What Earnings Say About Chemicals and Agriculture

by: Morningstar

By Elizabeth Collins

Several themes emerged as chemicals and agriculture companies reported earnings for the second quarter of 2010. We have highlighted the most important trends below.

Chemicals companies reported stronger demand from nearly every geography for almost every product. Of course, demand from emerging markets once again outpaced demand from developed economies. Areas of notable end-market strength included automotive markets. BASF, DuPont (NYSE:DD), and Rockwood (NYSE:ROC) were among the many companies reporting improving demand from nearly every market. A notable casualty of developed market underperformance was AkzoNobel's decorative paints business. Meanwhile, against the backdrop of slower recovery in North America and Europe, Ecolab (NYSE:ECL) was able to add share in important end markets, as its products help customers cut spending on water and energy--a good proposition in a weak economic environment.

Improved cost structures led to better profits on lower sales--relative to pre-recession levels--for many companies. Many chemicals companies worked hard in 2008 and 2009 to lower their costs and restructure their assets. As chemicals markets improved, this showed up in lower breakeven levels of profitability. Now, with greater momentum in chemicals demand, some companies are posting record profits even through revenues have not yet matched pre-downturn levels. Cytec Industries (NYSE:CYT) and Eastman Chemical (NYSE:EMN) were notable winners in this category.

Strong demand from the electronics industry reverberated throughout the chemicals complex during the second quarter. High utilization at semiconductor foundries, strong demand for consumer electronics, and robust production of panels all contributed to stronger demand for chemicals from this sector. DuPont noted that demand from electronics and communication markets actually surpassed pre-recession levels. Dow Chemical (NYSE:DOW) and Solvay (OTC:SVYSY) were other beneficiaries of this trend.

Construction end markets in North America and Europe remain weak. In contrast to virtually every other end market important to the chemicals industry, construction activity in North America and Europe remains in the doldrums. BASF added that the construction environment in Japan is discouraging as well. Weak construction activity in North America and Europe hit PPG Industries (NYSE:PPG), but this was more than offset by growth in industrial activity and strong demand in the Asia-Pacific region and Latin America. We can also count Dow Chemical and Solvay among the victims of weak construction activity in developed markets in the second quarter.

Besides construction, the pharmaceutical industry was the other notably weak end market for chemicals manufacturers, although this dynamic affected a smaller number of players. Sigma-Aldrich (NASDAQ:SIAL) was able to offset this weakness in large pharmaceutical customers with strength from industrial, diagnostic, and academic end markets. DSM was also hurt by the challenging conditions in the pharmaceutical industry.

Demand for fertilizers is approaching normal levels. Potash Corporation (NYSE:POT), Agrium (NYSE:AGU), Mosaic (NYSE:MOS), CF Industries (NYSE:CF), and Intrepid Potash (NYSE:IPI) are all benefiting from a year characterized by more-normal fertilizer application rates. Still, there are lingering signs of the fertilizer standstill of 2008/2009. Potash Corp expects China to consume only 8.5 million metric tons of potash this year, short of the 11 million metric tons consumed during the year prior to the downturn. Furthermore, distributors remain wary of taking inventory and price risk. Looking ahead, droughts in China and Russia--among other factors--are contributing to a likely tightening in the global supply and demand balance for grain, which should support crop prices and therefore fertilizer applications.

China's increased demand for soybeans, coupled with South American farmers' slower selling, created opportunities for ADM and a serious profit hit for Bunge. Archer-Daniels Midland's (NYSE:ADM) soybean crushing operations in North America and Europe benefited from relatively ample supply of soybeans and strong demand, which boosted the firm's crushing margins. This same dynamic caused a serious earnings hit at peer Bunge (NYSE:BG), whose South American crushing operations suffered from relatively weaker supply of soybeans.

Crop protection profits were weak across the board. Pricing pressure hurt profitability at Syngenta (NYSE:SYT), Dow, and Monsanto (NYSE:MON). The combination of high channel inventories following 2009's low pest pressure and increased generic competition led to intense price competition. Looking ahead, increased global glyphosate capacity is likely to mean structurally lower prices and profits for years to come.

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