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Industry Analysis: Specialty Chemical
The Specialty Chemicals Industry is a mature sector. For decades, many industries have utilized specialty chemicals in manufacturing and finishing. Some specific areas where these products are used include: agriculture, requiring fertilizers and crop protection applications; electronics, needing agents to produce printed circuit boards and other components; housing, which relies on chemicals for construction materials, sealants, coatings, paints and plastics; and consumer goods, such as perfumes, detergents, paper items and pharmaceuticals.
Despite a lengthy history, there's still room for innovation. Since specialty chemicals are widely used, changes to industrial and consumer product life cycles and new offerings can create demand for variations. Notably, growing concern about the global environment has led to eco-friendly restrictions, with the aim of reducing pollutants and greenhouse gases. This, in turn, is resulting in unique chemical applications, such as water-based plastics and paints, biodegradable electronic components, and low-impact food-and-beverage packaging. Too, developing energy fields, e.g., rechargeable batteries, wind and solar power, hold promise for expanded markets.
Though this industry is mature, member companies, some more than others, are subject to swings in the macroeconomic cycle. Indeed, for many, sales and earnings performance will track the fortunes of the housing, heavy construction, and industrial sectors. Investors might want to monitor industrial output, railcar loadings, housing starts, and other economic indicators to gauge the demand for specialty chemicals.
Investors should also consider the supply/demand balance in this industry. Not surprising, excess inventory may be an indicator of a slowdown and coming price pressure and earnings weakness. Importantly, competition is a factor. The population of specialty chemical manufacturers is growing, especially in low-cost, moderately regulated locales in Asia, the Middle East, and South America.
The net profit of a specialty chemical company is sensitive to the cost of raw materials. Energy and commodities prices are volatile. Natural gas and petroleum products are widely used to create specialty chemicals. For example, many paints and coatings are made with titanium dioxides and petroleum distillates. Also, plastics require various petroleum-based resins. Minerals and metals, such as cobalt, nickel and certain powders, play a large role in producing some chemical products, and their prices can soar during periods of industrial expansion, impacting margins.
Fortunately for these companies, when energy and/or commodities costs are high, they can implement surcharges, as long as customers are aware of the situation. Pass-through agreements with customers, linking product prices with raw-material price indexes, are common. Investors should note, though, that surcharges often lag the cost trend, leading to seemingly contradictory demand/earnings relationships.
Historically, Specialty Chemical companies have turned in very respectable operating and net profit margins, in the teens and high single-digits, respectively. Managements usually react quickly when inventories are building and there are signs of a broader downturn. They may undertake restructuring, entailing temporary plant shutdowns, production consolidation, staff reductions, product line eliminations, and asset divestitures. Too, companies sometimes build facilities in foreign countries with close proximity to end-markets, economical labor, and limited government oversight. Wide margins are a good measure of operating efficiency, and typically yield favorable returns on shareholder equity.
Generally, Specialty Chemical companies have high capital spending requirements, mostly involving the upkeep and expansion of production and transportation facilities. In the industry, debt-to-total capital ratios range from zero to as high as 60%, with the mean hewing close to 30%. Those producers with substantial leverage pose greater interest rate risk to investors, especially if a significant portion of borrowings needs to be refinanced in the short term or is subject to floating rates. Heavy debt burdens are not necessarily bad. They often indicate a period of expansion.
Many of the companies in this industry are decent cash flow generators and have built up solid cash positions. They favor using funds for product development, brick-and-mortar expansion, and acquisitions, activities that enlarge the customer base. Management has to initiate expansion carefully and at the right time in the business cycle. There are a number of chemical companies that have endured costly, poorly timed, and badly executed business combinations. Their stockholders have suffered along with them. Safer uses of cash include, share repurchases, special payouts to investors, and regular dividend hikes.
On balance, the stocks of Specialty Chemical companies are best classified as growth-and-income holdings. But that's not to say that growth investors should look elsewhere. When a company is new or has developed a product with meaningful sales potential or entered a large market, it may well enjoy an extended period of expansion, with commensurate gains in its stock price. Over time, however, the majority of new entrants mature and typically wind up offering Wall Street good diversification, international exposure, downside protection, and steady dividend payments.