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Industry Analysis: Chemical, Basic
The Basic Chemical Industry is a rather small group. Nonetheless, it includes some large and well-established chemical companies, manufacturing an array of products aimed at a wide range of markets. In addition, fertilizer producers are well represented here, giving the industry a degree of end market concentration. Our presentation of historical figures, estimates, and projections for companies in this industry follows the standard Value Line report format. We provide sales and operating margin data by business line for very large enterprises.
Fertilizer production is, naturally, linked to the agricultural sector. As world populations rise, farm commodity requirements increase. This is a positive, long-term underlying trend. In times of marked economic prosperity, as the middle class expands, especially in developing nations, richer diets give an additional lift to the demand for and prices of grains and other staples. When farm incomes are healthy, spending on fertilizer is favorable. Scientific breakthroughs will also lead to upswings in the fertilizer business. Going forward, notwithstanding possible volatile intervals, farmers will surely continue to seek the means to improve crop quality and yield, auguring well for the fertilizer segment. The stocks of fertilizer producers are generally considered good growth vehicles.
Historically, the operating performance of other chemical companies in the industry has proved to be more cyclical. Sales and earnings rise and fall with the fortunes of the particular markets served and strength or weakness of the broader economy. It is not uncommon for a company to experience several difficult years, which may include losses, followed by a period of solid earnings advances. There are many external factors beyond management's control. Organizations that offer a wide variety of products are usually better situated to deal with macroeconomic weakness than those focused on a limited number of lines. Still, they are not completely insulated.
Investors should be aware of an important stock characteristic. Price-to-earnings ratios often expand considerably during hard times, due to significantly lower earnings. This might lead a prospective investor to falsely conclude that Chemical equities are overvalued, when, in fact, they are not. Indeed, the sector could be on the verge of an upturn, over the course of which P/E ratios typically decline. Ideally, investors with a long time horizon should buy into these stocks, once end markets have clearly hit a nadir. Momentum-oriented accounts will benefit, as well, in the midst of a cyclical upswing. There are a select few equities (of major operators) that are decent income holdings.
Sales and Earnings Performance
A company's sales trend is, of course, a key measure that investors should consider. Top-line performance is closely tied to the demand for a company's particular products from specific markets served. It can be a challenge for management to balance supply with varying customer demand in the short run, so planning is more focused on long-term industry prospects. Individual profitability will notably stray from the overall mean, depending on a Chemical company's end markets, product lineup, competitive position, feedstock (e.g., petroleum) costs, and overall expense structure.
Fixed costs are significant in this industry. Incremental sales growth can be substantially levered at the bottom line. This will be evident in the Annual Rates box on the Value Line page, which shows a company's past growth performance and our projections. Cash flow and earnings gains accelerate as sales steadily rise. Weak demand will pressure profitability. Return on Share Equity will whipsaw through the economic cycle. The largest industry members, though, produce more consistent returns over time. Steady, positive results may indicate that a company has a favorable competitive position and a competent management team.
Broadening Market Reach
Capital spending to maintain operations can use up a good portion of annual cash flow. Facility upgrades and expansion projects are also heavy uses of funds. Importantly, active research and development can lead to attractive new products, increased production, and greater market coverage. Debt funding is common in the industry, and obligations may be hefty at times.
It is not unusual for Chemical companies to complete strategic acquisitions or form partnerships. Such activity allows them to quickly and economically enhance their ability to serve new and existing customers. The takeover of a rival may reduce competitive pressure. And the purchase of a technology can bolster the product lineup or bring exposure to appealing new markets. Acquisitions and partnerships help to diversify operations and support dependable long-term sales and earnings streams. Sizable deals generally will raise the debt ratio and financial leverage.
From time to time, certain members of the industry will undertake a restructuring to improve business prospects or operating efficiency. The corporate structure may be realigned according to markets served or product lines. Sometimes core operating segments are combined. Other times, underperforming assets are divested. Workforce reductions might take place to save money. Also, new systems, technologies, and processes may be implemented to raise operating performance. Management takes these measures with the aim of strengthening profitability and return on shareholder investment.