Chemicals Industry Stock Outlook - July 2017

The chemical industry is getting its mojo back after a long dry spell. The highly cyclical industry is finally finding traction again after bearing the brunt of the global economic crisis.

The industry got off to a buoyant start to the year with a strong performance in the first quarter, notwithstanding a few headwinds. The March quarter showed strong demand trends for chemicals across key end-use markets such as construction, automotive and electronics.

A host of companies in the space including prominent names, such as Dow Chemical (DOW), DuPont (NYSE:DD) (DD), Eastman Chemical (EMN), Celanese (CE) and Air Products (APD), produced earnings beats in the quarter, many benefiting from strong volume gains. The outperformance was driven by solid demand across construction and automotive markets as well as strategic measures including productivity improvement, pricing actions, portfolio restructuring and earnings-accretive acquisitions.

Second-quarter earnings season is currently underway, with most of the major chemical players yet to come up with their quarterly numbers as of this write-up. The earnings momentum is expected to continue in the June quarter as the fundamental driving factors remain firmly in place.

The Chemicals industry has also outperformed the broader market year to date. The industry returned around 13% over the same time frame, while the S&P 500 index advanced nearly 11%.

Chemical companies continue to shift their focus on attractive, growth markets in an effort to whittle down their exposure on other businesses that are grappling with weak demand. The industry is also seeing a pick-up in consolidation activities -- exhibited by a wide swath of deals in the recent past -- as chemical makers are increasingly looking diversify their business and enhance operational scale.

Moreover, cost-cutting measures (including plant closures and headcount reduction) and productivity improvement actions by chemical companies are expected to continue to yield industry-wide margin improvements.

Notwithstanding some lingering headwinds, the industry’s momentum is expected to continue through the balance of 2017, supported by continued strength across key end-use markets, an upswing in the world economy and significant shale-linked capital investment.

U.S. Chemical Industry Set to Ride High

The prospects for the U.S. chemical industry look bright. The American chemical industry is set for strong growth this year and the next despite several challenges, including a strong dollar, soft export markets and a low oil price environment.

The American Chemistry Council (“ACC”), an industry trade group, envisions accelerated growth for the domestic chemical industry on the back of an improving global economy and a surge in shale-linked capital investment.

The ACC, in its year-end 2016 outlook, said that it expects national chemical production to rise 3.6% in 2017, further accelerating to 4.8% growth in 2018. The trade group also expects basic chemicals production to expand 4.2% in 2017 on the back of advances in manufacturing and exports. Moreover, production in the specialties chemical segment is expected to pick up pace and rise 3% in 2017.

The ACC also expects American chemical industry’s growth to transcend the nation’s overall economic growth in the long haul. It sees domestic chemical sales to cross the $1 trillion milestone by 2020.

The shale gas boom in the U.S. has also been a huge driving force behind chemical investment on plants and equipment in the country and has provided domestic petrochemicals producers a compelling cost advantage over their global counterparts. The shale revolution has made the U.S. an attractive investment hotspot and incentivized a number of chemical companies including industry heavyweights such as Dow Chemical, BASF (BASFY) and LyondellBasell Industries (LYB) to pump in billions of dollars to beef up capacity. The ACC expects domestic chemical industry capital spending to increase at a 7% annual rate through 2021.

EU Chemical Sector in Recovery Mode

The European chemical industry is finally showing signs of recovery after remaining in a rut for a while. The rebound is supported by a resurgent Eurozone economy, which got off to a rollicking start to the year with better-than-expected GDP growth in the first quarter.

The business environment for the European chemical industry improved during the first quarter on the back of improving global economic sentiment, according to a report from the European Chemical Industry Council (CEFIC). Chemical companies in the region saw healthy demand for chemical products and an uptrend in pricing during the first quarter. Key consumer industries such as automotive and construction also posted healthy growth in the quarter.

Amid this favorable operating environment, the European chemical industry saw a spike in output across most chemical sub-sectors during the quarter, with overall production rising 2.3% year over year to reach the highest level in eight years. Capacity utilization in the sector also reached the second highest level in six years in the first quarter. Total sales also climbed 7.8% year over year in the quarter.

While lingering uncertainties and political risks could hinder performance, the CEFIC expects the recovery momentum to continue moving ahead and envisions chemical output in the European Union to rise 1.5% year over year in 2017 after paltry growth of 0.5% in 2016.

A Few Lingering Worries

The chemical industry remains buffeted by certain headwinds. Concerns over 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.

Moreover, chemical makers continue to feel the pinch of depressed demand across agriculture and energy markets. A low crude oil price environment is still hurting demand for chemicals in this important end-use market and is also affecting chemical prices. A strong dollar is also weighing on U.S. chemical exports, reducing their attractiveness in overseas markets.

The outlook for the fertilizer and agricultural chemicals space also remains cloudy due to continued weakness in crop commodity prices, low farm income and sluggish economic conditions in certain emerging markets, including Latin America.

Valuation Looks 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 a bit stretched at the moment when compared to its own range and the broader market.

The industry has a trailing 12-month EV/EBITDA multiple of 12.5X, which is at the high level it scaled in the past year and also above its own average of 11.2X over that period. Moreover, the industry compares unfavorably with the market at large, as the trailing 12-month EV/EBITDA for the S&P 500 is at 11X and the median level is 10.5X. As such, there seems to be little room for upside moving ahead.

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 is expected to have a 2.4% share of total earnings for the S&P 500 in 2017.

We rank 265 industries in the 16 Zacks sectors, based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our 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). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (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. The Zacks Industry Rank is #34 for Chemical Diversified (placing it at the top 13% of the 250 plus Zacks classified industries), #85 for Chemical Plastics (at top 33%) and #117 for Chemical Specialty (at top 46%).

Looking at the exact location of these industries, one could say that the general outlook for the chemical industry is ‘Positive.'

Strong Q1, but Q2 Picture Lukewarm

Basic Materials is among the sectors that racked up double-digit earnings growth in first-quarter 2017. Looking at the overall results of the sector, earnings for the sector participants on the S&P 500 index for the quarter jumped 15.9% from the same period last year. Total revenues for these companies also went up 5.4% in the quarter.

However, the outlook for second-quarter 2017 shows moderation in both earnings and revenue growth. While overall earnings for the sector are expected to rise 1.5%, revenues are forecast to increase 2.8% in the quarter.

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

Final Thoughts

While the industry still remains saddled by a few challenges, its healthy momentum is expected to continue in the back half of 2017. Strategic initiatives including continued focus on cost and productivity, operational efficiency improvement and expansion of scale through acquisitions should help chemical makers weather the macroeconomic and industry-specific headwinds.

More Stock News: This Is Bigger than the iPhone!

It could become the mother of all technological revolutions. Apple (NASDAQ:AAPL) sold a mere 1 billion iPhones in 10 years but a new breakthrough is expected to generate more than 27 billion devices in just 3 years, creating a $1.7 trillion market.

Zacks has just released a Special Report that spotlights this fast-emerging phenomenon and 6 tickers for taking advantage of it. If you don't buy now, you may kick yourself in 2020. Click here for the 6 trades >>