I've been developing a chemical attraction. Or perhaps I should say an attraction to chemical stocks.
You probably think I'm nuts to be looking at cyclical stocks when we are likely headed into a recession. But the way I see it, if a slowing economy was the problem for chemical manufacturers, they would have to respond by cutting prices, or at least holding price increases in check.
That isn't happening. For example,
(DOW) announced a 20% price increase in May of this year. Then in June, they increased prices another 25%. Two double-digit price increases in as many months tells me that the balance between supply and demand is, if anything, in Dow's favor.
What's more, Dow isn't alone. According to the most recent producer price index release, the 38% year/year average chemical price increase in May is the largest in more than 10 years for the industry.
Regardless of the current pricing power, for some of the stocks in the sector, it probably is a bit too early to make the call. In other cases, however, I think the potential rewards outweigh the risk that the bottom hasn't quite been reached. The rest of this column will cover some of the names I think are most worthy of investor attention.
The Cost Leader
Let's start with
(CE). Celanese is an industry leader in acetyl products and high-performance polymers used in a wide variety of industries. The company claims to be the low-cost producer in the industry, an assertion backed by its industry-leading profit margin and return on equity.
Celanese is also globally diversified, which should mitigate any effects from a slowdown in the United States. In 2007, the company earned 29% of its $6.5 billion in revenue in North America, 43% from customers in Europe and Africa, and the remaining 28% in Asia and the rest of the world.
After a strong run in the first half, Celanese stock has pulled back nearly 15% in the last 10 days. Given that the company exceeded earnings estimates by more than a dime in each of the last three quarters, I think the pullback marks a good buying opportunity.
Estimated 2008 earnings for Celanese currently stand at $3.96, up from $3.74 three months ago. The 2009 earnings estimates have also increased, from $3.91 to $4.26. That means Celanese is now trading at just over 10 times next year's earnings, compared to an industry average P/E of 14.2 times. If Celanese earns the industry average P/E on $4.26 next year, it could trade at $60 within the next 18 months -- which is more than 40% above the current price.
The Other Kind of Gas
Another stock that looks attractive here is
(ARG). Airgas distributes industrial, medical, and specialty gases such as nitrogen, oxygen, argon, helium, and hydrogen; welding and fuel gases, such as acetylene, propylene, and propane; and carbon dioxide, nitrous oxide, ultra high purity grades, special application blends, and process chemicals.
We all know the price of gas at the pump is rising, but did you know that prices are rising for industrial gases as well?
The company recently announced that, beginning Aug. 1, it will increase prices on gases and equipment by 15% to 20%. The pricing power is showing up in the earnings estimates for Airgas. For the current fiscal year (which ends in March 2009) the estimate has risen from $3.10 to $3.38 in the last 90 days.
Airgas doesn't look particularly cheap, given that its current P/E multiple of 21 times is in line with its average P/E over the last five years. However, according to Zacks Research Wizard, analysts expect the company to post average earnings growth of 16.9% over the next three to five years. Add in another 0.8% for dividends, and the total annual return could be 17.7% per year as long as the average P/E is maintained.
A Contrarian Play
Airgas and Celanese have been taking advantage of rising prices, and it has shown up in rising earnings estimates. The exact opposite is the case for
Methanex is the world's largest supplier of methanol, a liquid chemical feedstock (used to manufacture other products) which has historically been produced from natural gas. Although supply of methanol has been tight, problems sourcing natural gas at its Chilean plant has kept Methanex from capturing the full benefit. Meanwhile, China's significant investments in plants to produce methanol from coal have resulted in that country switching from a net importer to a net exporter.
As a result of these issues, Methanex earnings have been headed in the wrong direction. After reaching a peak of $4.41 in 2006, earnings per share declined to $3.68 in 2007, and are expected to decline further in 2008 and 2009.
Eventually, though, lower profits in the industry will stem the investment in new plants and the trend will reverse. When that finally happens, patient investors could profit handsomely.
If Methanex can repeat its earnings performance in the next cycle and earn a multiple of 10 times peak earnings at some point during the cycle, its shares could rise to $45 per share from the current $26.20. Even if it takes five years for this to happen, the average annual return would be in the double digits.
So there you have it. Regardless of one's preferred investment style, I think there are reasons to be attracted to chemical stocks. Find one that's right for you, and it may be the catalyst for a positive reaction in your portfolio.
William A. Trent, CFA, is a freelance equity analyst based in the New York metro area. He has been an equity analyst since 1996 and is co-author of
. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Trent appreciates your feedback;
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Celanese, a globally diversified provider of acetyl products, among other things, has seen its price pull back enough that with its fundamentals, looks like an interesting purchase here.
Industrial gas supplier Airgas is showing impressive pricing power which has resulted in a raise in earnings estimates for the year.
A contrarian play is Methanex, a methanol supplier who's business is suffering from higher natural gas prices and increased competition, but who may be able to wait out its problems and emerge a better company.