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Chemical - Diversified Stock Outlook: Good Run to Continue

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The chemical industry continues its positive run this year, sustaining the momentum witnessed in 2017. The industry’s upswing is backed by a resurgent global economy, strength across major end-markets, such as construction and automotive, and a recovery in demand for chemicals in the energy market supported by a rebound in oil prices. Notwithstanding some headwinds, the industry’s upturn is expected to continue in the short haul as the fundamental driving factors remain firmly in place.  

The chemical diversified industry, which includes manufacturers of basic chemicals, plastics and agricultural chemicals, seems to be in fine fettle and poised for growth in the near term. While companies in this space face margin headwind from a spike in raw materials costs as a result of short supply, softness in agricultural commodity prices due to persistent grain glut and trade war risks, they should continue gaining from strategic measures including productivity improvement, price increase actions, portfolio restructuring, expansion into high-growth markets and earnings-accretive acquisitions.

President Trump’s business-friendly tax reform, which contributed to the recent impressive earnings performance of the U.S. chemical diversified companies, would remain a major tailwind. The tax reform is expected to boost their bottom line, improve cash flows and incentivize capital investments in new chemical projects.

Industry Trails on Shareholder Returns  

The Zacks Chemicals Diversified industry, which is a 44-stock group within the broader Zacks Basic Materials Sector, has underperformed both the S&P 500 and its own sector over the past year. While the stocks in this industry have collectively gained 10.2%, the Zacks S&P 500 Composite and Zacks Basic Materials Sector have rallied 14.3% and 21.8%, respectively.

The underperformance appears to partly reflect trade-related worries for the chemical industry. Fears of a fierce trade war between the United States and China have gripped the markets since March 2018. The good fortunes of the chemical industry have been, of late, clouded by prospects of a trade war between Washington and Beijing.

The Trump administration, in March, proposed sweeping tariffs on $50 billion of Chinese imports including chemicals. China subsequently retaliated with plans to levy 25% tariffs on nearly $50 billion of U.S. imports that would harm a major market for a range of U.S.-produced chemicals and plastics. The United States is pushing ahead with its plans and recently announced a new list of Chinese products slated for tariffs, thereby intensifying chances of a trade battle.

Threats of tariffs on U.S. chemical exports by China and the Trump administration’s actions to impose heavy tariffs on steel imports have raised concerns that chemicals companies would reconsider their investments in new projects, which would lead to a slowdown in growth. The hefty steel tariffs are likely to push up the costs of building chemical plants that use a significant amount of steel, thereby eroding the economic benefits of chemical projects. All these have left investors jittery about the prospects of the chemical industry.

One-Year Price Performance


 

The Group’s Valuation Looks Bit Stretched

Notwithstanding the underperformance of the industry over the past year, the valuation doesn’t look cheap now. One might get a good sense of the chemical diversified industry’s relative valuation by looking at its EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio.

The EV/EBITDA multiple is a preferred valuation metric for cyclical industries like chemicals that have significant fluctuations in earnings from one quarter to the next. Notably, the value of commodity companies is dependent on the movement of prices of commodities and growth in the underlying industry/economy, both of which typically move in cycles.  

Going by this multiple, valuation for the chemical diversified industry looks a bit stretched at the moment when compared to the broader market and its own sector.

The industry has a trailing 12-month EV/EBITDA ratio of 12.8, which is below its own average of 14.2 and the highest level of 19.8 in the past one year. However, the industry compares unfavorably with the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is at 11.6 and the median level is 11.3.

Enterprise Value/EBITDA (TTM)

Moreover, a comparison of the group’s EV/EBITDA ratio with that of its broader sector indicates that the group is trading at a premium. Zacks Basic Materials Sector’s trailing 12-month EV/EBITDA ratio of 10.3 and the median level of 10.2 for the same period are below the respective ratios of the Zacks Chemicals Diversified industry. As such, there seems to be little room for an upside moving ahead.

Earnings Outlook Paints Favorable Picture

Chemical diversified stocks are expected to continue delivering positive shareholder returns over the near term on the back of favorable end-market fundamentals and expectations of industry-wide margin improvement driven by cost-cutting and productivity measures and price increase actions to offset higher feedstock costs. But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences the performance of its stock.

While one could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with last year’s reported number, an effective measure could be the magnitude and direction of the recent change in earnings estimates.

The consensus earnings estimate for the Zacks Chemicals Diversified industry of $5.13 per share reflects a 2.6% year-over-year improvement. Also, the trend in earnings estimate revisions appears favorable.
 

Price and Consensus: Zacks Chemicals Diversified Industry

 

Looking at the aggregate earnings estimate revisions, it appears that analysts are hopeful of this group’s earnings potential.

The consensus EPS estimate for the current fiscal year has been revised positively (by a penny) since Mar 31, 2018.
 

Current Fiscal Year EPS Estimate Revisions

 

Zacks Industry Rank Indicates Upbeat Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates a positive picture for the near term.

The Zacks Chemicals Diversified industry currently carries a Zacks Industry Rank #49, which places it at the top 19% of more than 250 Zacks industries. 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.

Our proprietary Heat Map shows that the industry’s rank has been hovering in the top half over the past eight weeks.
 

 

Long-Term Growth Prospects Look Promising

The long-term (3-5 years) EPS growth estimate for the Zacks Chemicals Diversified industry appears upbeat. The group’s mean estimate of long-term EPS growth rate has been increasing since May 2018 to reach the current level of 10.6%. This compares to 9.8% for the Zacks S&P 500 composite.
 

Mean Estimate of Long-Term EPS Growth Rate

 

One key reason for this long-term EPS growth could be the recovery in top line that stocks in this industry group have been showing since the beginning of 2017.

 

 

Another important indication of solid long-term prospect is the improvement in the group’s EBITDA, which is an important metric for evaluating chemical stocks.

 

Bottom Line

Companies in the chemical diversified space are hamstrung by a few challenges including feedstock cost pressure, weakness in agricultural commodity prices and concerns over trade tariffs. However, strategic actions including expansion of scale through acquisitions, operational efficiency improvement and continued focus on cost and productivity should help them weather the macroeconomic and industry-specific headwinds over the short haul.

The industry’s momentum is expected to continue on sustained demand strength across automotive and construction markets, a rebound in demand in the energy space and investment on capacity expansion.

Cost-cutting and productivity improvement actions are expected to reap industry-wide margin improvements. Moreover, price hike actions by these companies in the wake of rising raw materials costs should also provide margin benefits. Continued shift of focus on high-growth markets should also allow them lower their exposure on businesses that are grappling with weak demand and input costs pressure.

There are many reasons to be optimistic about the chemical diversified industry over the near future. Keeping the long-term expectations in mind, it would be prudent to bet on a few stocks in this space that have a strong earnings outlook.

Below we list four stocks that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #1 (Strong Buy) or 2 (Buy).

(You can see the complete list of today’s Zacks #1 Rank stocks here.)

The Chemours Company (CC - Free Report) : The consensus EPS estimate for this Wilmington-based company has moved 5.9% higher for the current year, over the last 60 days. The stock has rallied 28% over the past year.

Price and Consensus: CC

 

FMC Corp. (FMC - Free Report) : The stock of this Philadelphia-based company has gained 17% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 9.5% upward over the last 60 days.

Price and Consensus: FMC


 

Methanex Corp. (MEOH - Free Report) : The consensus EPS estimate for this Vancouver, Canada-based company has moved 1.3% higher for the current year, over the last 60 days. The stock has rallied 71% over the past year.

Price and Consensus: MEOH



 

Innospec Inc. (IOSP - Free Report) : The Colorado-based company’s shares have gained 24% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 2.3% upward over the last 60 days.

Price and Consensus: IOSP



 

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