5 Chemical Firms to Consider

The Chemical industry has been near the top of the Zacks industry ranks for several months now. As the world economy has recovered so has demand for the basic building blocks of most of the products we buy. Since these firms tend to be big buyers of oil, one might think that their margins would get squeezed by higher oil prices, but that has not been the case so far.

Earnings for the group are growing nicely, and are growing much faster than are sales. In other words net margins are going up, not down. Earnings have come in much higher than expected, and as a result analysts are raising their estimates for both this year and next.

I want to highlight some of the Chemical firms that currently hold the Zacks #1 Rank, or Strong Buy. This designation is given to only the top 5% of all stocks, and is based primarily on estimate revisions and earnings surprise. It has one heck of a long-term record, particularly if you are willing to trade in and out of stocks, and have a holding period of only a few months.

I will start with the largest of these firms, and then move to some of the smaller names. Prices are as of the close 5/17/11.

BASF (BASFY). This is a giant firm based in Germany. This year, it is now expected to earn $8.93 and those earnings are expected to rise to $9.80 in 2012. That is up from $7.61 in 2010.

Just last month, it was only expected to earn $8.30 in 2011 and $8.88 in 2012. Three months ago, it was expected to only earn $7.18 for 2011 and $6.89 for 2012. Remember, an estimate in motion tends to stay in motion, so the odds are that the current expectations, particularly for this year, will prove to be too conservative.

In other words, its “true” P/E will turn out to be less than the 10.0x implied by the current estimate. Its balance sheet is solid, if not exactly pristine. BASFY has a 2.57% dividend yield, but unlike most domestic firms, the payout comes but just once a year, so you will have to wait almost a full year to get a dividend on this one.

Dow Chemical (DOW) is the largest U.S.-based chemical firm. It is expected to earn $2.80 this year, with EPS growing to $3.49 next year. That is relative to $1.97 in 2010. Just a month ago, the expectations were for it to earn $2.57 in 2011 and $3.36 in 2012.

In the first quarter, earnings beat expectations by 22.4%. Based on this year’s earnings it is trading at 13.7x, which is reasonable, but not bargain basement. Looking out to 2012, the multiple falls to 11.0x.

The firm just boosted its dividend by 66% to $0.25 per quarter, from $0.15, but that is still below its payout before the financial crisis hit ($0.42). That puts the dividend yield at a very respectable 2.74%. It would not surprise me if the old dividend level were regained within two or three years.

Celanese (CE) is a much smaller firm than either BASF or DOW, but it is also benefiting from the same trends. It is currently expected to earn $4.36 for this year, rising to $4.92 next year, up from $3.37 in 2010. Just a month ago, the estimates stood at $3.89 and $4.52, respectively. That was before it beat the consensus expectations by 15.7% in the first quarter.

Celanese does not provide the same sort of dividend income as the other two, with a nominal payout of just $0.05 per quarter. It is trading at 11.3x this year, and 10.0x next year’s earnings estimates, and the estimates are marching higher. Its balance sheet is a bit on the questionable side, but that leverage has allowed it to earn a very strong 63.7% ROE over the last twelve months.

Huntsman (HUN). Smaller still than Celanese, and much more commodity-oriented, Huntsman has been knocking the cover off the ball. In the first quarter, it posted a 95.8% positive surprise. In other words, it earned almost twice what the street was expecting. That was the fourth time in a row that HUN posted a major positive earnings surprise.

Earnings are currently expected to rise from $0.83 in 2010 to $1.76 in 2011 and $2.08 in 2012. Before its earnings were announced, the expectations were for $1.41 this year and $1.79 next year. HUN has a quarterly dividend of $0.10, which at current prices provides a yield of 2.1%. The P/E ratios are very reasonable at 10.7x this year and 9.1x 2012 expectations. The balance sheet, like that of CE, is a bit on the aggressive side.

Olin (OLN) is not a pure play in chemicals — it also has a big division that makes ammunition (Winchester) — but it seems to be doing just fine as well. The company just posted a positive surprise of 16.7% in the first quarter, its 8th straight quarter of beating expectations.

Earnings are expected to rise from $1.15 in 2010 to $1.93 in 2011 and $2.33 in 2012. Last month, it was only expected to earn $1.71 this year and $2.14 in 2012. Three months ago, the expectations were for just $1.29 and $1.50, respectively. While OLN is the smallest of the five, it has the strongest balance sheet, and the best dividend yield. Its $0.20 quarterly payout translates to a 3.51% yield. That dividend, however, has not been raised for over a decade.

In short, the Chemical industry offers a nice combination of rapidly rising estimates for both this year and next, along with reasonable P/E ratios. In the short term, EPS growth will be rapid, but because these firms are classic cyclicals, it would be a serious mistake to extrapolate those growth rates beyond 2012.

I think we are still very much in the early stages of the world economic recovery (and for the Chemical firms, it is the health of the world economy — not just the U.S. economy — that matters). These firms will probably see some further growth in 2013 and 2014, only to see earnings fall sharply in the next downturn.

All five pay dividends, although the dividend profiles are very mixed. The payout ratios are low, especially based on 2012 earnings, so there is room for dividends to rise. While these firms have had a nice ride over the last year, they are not trading for excessive valuations. Thus there could well be more room for them to run. In short, these firms might be the right solution for your portfolio.

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