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Chemical - Specialty Outlook: Trade Tensions Cloud Prospects

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The chemical specialty industry includes manufacturers of specialty chemical products for a host of end-use markets such as textile, paper, automotive, electronics, personal care, energy, construction and agriculture. These chemicals (includes catalysts, surfactants, speciality polymers, coating additives, pesticides and oilfield chemicals) are used based on their performance and have a specific purpose. They have application in the manufacturing process of a vast range of products including paints and coatings, cosmetics, petroleum products, inks and plastics.

The companies in this space are gaining from strong demand in end-use markets such as construction, electronics, automotive and agriculture as well as strategic measures including cost-cutting and productivity improvement, expansion into high-growth markets, price hike actions and earnings-accretive acquisitions. American specialty chemical companies are also benefiting from the U.S. corporate tax reform, which is favorably impacting their bottom lines and cash flows.

However, the near-term prospects of the industry are being clouded by escalating trade tensions between the United States and China. Fears of a fierce trade war have spooked the markets since March 2018.

The Trump administration, in July, imposed tariffs on $34 billion in Chinese goods that led to China retaliating with tariffs on American products of equal value. The United States and China, in August, also levied a 25% tariff on $16 billion worth of each other’s products. China’s list of U.S. goods hit with tariffs includes a wide range of chemicals and plastics.

Moreover, the Trump administration recently slapped a 10% tariff (rising to 25% starting 2019) on $200 billion worth of Chinese imports. In response, China hit back with tariffs on an additional $60 billion in American products. The U.S. administration has also threatened to impose tariffs on around $267 billion of additional Chinese imports.

China is one of the biggest export markets for U.S. chemicals and thus, leaves the American chemical industry heavily exposed to Beijing’s retaliatory trade actions. The tariffs have created an uncertain demand environment for U.S. chemical products in this major market. Chemical industry trade groups are worried that the tariffs would hurt U.S. chemical exports and the competitiveness of the domestic chemical industry.

Companies in the chemical specialty space are also hamstrung by feedstock cost pressure. These companies face headwinds from a spike in costs of raw materials as a result of short supply partly due to production outages and plant shutdowns.

China’s environmental crackdown has led to the tightening in the supply of certain key raw materials as a result of plant closures. The disruption in the supply chain has pushed up the prices of these inputs in a high demand environment. Higher raw material prices are, thus, likely to squeeze margins of specialty chemical companies over the short haul.

Industry Trails S&P 500 on Shareholder Returns  

The Zacks Chemicals Specialty industry, which is a 30-stock group within the broader Zacks Basic Materials Sector, has underperformed the S&P 500 over the past year. Nevertheless, the industry has topped its own sector over the same period. While the stocks in this industry have collectively gained 12.8%, the Zacks S&P 500 Composite and Zacks Basic Materials Sector have gained 15.9% and 4.9%, respectively.

The underperformance vis-à-vis the benchmark index appears to partly reflect trade-related worries for the chemical industry. Investors’ confidence on the industry’s prospects has taken a beating due to heightened trade tensions between Washington and Beijing.

One-Year Price Performance



 

The Group’s Valuation Looks 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 specialty 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 measure for valuating 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 movements of the 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 specialty industry looks 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 22.7, which is above its own average of 22, but below the highest level of 25.1 in the past one year. The industry compares unfavorably with the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is at 12 and the median level is 11.6.

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 8.3 and the median level of 10 for the same period are well below the respective ratios of the Zacks Chemicals Specialty industry.

Enterprise Value/EBITDA (TTM)



 

Earnings Picture Shows Improvement

Amid heightened U.S.-China trade tensions and sustained challenges from raw material cost inflation, 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 Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

Price and Consensus: Zacks Chemicals Specialty industry


This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the $1.86 EPS estimate for the industry for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks Chemicals Specialty industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry's earnings per share for 2018 but how this estimate has evolved recently.

Current Fiscal Year EPS Estimate Revisions


As you can see here, the EPS estimate for 2018 is up from $1.56 at the end of August, $1.62 at the end of July, $1.64 at the end of June and $1.76 this time last year. In other words, the sell-side analysts covering the companies in the Zacks Chemicals Specialty industry have raised their estimates.

Zacks Industry Rank Indicates Bleak Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Chemicals Specialty industry currently carries a Zacks Industry Rank #226, which places it at the bottom 11% 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.

Industry Shows Potential in the Long-Term

The long-term (3-5 years) EPS growth estimate for the Zacks Chemicals Specialty industry appears upbeat. The group’s mean estimate of long-term EPS growth rate is at 12.35%, above the 9.83% growth rate for the Zacks S&P 500 Composite.

Mean Estimate of Long-Term EPS Growth Rate


One key reason 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 2018.

 

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

Chemical specialty companies are bearing the brunt of trade tariffs. Moreover, margins of these producers will remain under pressure over the short haul amid an inflationary environment given raw material supply constraints.

The industry might not be an appropriate choice for investment in the near term due to the prevalent headwinds.

So, it may not be a good idea to bet on this space right now. Keeping this in mind, investors may want to steer clear of the following stocks:  

Venator Materials PLC (VNTR - Free Report) : UK-based Venator carries a Zacks Rank #5 (Strong Sell). The stock has lost roughly 61% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 26% downward over the last 60 days.

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

Price and Consensus: VNTR



 

American Vanguard Corporation (AVD - Free Report) : The consensus EPS estimate for this California-based company has moved 4.8% lower for the current year, over the last 60 days. The stock, which carries a Zacks Rank #5, has lost around 17% over the past year.

Price and Consensus: AVD



 

Valvoline Inc. (VVV - Free Report) : Kentucky-based Valvoline has a Zacks Rank #4 (Sell). The consensus EPS estimate has moved 3.7% lower for the current year, over the last 60 days. The company’s shares are also down around 8% over the past year.

Price and Consensus: VVV



 

AdvanSix Inc. (ASIX - Free Report) : The consensus EPS estimate for this New Jersey-based company has moved 21.9% lower for the current year, over the last 60 days. The stock, which carries a Zacks Rank #4, has lost around 14% in a year’s time.

Price and Consensus: ASIX



 

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