When we sat down recently with Zacks senior equities analyst Paul Raman, CFA, we were interested in finding out how the chemicals & fertilizer industry is doing. Is it fostering growth, or something to be wary of stepping in?
How are you viewing the chemicals & fertilizer industry at the present time?
Our outlook for the industry is positive. The industry is divided into commodity chemicals (45%) and specialty chemicals (55%). The commodity segment tends to be more concentrated.
In the commodity segment, cost reductions, improving yield from better technology and economies of scale are important. In the specialty segment, margins are higher due to better pricing and more efficient operations. Demand for fertilizers is driven by crop plantings and crop prices, both of which are favorable. Economies of scale are important to keeping costs low.
What's a good rule-of-thumb for investors who may be looking to increase exposure to this group?
Investors should neutral-weight chemical stocks now. The group is likely to track the S&P in the next six months. The chemical industry is a large consumer of oil, natural gas and energy. Raw material costs have been at historically high levels, which is a very serious challenge for the industry.
However, oil and gas prices will fall. Demand growth is near 0% currently. Demand for chemicals tracks global industrial production and global GDP very closely. Nearly 10% of chemical demand is directly tied to the housing sector, and housing and auto markets could continue to weaken. An additional 10% of demand is tied to the auto sector.
Prices are improving by 7-8% in this industry. Pricing power is a function of three variables: inflation, capacity utilization and raw material price changes. Inflation is low (but likely to increase with aggressive monetary policy), capacity utilization levels are improving but still in the low 80s, and oil prices are elevated, but falling.
Which companies under coverage are your top Buy recommendations at this time?
With this backdrop, two companies we recommend are Agrium (NYSE: AGU - News) and CF Industries (NYSE: CF - News). Demand for fertilizers is driven by population growth, and demand has been exceptionally strong in China and India.
Any caveats and/or Sell ratings for investors to take note of?
Capacity growth is minimal in this segment. Fertilizers are needed to improve the yield of crops. These companies are highly leveraged to rising global prices for nitrogen, potash and phosphate due to strong demand from China and India. Operating rates of 90-100% should hold until 2010/2011.
One company to avoid is Georgia Gulf (NYSE: GGC - News), as we expect them to file for bankruptcy. This is due to excessive housing market exposure along with high financial leverage.
Paul Raman, CFA is a senior analyst covering the chemicals & fertilizer industry for Zacks Equity Research.
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