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Strong Cash Flow and Cautious Spending in Wall Street Transcript Chemicals Issue
Thursday June 22, 10:33 am ET

The commodity chemicals are enjoying a four year up cycle, which is expected to last at least through 2006 and 2007. Topics include: Impact of higher energy prices, Impact of feedstock prices, Demand and supply, Growth of chemical companies in Europe and Asia, Deployment of cash, Management changes, M&A activity, Cost cutting measures, Turnaround situations, Macro issues, Offshoring and globalization, Defensive growth companies, Commodity and specialty valuations, Stock recommendations, Stocks to avoid, Industrial gases outlook, Technology & costs, Science and innovation.

Companies include: Agrium Inc. (AGU), Dow Chemical (DOW); Altair Nanotechnologies Inc (ALTI), Bio Solutions Manufacturing Inc. (BSLM), Clean Diesel Technologies Inc. (CDTI), Celanese (CE); Ecolab Inc. (ECL), H.B. Fuller Company (FUL), Hercules Incorporated (HPC), NOVA Chemicals (NCX), Omnova Solutions INC (OMN), Resin Systems (RS:TSX), Huntsman (HUN); 3M (MMM); Corning (GLW); Ashland (ASH); Cabot Microelectronics (CCMP); Lyondell (LYO); DuPont (DD); Praxair (PX); Cabot (CBT); PPG Industries (PPG); BASF (BF); Air Products & Chemicals (APD); International Flavor & Fragrances (IFF), Georgia Gulf (GGC), Westlake Chemical (WLK), Dow Chemical (DOW). Analysts Include: David Begleiter, Deutsche Bank; Jeffrey Cianci, UBS Warburg; John Roberts, The Buckingham Research Group, Hassan Ahmed, HSBC.

In the following brief excerpt from the 55 page report, the roundtable analysts discuss the strong cash flows that Chemicals companies are enjoying and their options for using it. Plus they highlight the outlook for investors.

TWST: David, you mentioned this strong cash flow. What are the companies doing with it?

Mr. Begleiter: Chemical companies are deploying their cash in a balanced fashion, through a combination of share buybacks, dividend increases, debt pay down and acquisitions. That said, acquisitions remain expensive due in part to the entry of private equity firms into the chemical sector. As we move into the latter portions of the cycle and free cash builds, I expect to see an increase in share buybacks, especially among the commodity chemical companies like Dow Chemical.

TWST: Is that what they should be doing?

Mr. Begleiter: I think it is. The reality is that US-based chemical production is increasingly disadvantaged due to high feedstock costs and, to a lesser extent, high environmental, legal and labor costs. As a result, you have a growing number of Middle Eastern, Asian and Eastern European producers that have been, and will continue, to gain versus US-based producers. Often the most viable option for US producers is to return their excess cash to their shareholders.

TWST: Jeff, are we going to see this industry continue to be cautious on spending and return cash flow?

Mr. Cianci: Yes, most of the expansions on the specialty side are only when needed and contracted for. On the commodity side, they are mostly outside the US, and only a few of our companies participate in that, such as Dow Chemical, but even there, they're building great cost-advantaged plants. So we are seeing very disciplined capital spending related to previous cycles, and we expect to see a return of cash to shareholders. We like the high debt companies for that reason, because they will have a rapid delevering, a period of high interest rates shifting to low rates, and an upgrade of investment ratings as well.

TWST: What's at the top of your list, David?

Mr. Begleiter: My top pick today is Celanese. At 6.7 times estimated 2006 EPS, Celanese is being priced as a commodity chemical company. I believe that is incorrect. Investors are looking at Celanese's historical past when they didn't have a downstream business to cushion the impact of upstream volatility. Following a number of acquisitions and organic growth, I think comparable companies are Eastern Chemical and Rohm and Haas, the midpoint of which would imply a 12-13 p/e multiple, or nearly double their current multiple.

Further distancing Celanese from other commodity chemical companies is their unique technology advantage in acetic acid, the basic building block for the acetyls chain. Acetic acid is the only commodity chemical where technology trumps feedstock costs. Celanese's acetyls technology gives them an advantage on both conversion costs and capital costs. In addition, the acetyl's chain has the best market structure of any commodity chain with two players dominating the chain - Celanese and BP (BP). As we mentioned before, over the last five years, Celanese has significantly enhanced its downstream businesses, thus cushioning the impact of margin pressure in their downstream businesses (which should happen when acetic acid margins compress). This was proven in Q1 2006, when acetic acid prices fell 30% year over year, but Celanese's overall acetic business earnings fell only 10%, as you did see downstream expansion in their emulsions and their PVOH businesses.

A full validation of this unique, hybrid model will happen in 2007-2008 when a large amount of capacity will come on stream from Celanese and BP. I believe Celanese's earnings resiliency in 2007-2008 will prove to investors why it is more akin to a Rohm and Haas than a Dow Chemical.

TWST: Where is the stock at this point, and what's your target on it?

Mr. Begleiter: The stock is at $19 per share and our target is $32. As I mentioned, the stock is at 6.7 times our 2006 estimate, versus a range of 11-15 times for its best comps.

TWST: So there is a lot of upside opportunity here?

Mr. Begleiter: Yes.

TWST: Jeff, what's at the top of your list?

Mr. Cianci: I think that 3M is a quality growth name that can benefit from a late cycle industrial manufacturing environment and remain healthy. It should become a favorite of growth stock investors. It has EPS growth in the mid-teens, and a top line approaching 10%. I think that the market's mood, combined with a new CEO's bottom-up fundamental growth story, can let a defensive chicken cyclical shine. It's around $83 right now, and I think that this can clear $100.

TWST: What's it going to take for that to happen?

Mr. Cianci: First, earnings surprises over the near term. Guidance will likely be revised up each quarter as you go, and equally important, a top-line acceleration should become evident in the next couple of quarters.

TWST: John, what's your top pick?

Mr. Roberts: I think that leads into my pick, because with 3M, one of the things accelerating them is their optical film business, which goes into LCD displays. It accounts for perhaps as much as 15%-20% of their earnings. It's one of their biggest SBUs. But the most pure play material stock in that LCD opportunity is Corning, which is really just a materials company. It's still covered by a lot of telecom analysts because of the optical fiber bubble. But optical fiber has been at breakeven for Corning for many years now, and there's no sign of resurrecting it as the major business there.

The primary business is just flat sheets of glass that go into the LCD display market, and in that instance, they are really no different than PPG. Their main competitor is Asahi Glass, which is one of the largest glass companies in Asia. Corning trades at 17.5 times the 2007 earnings estimates, around the same multiple as maybe the more mature chemical stocks, and yet, the LCD glass business (which accounts for 70% of their earnings) is up about 70% year on year this quarter. I think that we will probably maintain a 50% growth rate over the next three years.

Source: Wall Street Transcript

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