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The chemical industry is riding an upturn in the world economy and continued strength across major end-use markets such as construction, automotive and electronics. Another positive for the industry is a recovery in demand in the energy space – a key chemical end-market that had been out of favor for a spell. The recovery has been driven by the rebound in crude oil prices from their historic lows.

The Zacks Chemicals Diversified industry has outperformed the broader market in a year’s time. The industry has gained around 19.4% over this period, higher than the S&P 500’s corresponding return of roughly 17.8%.

Fourth-quarter earnings season had been a good one for chemical stocks. Notwithstanding a few headwinds including some lingering impacts of devastating hurricanes, chemical companies continued the earnings momentum in the December quarter. We note that a number of companies in the space – including prominent names such as Eastman Chemical Co. (EMN - Free Report) , Celanese Corp. (CE - Free Report) , PPG Industries, Inc. (PPG - Free Report) and Air Products and Chemicals, Inc. (APD - Free Report) – produced earnings beats in the quarter.

The outperformance was driven by solid demand across major end-markets as well as strategic measures including productivity improvement, pricing actions, portfolio restructuring and earnings-accretive acquisitions.

Chemical companies continue to shift their focus on high-growth markets (driven by megatrends) in an effort to cut their exposure on other businesses that are struggling with weak demand and input costs pressure. These companies are also increasingly looking for cost synergy opportunities and enhanced operational scale through consolidations.

Cost-cutting measures and productivity improvement actions by chemical companies should continue to reap industry-wide margin improvements in 2018. Moreover, a number of chemical makers are taking appropriate pricing actions to offset raw materials cost inflation, which should also provide margin benefits.

Chemical makers also continue to see strong demand from construction and automotive sectors – major chemical end-use markets. The underlying trends in the housing space remain strong, backed by strong economic growth, steady buyer demand, high homebuilders’ confidence and low unemployment levels.

The automotive sector also continues its good run amid certain challenges, supported by an improving job market, rising personal income, favorable credit conditions, improved consumer confidence and impressive vehicle launches. Rising demand for profitable crossovers, sports utility vehicles and pickups are also aiding the auto industry.

A rebound in crude oil prices has also led to a recovery in demand for chemicals in the energy space, an important end-use market. The recent uptrend in oil prices has been supported by a decline in U.S. oil stockpiles and extension of oil production cuts by OPEC and other major world producers until the end of 2018. The recovery in oil prices has also led to a favorable pricing environment for chemical products.

U.S. Chemical Industry Set to Ride Growth Wave

The U.S. Chemical Industry has recovered from the damaging effects of hurricanes and is set for solid growth in 2018. The American Chemistry Council ("ACC"), an industry trade group, envisions national chemical production (excluding pharmaceuticals) to rise 3.7% in 2018, further accelerating to a 3.9% growth in 2019. The growth is expected to be spurred by higher demand across light vehicles and housing markets, capital investments and improved export markets.

The trade group also expects basic chemicals production to expand 4.7% in 2018 and further gain steam with a 5.2% rise in 2019 on the heels of new capacity additions. The specialty chemicals segment is also expected to see production growth of 2.3% in 2018, per the ACC.

Surging Capital Spending

The United States remains an attractive investment destination for chemical investment and domestic chemical makers continue to enjoy the advantage of access to abundant and cheaper feedstocks and energy. This is driving investment in chemical production projects.

The shale gas boom has incentivized a number of chemical companies including industry heavyweights such as BASF SE (BASFY - Free Report) and LyondellBasell Industries N.V. (LYB - Free Report) to invest billions of dollars to beef up capacity. According to the ACC, roughly 320 chemical projects have been already announced worth more than $185 billion, 62% of which is foreign direct investment.

Moreover, roughly 65% of the chemical investment announced since 2010 are complete or under construction. New capacity is expected to provide a boost to chemical production as these investments come on stream.

The ACC expects chemical industry capital spending to rise 6.3% in 2018 and 6.8% in 2019 and eventually reach $48 billion by 2022.

Strengthening Export Markets

The ACC sees improving export markets to contribute to solid growth of the domestic chemical industry. Strengthening export markets and increasing capital spending are driving chemical demand across key end-use markets such as light vehicles and housing. Major export markets, such as Latin America and Asia, are also expected to play a significant role in basic chemical production growth this year and the next.

EU Chemical Sector Back in Business

The European chemical industry has also swung back to life on the back of improving global economic sentiment and a resurgent Eurozone economy. Eurozone’s recovery has been backed by a pick-up in global economic activity, declining unemployment and strengthening business and consumer confidence.

The outlook for the European chemical industry is positive. The European Chemical Industry Council (CEFIC) expects chemical output in the European Union to rise 2% year over year in 2018.

Per the CEFIC, the growth of manufacturing production across sectors such as automotive, construction, metal production and electronics in the European Union has led to higher demand for chemicals in the region. Exports of chemicals produced in European Union have also increased, particularly in Asia and Russia.

A Few Concerns

The chemical industry, however, faces certain headwinds. A number of chemical companies are witnessing a spike in raw material prices, exacerbated by short supply due to last year’s hurricanes. Some of these companies, in their fourth-quarter earnings call, had warned of continued headwinds from elevated input costs through the first half of 2018. As such, raw material cost inflation may unfavorably impact margins of these companies.

Chemical makers also continue to feel the pinch of depressed demand in agriculture markets. Sustained pressure on agricultural commodity prices is scuttling a meaningful recovery in this key chemical end-market.The outlook for the fertilizer and agricultural chemicals space remains cloudy due to continued weakness in crop prices, low farm income and sluggish economic conditions in certain emerging markets, including Latin America.

Moreover, concerns regarding China’s future growth remain a source of near-term uncertainty for the chemical industry. Uncertainties surrounding China – a key market for chemicals – is expected to remain an overhang on the industry in the short to medium term. Sustained overcapacity, weak private investment and high levels of corporate debt are still hurting the world’s second-largest economy.

What Zacks Industry Rank Says

Within the Zacks Industry classification, the chemical industry falls under the broader Basic Materials sector (one of 16 Zacks sectors), which had a 2.6% share of total earnings for the S&P 500 in 2017. We rank all of the more than 250 industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. (To learn more, visit: About Zacks Industry Rank.)

We have three chemicals related industries – Chemical Diversified, Chemical Plastics and Chemical Specialty – at the expanded (aka "X") level. We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Our back-testing shows that the top 50% of the Zacks ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The Zacks Industry Rank is #63 for Chemical Diversified (placing it at the top 25% of the 250 plus Zacks classified industries), #88 for Chemical Plastics (at top 34%) and #183 for Chemical Specialty (at bottom 29%).

The location of these industries suggests that the general outlook for the chemical industry as a whole is leaning toward 'Positive.'

Solid Q4 Earnings, Q1 Predictions Look Promising

The Basic Materials sector is among the Zacks sectors that racked up the strongest gains in fourth-quarter 2017. Overall earnings for the sector climbed 45.2% while revenues spiked 21.3%. Roughly 89.5% of the sector participants posted earnings beat and around 73.7% surpassed revenue estimates.

The Basic Materials sector is expected to continue the earnings growth momentum into first-quarter 2018. Earnings for the sector are projected to rise 42.1% in the first quarter while revenues are expected to go up 21%.

For more details about the earnings of this sector and others, please read our Earnings Trends report.

Valuation Looks Bit Stretched

Going by the EV/EBITDA (Enterprise Value/Earnings before Interest Tax Depreciation and Amortization) multiple, a preferred valuation metric for cyclical industries like chemicals, valuation for the ‘Chemicals’ industry looks bit stretched at the moment when compared to its own range and the broader market.

The industry has a trailing 12-month EV/EBITDA ratio of 15.7, which is above its own average of 12.7 in the past year. Moreover, the industry compares unfavorably with the market at large, as the trailing 12-month EV/EBITDA for the S&P 500 is at 11.8. As such, there seems to be little room for an upside moving ahead.

Final Thoughts

While the chemical industry still faces a few headwinds, its momentum is expected to continue this year on sustained demand strength across light vehicles and construction markets, a rebound in demand in the energy place and significant shale-linked capital investment. Strategic actions including expansion of scale through acquisitions, operational efficiency improvement and continued focus on cost and productivity should help chemical makers weather the macroeconomic and industry-specific headwinds in 2018.

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