Chemicals and emerging catalysts

Demand has been sapped in recent months by growing economic instability in Europe - the industry's biggest market. Most of the big names generate at least 50 per cent of revenues on the continent, including Synthomer (SYNT) - formerly Yule Catto - which has a whopping 80 per cent exposure to the troubled region. Last month, Synthomer, a manufacturer of industrial emulsion polymers, issued a profit warning driven by a construction squeeze that caused third-quarter volumes to drop 3 per cent. Softening construction markets could hurt Elementis (ELM), too, as its coating business sells additives that enhance paint products, although its greater exposure to healthier US markets could provide some breathing space. The same can't be said for Croda (CRDA), however. Its premium personal care and cosmetic products are mostly sold in Europe and, in spite of well-received takeover speculation, the group's share price has fallen 11 per cent in the past six months on concerns that consumers are now seeking cheaper alternatives in an increasingly competitive market.

Winners and losers

Unsurprisingly, the majority of UK chemical companies have dedicated significant resources to increasing their exposure to emerging growth markets. Indeed, Victrex (VCT), which manufactures PEEK polymers found on every modern car, has enjoyed relative success in Asian markets, where transport and industrial demand has reportedly picked up sharply, while Elementis' high-margin personal care division has proved a hit in China.

But not everyone has fared fantastically in Asia. Synthomer, for example, has been struggling with increased competition and weaker profit margins in its Asian markets, and was certainly not aided by the fall-away in China's GDP growth. Triggered by a slump in its property market, China - Asia's main market - recently posted its weakest industrial output expansion since the global financial crisis, which has subsequently put markets on edge amid fears that its best days are over.

However, James Tetley, deputy head of research at N+1 Singer, believes that Asia, along with the US, is still the place to be for chemical companies. In response to markets panicking about a Chinese slowdown, he says that even if things weren't as good as before, GDP growth of between 7 per cent and 8 per cent is still far better than data coming out of Europe.

The slowdown in global GDP growth has been accompanied by a 27 per cent fall in the price of crude oil. There are opposing perspectives as to the likely implications arising from a weakening oil price. It could be argued that a drop in energy prices lowers the cost of the raw materials used by several of these companies; yet, on the other hand, it raises the prospect of destocking. In fact, the world's largest chemical company, BASF (Ge: BASX), recently warned that customers were delaying the purchase of chemicals in anticipation of getting cheaper deals as oil prices fall even further, while Croda's third-quarter trading statement blamed lower industrial chemical sales on weak commodity prices.

As its business model is slightly less defensive in nature than its sector peers in speciality chemicals, Synthomer is even more exposed to inventory speculation, as half its costs are linked to petrochemicals. The bulk of Synthomer's peers in the sector are probably better placed to ride out any cyclical downturn. Accordingly, Adam Collins, speciality chemicals and materials analyst at Liberum, reckons speciality chemicals are insulated from oil price volatility, and that companies exploiting certain end markets could eventually benefit. He notes that Victrex, which sells into the aerospace market, could benefit from low oil prices, as well as several companies in the automotive markets, including Alent (ALNT) and Johnson Matthey (JMAT). Aside from this potential bull point, automotive markets have been struggling with a lull in consumer demand, though, and as is often the case in such a varied sector, some companies have more preferential exposure than others.

For example, while Johnson Matthey is adversely exposed to slumping car sales in China and Europe, it is deriving specific benefit from its manufacture of catalytic converters. Driven by stricter legislation for fuel efficiency, catalytic converters are in strong demand. This helped Johnson Matthey, which also has a thriving medical business, deliver stellar results in the year to 31 March 2014 and should stand it in good stead for the future.

Unfortunately, neither Victrex nor Alent have the added bonus of a legislative dynamic behind their products, although a solid sales environment in the electronics market could offset any problems arising from a decline in global car sales. The good news is that global economic uncertainty has yet to translate into a slump in consumer electronics sales. Victrex continues to benefit from high deliveries for its smart device, while Alent, whose solder paste is used in printed circuit boards for PCs, smartphones and tablets, has seen increased demand from the likes of Apple, Samsung, HP and LG.

Rewarding shareholders

Scapa (SCPA) is also a beneficiary of this strong end market. The company, whose bonding products and adhesive components are also used in healthcare, industrial and automotive markets, has been a favourite with investors since it announced plans to double its dividend in May. Consequently, the share price has increased by 36 per cent from its level 12 months ago, but Scapa's largesse has been repeated across the industry. In spite of relatively difficult market conditions, lots of other chemical companies have been impressing shareholders with promises of bumper dividend payouts. For example, Synthomer delivered a chunky 25 per cent dividend hike and confirmed its intention to return excess cash to shareholders in the future. Elementis has also pledged to return excess capital from its highly cash-generative business, while Victrex is widely expected to deliver a special dividend in December. Such generosity has helped calm investors' nerves, with share prices of most of the companies not far off where they were when Europe was expected to recover one year ago.

IC VIEW: Given the broad nature of speciality chemicals and the niche, generally high-margin products that they offer, we believe there are always opportunities for respectable returns through careful stockpicking. That said, weak macro data, particularly in Europe, does not bode well for the sector, and we expect bigger gains for those with greater exposure to Asia and the US, as well as those exposed to healthier end markets. Furthermore, while currency headwinds from a strong pound/dollar rate have now subsided and should provide some respite, investors should be aware that both Croda and Synthomer could be negatively affected by a weak euro.

OUTSIDERS: Despite two years of little top-line growth, shares in Croda trade at almost 18 times earnings, making it one of the most expensive in its peer group. Rumours of a takeover bid have evidently boosted the share price in recent months, yet we feel the ongoing speculation does not justify paying a premium for a company impacted by weak consumer spending in Europe. Sell.

FAVOURITES: We remain keen on Alent (Buy, 310p, 6 Feb 2014). Its shares are priced at a discount to the sector despite a recent positive trading statement and an improving outlook for its core electronics business. Johnson Matthey and Elementis, meanwhile, also look like interesting plays, although we believe that their decent prospects are already reflected in their valuations, and we therefore continue to hold.