Takeovers, Turnarounds in Store For Chemical Producers

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

From macro uncertainty to takeover activity, contrasting drives have caused chemical companies to be quite volatile of late. While it may not be for the risk-averse, low multiples are likely to expand as input pressures mitigate and takeover activity buoys up confidence. I recommend broadly diversifying to avoid risk and preferentially backing those companies that have delivered promising momentum over only strong recent results. 

Buy DuPont (NYSE: DD) Over Dow

Over the last six months, DuPont has lost 16% of its value, but it still rated around a "hold" on the Street. EPS growth forecasts have fallen to just a 4.3% annual rate over the next 5 years--not nearly enough to make the company outperform at a multiple of 14.8x. Accordingly, let's look at the fundamentals to see whether or not positive earnings surprises are in store.

Much of the momentum erosion stems from poor macro conditions, but it is still trading below its historical multiples. This indicates that investors are particularly negative about the future. But the company has yet to realize all of the synergies from integrating high-margin businesses Danisco and Solae. Management expects to save $130 million worth of cost synergies from the Danisco buyout by the year's end while reducing $230 million in residual costs by divesting the Performance Coatings business ("DPC" was sold to Carlyle for $4.9 billion). The company remains committed to further cutting costs through consolidating facilities and improving the efficiency of supply chains.

In terms of geographical exposure, the company is delivering strong returns in Latin America. Despite a tough 3Q 2011 comp, 3Q 2012 ag sales were up 4%. Going forward, I am optimistic about more growth in Seed & Crop Protection due to greater farming in Latin America. China and Europe, however, have been worse than expected, with Performance Chemicals falling 37% as demand in these regions fell for Ti02 and fluoropolymers. Weakness in the core business contrasted with good strategic actions, making DuPont a mixed bag.

I would recommend buying the business over Dow (NYSE: DOW). The chemical conglomerate is 26.9% up from its 52-week low and rated closer to a "sell" than a "buy" on the Street. Although the dividend yield of 4.3% is compelling, it is under pressure from a low current ratio of 1.8x and a payout ratio of 87.3%. Since the payout is so high, Dow has very little room to reinvest in growth without accruing more debt. Yet analysts expect it to turn around from the 11.7% annual EPS declines over the past 5 years and achieve a 6.4% growth rate.

Fundamentals, Takeover Potential Driving Huntsman (NYSE: HUN)

In contrast to DuPont and Dow, Huntsman has been on a roll for the last 3 months, as it gained 26.9% - an out-performance of 3,710 basis points. The divergence really became pronounced over the last 30 days, in which Huntsman appreciated by 7.2% while its competitors fell by 11.8%. Even Dow was roughly flat during this time period. So how do you explain this out-performance?

For one, the company has delivered excellent results. 3Q 2012 EPS of $0.70 was ahead of consensus by $0.19, and this was particularly noteworthy in light of how it was driven by a successful price hike in polyurethane. The polyurethanes business improved nearly $100 million over the prior year as average selling prices rose 5%. Moreover, demand for wood products and adhesives in Europe and Asia both increased. They have offset a headwind from rising input prices, particularly for benzene. In addition, domestic trends are signaling a rousing recovery that will lift business for wood products and appliances.

In addition, the market is starting to appreciate Huntsman as a buyout target. With a free cash flow yield of 11.1% and double-digit growth prospects, a takeover could pay for itself. And if the acquisition by private equity Carlyle Group is of any indication, the market for corporate control in chemical is getting active. I recommend buying under increased speculation; and should nothing happen strategically, the fundamentals are at least moving in the right direction.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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