Get Rich Off Plastics
Megha Bahree, 12.11.06
You want a commodity play, but gold has gotten a little too rich for you? Time for some exposure to soda ash.
Oil, copper and gold are yesterday's commodity story. To get in on tomorrow's, think about the advice given to Benjamin Braddock, the graduate played by Dustin Hoffman in the 1967 movie of the same name: plastics. The idea is to buy shares of companies that make building blocks for polymers. The commodities in the spotlight are ethylene, polyethylene and chlorine. With glass as well as plastic in mind you might want to look into another raw material, soda ash.
Why now? Because, says Frank Mitsch, senior chemicals analyst at BB&T (nyse: BBT - news - people ) Capital, an investment bank that lends to chemical companies, all the regions of the world that stoke industrial demand for bulk chemicals will be growing. There's growth in Europe again and even in Japan (after nearly 15 years), while Brazil, Russia, India and China are keeping up their rapid industrial development. "This means operating rates will stay robust for the next few years," says Mitsch. "Companies in this business can generate a lot of cash."
Over the past three years global ethylene demand (measured in metric tons) has risen by an annual average of 5%. Prices have risen an average of at least 20% a year over the same period. The bull run is far from over, suggests Gary Adams, president of Chemical Market Associates, a market research firm in Houston that consults for producers and consumers of chemicals, plastics and synthetic fibers. He forecasts that demand will grow at an annual rate of 5% to 6% for the rest of this decade.
Ethylene can be made from crude oil or the heavier gases that come out of natural gas wells (ethane, propane and butane). The feedstock accounts for as much as three-quarters of production costs, so the price of ethylene is tied to the price of energy. But the spread between the price of the raw material and the price of the finished good is a function of the supply of ethylene-making capacity and the demand for ethylene. The latter is a matter, in turn, of the demand for polyethylene, the world's most commonplace plastic. At the moment polyethylene is very sought after.
What could go wrong? A lot of polyethylene is used in houses and autos, and so demand is at the mercy of the ebbs and flows of those industries. Next, the economy of China, which consumed 16 million tons of ethylene last year, a seventh of the world's output, might collapse one day. Finally, China, which this year will import 60% of its ethylene equivalents, has given the go-ahead to Sinopec and PetroChina (nyse: PTR - news - people ) to build six giant ethylene plants that would double domestic production to 15 million tons a year by 2010.
The purest ethylene and polyethylene play for investors is Nova Chemicals (nyse: NCX - news - people ), says Fitsch. Most of its production is in Alberta, Canada, where natural gas is cheaper than in the U.S. Despite the cost tilt, Nova managed to lose $104 million on revenue of $5.6 billion in 2005. It's rebounding now. In the first nine months of 2006 it earned $148 million on revenue of $5 billion. The stock yields 1.2%, but the fourth-quarter 2005 red ink makes its trailing price/earnings multiple meaningless.
Fitsch also likes Lyondell Chemical (nyse: LYO - news - people ). It is paying down debt by selling a titanium dioxide business, as well as through operating cash flow. Lyondell, which earned $531 million on revenue of $18.6 billion in 2005, pays a 3.6% dividend. Its stock sells at nine times 12-month trailing earnings.
But don't stop with the hydrocarbons. Balance out your portfolio with a dash of chlorine and caustic soda, a.k.a. lye. These two are an industrial pair because they are manufactured in the same process, by passing an electric current through salt water. Chlorine's largest use is as an ingredient in polyvinyl chloride, PVC being almost as popular a plastic as polyethylene. PVC is used in products as varied as pipes and blood bags. Lye is a handy ingredient in a wide array of products whose common feature is that greenies don't like them. (While we're on the subject of environmental worries: The electrolysis of brine gobbles up a lot of electricity.)
The demand for chlorine and lye is expected to grow 2% to 3% per year for the rest of the decade, says Adams, the chemicals market analyst. That growth, in turn, reflects PVC demand growing at 5% this year and an expected 4% to 5% rate for the rest of the decade. The company to bet on is Olin Corp. (nyse: OLN - news - people ), which got 85% of its $133 million net profit in 2005 (on revenue of $2.3 billion) from these chemicals, says BB&T's Mitsch. Another chlorine producer, also getting a buy rating from BB&T, is PPG Industries, formerly known as Pittsburgh Plate Glass. This firm is expanding its optical and coatings businesses, but the fat margins still lie in its chlorine-lye operation, which provided 30% of the $554 million net profit it reported for the nine months to September on sales of $8.3 billion. PPG is selling at 16 times earnings.
Another precious commodity is soda ash. This, too, can be produced in an energy-intensive industrial process that starts with salt. But there's also a natural way to get your hands on it--dig it out of the ground in Wyoming. (The natural origin may or may not endear this chemical to the greenies.) The primary use of soda ash is to make glass. Now think of all those shiny skyscrapers in Shanghai and imagine the possibilities. As recently as 2004 soda ash was sold at $79 per metric ton. Today it's selling at an average of $111.
FMC ($2.1 billion sales in 2005) is the only publicly listed U.S. soda ash company. Jay Harris, an analyst at Goldsmith & Harris in New York City, predicts earnings per share climbing from $5.44 in 2006 to $6.44 in 2007, with most of the gain because of soda ash. For the first time in 20 years this relic of another age (it used to be the Food Machinery Corp.) paid a quarterly dividend in 2006, all of 18 cents a share. The stock is pricey at a 17 multiple but would pay off if this commodity cycle lasts until Shanghai is built out. That could take a while.
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