Chemical plays still worth buying

Indeed, over the past 12 months, the FTSE 350 Chemicals index has risen 13 per cent to within sight of a record high and, until recently, matched the pace of the runaway FTSE All-Share index. As a result, the sector trades on 17.5 times forward earnings, about 26 per cent above the weighted average through-cycle rating; eighteen months ago it was less than 12 times. Sector PE ratios relative to the FTSE All-Share are near a 12-year high, too.

According to broker N+1 Singer, a return of multiples to the long-run average of 14 by the end of 2014 would require an increase in the implied compound annual growth rate in EPS from 12 per cent to 19 per cent. However, if forecasts for earnings growth of 12 per cent this year prove accurate, they'll need to rocket 27 per cent in 2014 to hit the average rating. That's a long shot.

Analysts at UBS are so worried about volumes that they've issued sell advice on Croda (CRDA), Dutch paints group Akzo Nobel (AKZA) and, most recently, Victrex (VCT). Gross margin and volume forecasts for the latter have been lowered, and earnings estimates for the next three years cut by between 5.6 per cent and 13 per cent. That not-so-modest downgrade spooked a nervous market and Victrex's shares tumbled.

Not all cyclicals are equal

Deutsche Bank has concerns, too, and prefers a selective approach. "Not all cyclicals are equal and individual chemical chain cycles can move very differently," it says. "In a low-growth environment, a top-down call on all cyclicals is difficult given the greater differentiation of businesses." Focus on pricing, positioning in specific cycles and niche growth becomes more noticeable in these circumstances and that leads to striking diversity of performance.

To prove a point, Elementis (ELM) had a decent first quarter, driven by acquisitions and a recovery in its oil & gas business which, if the current climate continues, could haul full-year earnings past existing City estimates. At the other end of the scale, AZ Electronic Materials (AZEM) last month shocked the Square Mile with a profit warning. Dual sourcing by customers and using less volume per silicon wafer will drop margins below 30 per cent in the first half. Fifteen months' worth of steady gains disappeared in a flash. Softness in electronics has affected parts of Victrex, too.

Most others were somewhere in-between. Better margins helped highly rated Croda turn flat quarterly sales into 6.5 per cent growth in pre-tax profit. Still, a late spring hit the fast-growing crop care business, so results missed forecasts, and volumes at Victrex - its shares always look pricey - only crept higher during the first half. Synthomer (SYNT) issues its first-quarter update as the Investors Chronicle goes to press, but we know the Asian nitrile latex market is unlikely to improve until later this year and Europe, where the company makes most of its money, remains a battleground.

In fact, Europe is easily the UK industry's biggest market and takes much of the blame for the sector's recent underperformance. It's also a key reason why we remain less positive on some of the sector's big names and, despite the odd glimmer of good news both on the continent and elsewhere, there's plenty of evidence to justify our caution. Unemployment in the eurozone has topped 12 per cent and economic indicators - most recently Markit's Eurozone Composite PMI - reveal business activity still contracting. It could be a long summer.

Motoring costs

Akzo Nobel is one of the biggest suppliers of paint to car manufacturers, so the downturn in Europe hurts. Revenue at its performance coatings division fell in the first quarter, although cost-cutting generated extra profit, which is why we like this restructuring play. That said, it was a similar outcome in decorative paints, again down to Europe. Lanxess (LXS), the German group behind high-performance synthetic butyl rubber used to makes car tyres more efficient, missed fourth-quarter forecasts and warned of weak demand, too.

That's borne out by industry data revealing European car sales slumped another 10 per cent in March. Brits, however, are buying more new motors than at any time in the past five years and Deutsche Bank sees signs that production schedules are improving sequentially and the automotive market is at least stabilising. Orders for trucks are up at Volvo, Scania and Daimler - the US has just had its best April since 2007 and the recovery in housing construction is driving demand for new pick-ups.

Clearly, catalyst maker Johnson Matthey (JMAT) is a key beneficiary. There's a long-term structural story here, with a slew of global emissions legislation slated for the next few years, starting with Euro VI legislation in trucks. Victrex also has serious exposure to the automotive sector - about a fifth of the business. Its lightweight PEEK plastics are perfect for replacing heavier metal parts like gears and seals, and the more resilient, high-value German marques are good customers.

Moreover, supplying numerous coatings to motor manufacturers generates around a quarter of sales for Alent, formerly one half of Cookson. Luckily, North America and Asia are offsetting the slump in Europe. Croda and Elementis rely on them less, although fluctuations in demand will make a difference. Interestingly, high-tech tape group Scapa (SCPA) has a significant opportunity here. Sure, downtrodden Citroen is one of its biggest clients, but there's a huge slug of business with Volkswagen that's up for grabs and a German salesman with strong links to VW is already in place.

IC VIEW:

We've downgraded many chemical stocks to hold, either on valuation grounds, or concerns about demand, particularly in Europe. Moreover, visibility is painfully short and there's no sign of an end to the volatility currently afflicting cyclical plays. Still, there are companies that are priced to go and worth buying now, especially when restructuring is likely to bolster the bottom line.