainability of China's economic growth raging on Wall Street, many may question Rohm & Haas' outlook for the region. Rohm and Haas has been particularly aggressive in establishing a foothold in the Asia Pacific region, and it now has 10 technical centers located there, second only to North America. Last year, Asia Pacific, mainly China, accounted for 17% of total sales.

So while the shares' current valuation may not be that enticing, concern over oil prices or China could cause a pullback to more reasonable levels in the mid-$30s. But with such strong free cash flow (roughly $575 million forecast for this year) and the likelihood of a dividend boost, it's hard to see them getting much lower than that.