Industry Analysis: Diversified Chemicals

The companies that make up the Chemical/Diversified group are largely intermediate producers of a broad array of chemicals and industrial gases. Their products are mostly used as raw materials by manufacturing industries. Major end markets served include automotive (plastics, paints), residential (carpets, fixtures, furniture) and commercial construction (glass, metals, wood), agriculture (fertilizers, herbicides, and pesticides), commercial aerospace (carbon fiber composites), and general manufacturing customers. Chemical/Diversified stocks are more commonly characterized as growth-and-income holdings, and are generally suited to investors seeking broad exposure to the manufacturing sector of the economy.

Main Categories
The products made by these companies fall into three main categories. Basic Chemicals have commodity-like characteristics and are sold in large volumes. These include petrochemicals, such as polymers used to make plastics and other man-made fibers. The category also includes such derivatives as carbon black and synthetic rubbers. Specialty Chemicals are more performance critical, value-added products, usually made to customer specifications. These include industrial gases, coatings, and chemicals used in electronics manufacturing. Finally, the Life Sciences segment encompasses animal health, crop protection, biotechnology, and pharmaceutical-related products.

Key Indicators
End markets supplied by this group typically face a wide range of economic prospects. Nonetheless, serving a variety of customers and geographic regions usually provides some downside protection in the form of diversified income streams. In general, though, basic chemicals have less pricing power during downturns, making specialty and life sciences products more stable in terms of profitability. Still, overall economic conditions play a large role. As such, the group's performance will largely mirror that of the broader manufacturing economy. In that regard, the Institute for Supply Management's Purchasing Managers Index (PMI) can be a useful guide. This index is designed to indicate whether the manufacturing sector as a whole is expanding (over 50) or contracting (below 50). Input costs are also key. Indeed, companies in this group consume large amounts of natural gas and oil, which are mostly used as feedstock. Naturally, lower input costs translate into higher margins, and vice versa. However, it's the volatility in the pricing of these two commodities that warrants more careful attention from an investment prospective, as changes are quickly reflected on the bottom line. As a result, most of these companies employ some degree of

hedging to smooth out rapid price moves. Oil and natural gas prices are less of an issue for those supplying industrial gases, where the primary concern relates to the utilization of production capacity.

Growth Via Globalization

The domestic market for chemicals is largely mature. Namely, the sizable automotive and housing sectors, through the economic cycle, post very modest average annual growth. The same is also true for the food industry (plastic bottles, agricultural products). By comparison, developing countries, most notably China and India, hold huge potential for rapid expansion in nearly all sectors. The majority of the companies in this group have long been capitalizing on the opportunities presented by this trend, and have steadily diversified operations, building far flung production facilities. Whereas a couple of decades ago, overseas business accounted for a relatively small portion of sales, that figure has grown substantially, now accounting for 60% or more of total revenue. In addition to the promise of high growth potential, building an international presence helps reduce exposure to economic downturns in any one region. Geographic diversification has also often resulted in a reduction of the overall corporate tax burden, because overseas jurisdictions usually have lower rates than those of the U.S. One of the potential drawbacks to this strategy, however, is increased currency risk. Reported overseas sales can boost results when the U.S. dollar weakens. But the opposite holds true if the dollar strengthens. Meanwhile, for many of these companies, international transportation costs are prohibitive (most notably for industrial gases), requiring them to make their products where they are to be sold. This also provides a natural hedge, in that production costs are priced in local currencies.

High Capital Requirements

Most of Chemical/Diversified companies are capital intensive, reflecting the large manufacturing facilities required to produce bulk quantities. Combined with the high technology requirements, this gives the industry a competitive advantage in terms of high barriers to entry. Because the industry operates with such high fixed costs, modest changes in sales can lead to wide swings in net income. During periods of strong demand, these costs may be spread over a larger sales base. As such, it's important to keep an eye on capacity utilization rates. Often, during economic downturns, when capacity usage is low, pricing power becomes more limited and operating margins suffer. Continuous capital investment is necessary to upgrade or replace existing facilities. Periods of stepped-up spendingto expand capacity or increase efficiency-often raise debt burdens and restrain free cash flow improvement. Investors should be aware of what, if any, major projects are in the offing.

Industry Analysis: Chemical, Basic

The Basic Chemical Industry is a rather small group. Nonetheless, it includes some large and well-established chemical companies, manufacturing an array of products aimed at a wide range of markets. In addition, fertilizer producers are well represented here, giving the industry a degree of end market concentration. Our presentation of historical figures, estimates, and projections for companies in this industry follows the standard Value Line report format. We provide sales and operating margin data by business line for very large enterprises.

Industry Fundamentals
Fertilizer production is, naturally, linked to the agricultural sector. As world populations rise, farm commodity requirements increase. This is a positive, long-term underlying trend. In times of marked economic prosperity, as the middle class expands, especially in developing nations, richer diets give an additional lift to the demand for and prices of grains and other staples. When farm incomes are healthy, spending on fertilizer is favorable. Scientific breakthroughs will also lead to upswings in the fertilizer business. Going forward, notwithstanding possible volatile intervals, farmers will surely continue to seek the means to improve crop quality and yield, auguring well for the fertilizer segment. The stocks of fertilizer producers are generally considered good growth vehicles. Historically, the operating performance of other chemical companies in the industry has proved to be more cyclical. Sales and earnings rise and fall with the fortunes of the particular markets served and strength or weakness of the broader economy. It is not uncommon for a company to experience several difficult years, which may include losses, followed by a period of solid earnings advances. There are many external factors beyond management's control. Organizations that offer a wide variety of products are usually better situated to deal with macroeconomic weakness than those focused on a limited number of lines. Still, they are not completely insulated. Investors should be aware of an important stock characteristic. Price-to-earnings ratios often expand considerably during hard times, due to significantly lower earnings. This might lead a prospective investor to falsely conclude that Chemical equities are overvalued, when, in fact, they are not. Indeed, the sector could be on the verge of an upturn, over the course of which P/E ratios typically decline. Ideally, investors with a long time horizon should buy into these stocks, once end markets have clearly hit a nadir. Momentum-oriented accounts will benefit, as well, in the midst of a cyclical upswing. There are a select few equities (of major operators) that are decent income holdings.

Sales and Earnings Performance

A company's sales trend is, of course, a key measure that investors should consider. Top-line performance is closely tied to the demand for a company's particular products from specific markets served. It can be a challenge for management to balance supply with varying customer demand in the short run, so planning is more focused on longterm industry prospects. Individual profitability will notably stray from the overall mean, depending on a Chemical company's end markets, product lineup, competitive position, feedstock (e.g., petroleum) costs, and overall expense structure. Fixed costs are significant in this industry. Incremental sales growth can be substantially levered at the bottom line. This will be evident in the Annual Rates box on the Value Line page, which shows a company's past growth performance and our projections. Cash flow and earnings gains accelerate as sales steadily rise. Weak demand will pressure profitability. Return on Share Equity will whipsaw through the economic cycle. The largest industry members, though, produce more consistent returns over time. Steady, positive results may indicate that a company has a favorable competitive position and a competent management team.

Broadening Market Reach

Capital spending to maintain operations can use up a good portion of annual cash flow. Facility upgrades and expansion projects are also heavy uses of funds. Importantly, active research and development can lead to attractive new products, increased production, and greater market coverage. Debt funding is common in the industry, and obligations may be hefty at times. It is not unusual for Chemical companies to complete strategic acquisitions or form partnerships. Such activity allows them to quickly and economically enhance their ability to serve new and existing customers. The takeover of a rival may reduce competitive pressure. And the purchase of a technology can bolster the product lineup or bring exposure to appealing new markets. Acquisitions and partnerships help to diversify operations and support dependable longterm sales and earnings streams. Sizable deals generally will raise the debt ratio and financial leverage.

Restructuring Measures
From time to time, certain members of the industry will undertake a restructuring to improve business prospects or operating efficiency. The corporate structure may be realigned according to markets served or product lines. Sometimes core operating segments are combined. Other times, underperforming assets are divested. Workforce reductions might take place to save money. Also, new systems, technologies, and processes may be implemented to raise operating performance. Management takes these measures with the aim of strengthening profitability and return on shareholder investment.