Finding The Right Chemistry

• Ken Spencer Brown
• On 6:45 pm EDT, Friday September 25, 2009

Most people might not consider specialty chemicals the sexiest investment on the block, but few other industries play as big a role in everyday life.

Companies in the sector supplied the raw chemicals used to make the electronics in the alarm clock that woke you up this morning, the compound that thickened your toothpaste and kept those "bursting beauty beads" from sinking to the bottom of your shower gel.

They even helped keep that chicken healthy enough to provide eggs for that morning omelet.

Despite a recession that has sharply cut into volume, specialty chemical makers have so far avoided a price collapse, thanks to their growing importance to so many other industries.

And as more and more signs point 15 a recovery, analysts say specialty chemicals firms are well-poised to cash in on the upswing.

"They're coming out of this recession much leaner and meaner than when they entered it," said John Raquet, a director with chemicals consulting group Spiritus Group.

As of Friday, specialty chemicals ranked No. 23 out of IBD's 197 industry groups, up from No. 73 six months ago.

1. Business

IBD splits the $3 trillion chemicals industry into four main categories: fertilizers, plastics, basic chemicals and specialty chemicals. (Some analysts lump pharmaceuticals into chemicals, though IBD counts drugmakers as their own industry group.)

The line between the chemical groups isn't always clear -- most chemical companies have been diversifying their sales, so many chemical makers engage in multiple segments.

IBD's specialty chemicals group comprises 49 companies that sell everything from industrial gases to consumer products.

"It's an industry that lacks homogeneity, because you have so many companies that have individual supply/demand and raw-material cost characteristics," said Saul Ludwig, an analyst at KeyBanc Capital Markets "So it's hard to discuss as a group."

Industrial gas suppliers Praxair (NYSE:PX - News) and Air Products and Chemicals (NYSE:APD - News) are by far the biggest companies in the group in market valuation, supplying a variety of commodity gases such as oxygen, nitrogen, argon, hydrogen and helium. Though gases remain the bulk of the companies' business, both also supply a variety of other chemicals to various industries.

Scores of smaller companies fill a variety of industry niches. NewMarket (NYSE:NEU - News), which owns Ethyl Corp. and Afton Chemical, makes additives for petroleum products such as lubricating oils to cut pollution or help engines run better.

Lubrizol (NYSE:LZ - News) also makes lubricant additives along with specialty chemicals for a wide range of industries.

KMG Chemicals (NasdaqGM:KMGB - News), meanwhile, makes chemicals involved in everything from building electronics to keeping farm animals healthy.

The oddball of the group, WD-40 Co. (NasdaqGS:WDFC - News), sells consumer products such as its namesake lubricant and several household cleaners such as Carpet Fresh and 2000 Flushes.

While industrial gases companies account for the bulk of sales, much of the sector's growth in recent weeks has stemmed from smaller companies establishing a foothold in fast-growing niches.

For commodity products, the key to profits is efficiency and top-notch service. Air Products and Chemicals in the 1940s pioneered the concept of producing and selling gases at or near customers' work sites. At the time, most industrial gases were packaged and shipped in metal cylinders.

Founder Leonard Pool figured that for big customers, building a gas-production facility near the customer and piping the product directly would be cheaper and easier for the customer. That's standard practice now.

Like most commodity businesses, size has its advantages. Building gas-producing plants requires huge capital resources. That natural barrier to entry, along with the mature sector's historically slow growth rates, has meant few new challengers for the bigger firms.

"Strong profitability has been a fairly recent phenomenon," said KeyBanc's Ludwig.

For other types of chemicals, innovation is vital -- even if it means cannibalizing sales of older products. That means continuously reinvesting profits into research and development.

"In many respects, we're competing against ourselves," said Mark Sutherland, Lubrizol's director of investor relations.

Name Of The Game: For industrial gases, operate as efficiently as possible, gain a global presence and leverage that size. For niche segments, innovation is key.

2. Market

Specialty chemicals are a global business, with demand in every corner of the world.

While growth in mature markets has slowed or even reversed amid the recession, Asia and Latin America has continued to grow, albeit at a slower pace than before. And demand is picking up in the Middle East, Raquet says.

Gas buyers come from a wide swath of industries -- even from within the specialty chemicals group itself. Industrial gases sold by the likes of Praxair are often the raw materials used by niche chemical makers.

Industrial users such as manufacturing plants represent another big market for gases.

Petroleum companies buy lots of compounds for everything from better lubricants to additives that boost mileage.

Steel makers, which use oxygen in the smelting process, are another market. Pharmaceutical firms represent another large base.

A wide swath of other industries uses specialty chemicals in all sorts of ways: in food, medicine, soap, plumbing and more.

3. Climate

Having covered the industry since the 1980s, Spiritus' Raquet has seen his share of slowdowns. But before last year, he had never seen chemical sales drop.

Commodity chemical sales hinge on overall economic activity. The recession has gutted demand, especially among industrial and petroleum customers as factories slow output and people drive less. Chemical firms reacted quickly, cutting workers and production.

Though the sheer size of Praxair and Air Products and Chemicals makes them a key proxy for overall performance of specialty chemicals, smaller companies have driven much of the group's growth in recent weeks.

For the group as a whole, lower commodity prices have proven a double-edged sword -- hurting industrial gas producers but providing relief to others in the group that buy those materials.

On the regulation front, new emissions rules for diesel trucks are boosting demand for lubricants and petroleum additives that cut pollutants and squeeze more mileage out of engines. Similar passenger car rules being mulled by the White House could spark more demand.

Continued strength in Asia and growing hope that the worst of the recession is over in the U.S. and Europe have boosted chemical stocks over the last few months, though few expect demand to quickly rebound to pre-recession levels.

Surprisingly, the price of auto lubricant has held up, despite recession-inspired penny-pinching. That's because fewer people are changing their own oil, KeyBanc's Ludwig says. The price of lubricants is only part of the overall cost of oil-change services, so consumer don't see price hikes directly.

4. Technology

Despite its reputation as an industrial-age holdover, the specialty chemicals industry is a hotbed of innovation.

Customers are constantly finding new uses for old commodity chemicals. At the same time, discoveries of new chemicals with unusual properties can help companies solve problems and develop new products.

Case in point: Personal care makers needed a way to include beads in facial washes without having them sink to the bottom. Lubrizol created a compound that was both clear and stable on store shelves.

Innovation has helped Lubrizol keep prices up even in a recession, because customers can see the payoff, Sutherland says.

"Our approach to innovation is making it so valuable that the benefits outweigh the incremental costs," he said.

Alternative energy is another area of potential growth.

Praxair, which sells a variety of gases used for making solar cells, sells supplies and services tailored to photovoltaic panel makers.

In a similar vein, Air Products and Chemicals is trying to woo producers of corn ethanol, cellulosic ethanol, biodiesel and biomass products.

5. Outlook

Analysts say 2010 will prove another challenging year, though things don't look quite as bleak as they did this time last year.

In the U.S. and Europe, analyst Raquet predicts flat sales at worst and a slight uptick at best, though emerging markets will pick up much of the slack. He's more optimistic over the longer term, predicting average growth of 5% to 6% over the next five years -- just slightly below his pre-recession forecast.

Ludwig sees a similarly muted comeback for the U.S. and Europe, but remains bullish on Asia and Latin America.

Upside: Continued growth in China and India should buoy demand as the rest of the world recovers from a recession.

Risks: A slow recovery or double-dip recession could prolong the pain.

On the other hand, if the economy bounces back quickly, companies that slashed worker rolls too deeply could miss out on the rebound.

The industry's global reach also makes it more vulnerable to unpredictable events such as weather catastrophes and political unrest.

Buzz up!