4 Chemicals Industry Stock Picks

On April 28, The Wall Street Transcript interviewed Dmitry Silversteyn, a Senior Analyst with Longbow Research covering the chemicals industry. Key excerpts, including his sector picks, follow:

TWST: Where are you pointing investors at this point? What names are at the top of your list?

Mr. Silversteyn: For the time being, I am still sticking to my thesis of avoiding exposure to economic and cost headwinds and really focusing on companies that are participating in growth markets, that still have pricing power and that have good international exposure and limited exposure to the cyclical markets. So companies like Ecolab (ECL), Sigma-Aldrich (SIAL), FMC (FMC) would be at the top of my list, as well as Hercules (HPC), which is not an intuitively obvious answer because they do have exposure to the paper industry, which is a low growth, cyclical industry, and they do have some exposure to the construction industry, but because of the company-specific drivers and catalysts, I think performance will surprise investors and I think the stock, given that it's already trading at trough multiples, really does not have a lot of downside, whereas the upside over the next couple of years can be north of 50%.

TWST: What is the appeal of a name like Ecolab?

Mr. Silversteyn: The appeal is that this company through good times and bad delivers on expectations. They grow their top line organically in the high single digits. With currency and acquisitions the growth is very often in the double-digit range. They grow their earnings at about a 15% clip. They have a very high return on equity north of 20%. They are cash flow positive. They have a good balance sheet that supports acquisitions and dividend increases and share repurchases as needed. They have a management team that is very aggressive and they have a culture within the company that is very aggressive when it comes to getting new business, and market share gain is really what drives the performance of this company. Their markets are not particularly fast growing, being mainly in cleaning and sanitizing on the institutional side, but because of their relatively small market share, even though they are the industry leader, they still have less than 20% share in most of the markets where they participate; there are plenty of opportunities for market share gains and that's what allows them to get faster growth. So you are looking at a company, as I said, that's growing close to double digits, that has a 50% plus gross margin, that has a 20% plus return on equity and 15% average growth in earnings in a very predictable, stable way and investors have been willing to pay a higher multiple for that predictability. I think that will continue. And again, given the lack of economic sensitivity of this company, we think it has an appeal to both growth investors as well as those looking for a safe haven.

TWST: And Sigma-Aldrich?

Mr. Silversteyn: Sigma-Aldrich has exposure to largely life science and high technology markets. So they are cyclical in their own right, but they don't have a GDP cycle. Right now, certainly the life science portion seems to be in an up cycle in terms of R&D spending by biotech and pharmaceutical companies, growth of pharmaceutical companies beyond North America and Western Europe into Eastern Europe and Asia, and growth of R&D budgets, unfortunately right now outside of the United States, but I think that with the new administration, R&D budgets in the US, certainly government portions of them, will start increasing and NIH funding will get better. So this is a company that will again, has a high single digit organic growth capability, has very high margins, gross margins at around 50%, operating margins north of 20%, excellent return on equity, very strong balance sheet, has done some bolt-on acquisitions that have been done in an accretive way, and has a management team that really seems to be in tune with shareholders as far as realizing shareholder value from the company. So again, a GARP maybe more than a growth company, because I guess 10%-12% earnings growth does not necessarily qualify the stock to be a growth stock, but certainly growth at a reasonable price still works. Plus it might be considered a safe haven investment and some would say countercyclical investment at this time.

TWST: You mentioned Hercules, which I would assume is a little controversial.

Mr. Silversteyn: Hercules is an interesting name. Half the company's business is derived from the pulp and paper market, the other half is from broader industrial markets, including some life science and personal care products but some coatings and adhesives products as well. So looking at the portfolio, you would think that this company is significantly tied to the economic cycle, whereas in reality, the paper cycle is fairly shallow. The company's global presence allows them to take advantage of growth in the paper demand in other parts of the world. Also their position within the paper industry where they supply chemicals disproportionately toward the higher value-added part of the paper market, which includes things like toilet paper and tissue and paper towels, which you don't think of as high tech products, but actually, if you consider how fast the spools are flying in a manufacturing plant and keeping that thin tissue from tearing and imparting it all the properties from absorption to wet strength that these products need, there is actually a lot of technology that goes into these products.

They tend to be consumer staples in the developed parts of the world so they are not subject to the economic cycles, and in emerging parts of the world, it is actually a growth sector. As those economies are getting richer, the middle class is developing a taste for Western-style toilet paper and tissue and paper towels, which is actually resulting in a bit faster growth for this business than the overall paper market. You also have a company that is the largest paper chemicals supplier in the world. So they have the geographic breadth and the product breadth to allow them to dominate this market and to get pricing and new products into the market, which allows them to expand their margins.

Their raw material costs are fairly dispersed; there is no single raw material that makes up a significant percentage of their cost of goods sold, and a lot of their raw materials are not petrochemical-based, which provides a bit of countercyclicality to the petrochemical cycle as well.

The problem with Hercules has been that as they have gone through their restructuring and realignment process over the last several years, investors perhaps lost sight of the company during that time and missed some of the good developments that have happened within the company as far as balance sheet strength, pension funding, addressing some environmental liabilities and asbestos liabilities, things that would keep an investor from a value stock like that. A lot of that is behind the company. What they need to do now is string together a couple of quarters with no negative surprises and I think the stock will respond.

TWST: Given the dichotomy of their businesses, are investors going to pay attention?

Mr. Silversteyn: For a chemical company, it's not that difficult a business to understand. They only have two divisions — Paper Technologies and Aqualon. Aqualon is the naturally derived polymers division that manufactures products derived either from wood pulp or from citrus peel or some other renewable source that's used in everything from personal care and cosmetics to packaged foods and pharmaceuticals as well as some industrial exposure, as I said, where it is part of a coating or a piece of formulation for waterborne systems. I don't think it's that difficult to understand. I think it's just kind of counterintuitive, when investors are looking at it for the first time, that a company with exposure to the paper cycle can have such stable results and actually show improvement in their results despite some tough times for their customers (the paper mills).

The fourth name I mentioned I think was FMC. Only about 20% of their portfolio is exposed to the economy; they are a global company for two of their three businesses, agriculture chemicals and specialty chemicals. Their industrial chemicals are largely North American based, but the biggest part within industrial chemicals is a product called soda ash, where they are the largest producer in North America. There are only five producers total, and that market is operating at a 100% utilization rate, so they have been enjoying very strong pricing power over the last several years as well as benefiting from a strong export market, given that North America is still the lowest cost region for producing soda ash by a wide margin. About 40% of the product produced in North America is exported abroad. So we have a company here that at a reasonable multiple is really a vehicle for taking advantage of the alternative energy megatrend. Their crop protection business, which is mostly insecticides in Latin America and North America, is levered to fuel crops, in other words, sugarcane in Brazil, corn in the US, rape seed in Europe, and that's what's driving the performance of that division; north of 50% of operating profit is generated by that division.

And then the other business that's levered to the alternative energy megatrend is the lithium business. They are one of three integrated lithium producers in the world, probably have a higher value-added portfolio than their two chief competitors and are enjoying very good volume growth right now driven by rechargeable batteries as well as pharmaceutical and catalytic applications for lithium. With the new capacity that's being brought on by two of their competitors, you probably are going to see pricing, which has been a big driver of this business over the past couple of years, maybe take a breather for 2008, but growth should resume in 2009.

In the meantime, for 2008, there are other positive differences between this year and last that should drive earnings growth of close to 20%. In this environment, that really makes the company stand out.