2 Stocks to Avoid, 1 to Buy in Chemicals
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The chemicals business may be full of ups and downs, but this has caused some businesses to become overly discounted. As a result, the industry is ripe for takeovers. While I see Huntsman (NYSE: HUN) as an ideal target, I do not believe the upside from this speculation warrants an investment. For greater risk/reward, I would go after the potential suitor-to-be in chemicals: DuPont.
Huntsman & Dow: A House of Risk
Dependent on rising confidence over margins in its MDI and TiO2 products, Huntsman has too much downside to warrant an investment. Over three-fifths of EBITDA growth over the last 3 years has come from TiO2. At a time when Asian markets are particularly soft, there is no better place to be than on the sidelines. Even coating demand, which represents half of TiO2 consumption, will have to increase significantly across the world to justify taking on the risk of investing in Huntsman.
MDI’s margins may improve slightly in Europe for the third quarter with force majeure declared at Dow Chemical's (NYSE: DOW) facility. However, 30% of Huntsman’s business – which is way too much - is aligned towards Europe, which is likely to have a poor housing market in this second half of the year. On the positive side, all these headwinds have made the firm particularly cheap for a suitor to come in and take over the company. The parts are likely worth more than the sum given how uncertainty in TiO2 is causing investors to forget about the attraction of MDI. Most of the business comes from lower margin commodity chemicals, which dampens this outperforming segment.
Dow has recently added substance to investor anxiety in the market. After announcing a second quarter miss of 14%, shares fell 4%. Worse yet, management guided for a cautious 2Q 2012 and the timeframe for earnings targets of $10B EBITDA had to be extended. This put a damper on bull forecasts for quicker-than-expected earnings realizations. Until now the story had been that Dow is a growth company with a justifiable premium. Now, it has lost the momentum to maintain investor confidence. In fact, the market has been so weak that Dow is looking to increase interventions by 50% to $1.5 billion. These "interventions" are aimed at cutting costs.
For Better Risk/Reward, Go With DuPont
Unlike Dow, DuPont (NYSE: DD) actually reported a second quarter beat with adjusted EPS of $1.48. Despite being modestly ahead of consensus by $0.02, management still shifted guidance to the lower range of what was originally anticipated. Even still, I was pleased by the strong results in performance chemicals, which is a key area in which DuPont can widen the gap against peers. It already has realized a pricing advantage compared to its peers, and continues to improve prices.
Agriculture returns have also been strong, although margins declined slightly. This margins erosion stemmed from greater seed production costs, and it could worsen from the drought this year. However, I believe that the market has already priced in this headwind and thus set the bar low for outperformance. More than 30% of sales have come from new products over the last 4 years, so innovation will help make up for any uncertainty.
Equipped with a strong balance sheet, DuPont is more likely to be a takeover artist than the company that gets taken over. After purchasing Danisco, integrations thereafter have proceeded smoothly. DuPont’s large economic moat grants it a premium position in the market - a quality under-appreciated as of now.
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