Specialty chemicals are used in thousands of consumer and industrial goods and everyday items. Unlike bulk chemicals, which are produced in massive quantities by applying a standardized chemical reaction, specialty chemicals are custom-produced in much smaller quantities to meet a certain need or for a specific purpose. Bulk chemicals are essentially commoditized, since just about anyone can set up shop and produce such products with a standard recipe. But specialty chemicals are prized not for their components or what basic chemicals they themselves contain, but for what they can do. From windshields and tires to construction and architectural applications, these formulations play a huge role in shaping tens of thousands of end-products. The industry has been around for a long time, but that is not to say that is a staid or boring business. These companies are known for their ability to innovate and to come up with new and better processes to improve or replace existing ones.
Take Solutia (SOA), for example. The company serves a diverse set of industries including the automotive, solar energy, and aviation industries. SOL derives approximately 20% of its revenues from the tire and rubber markets, which includes companies that manufacture solid tires, belts, hoses, and even footwear. These companies rely on Solutia to make their products stronger, safer, and more durable, by applying chemicals, such as vulcanizing agents and antidegradents, to them during the manufacturing process.
Market Dynamics are Changing
Growing concerns over the environment and an eco-friendly attitude have pushed global governments to action. The United States and Europe already have tighter emissions standards in place and there are even stricter requirements that will have to be met in the next decade. For example, demand for newer automobiles that meet those requirements should be fairly strong going forward. The specialty chemicals companies stand to benefit, since they serve the automakers both directly and indirectly.
In addition, new markets are springing up as solar power and other alternative energy sources are more widely adopted. Going back to our feature company, Solutia develops encapsulating materials for use in thin-film solar panels as well as heat-transfer fluids for use in solar power. End-user markets for specialty chemicals should continue to grow as new industries are developed. To that end, the industry is dependent on innovation, both within its own ranks, but also in other industries.
The Industry Is Cyclical
The health of the specialty chemicals industry is tied directly to the macroeconomic environment. When there is a slowdown in industrial production, the companies within this industry will be among the first to feel their top lines pressured. Indeed, the industry fared much worse during the 2007-2009 recession than the market in general, but also recovered a lot faster when stock prices began to climb. As a group, the specialty chemicals companies are probably most sensitive to the housing and industrial sectors, because that is where most of the demand is coming from. In our opinion, the specialty chemicals industry has not fully recovered since the last recession and its prospects are mixed right now. The glut of houses currently on the market is keeping housing starts improvement at bay and, because of an uncertain economic climate, homeowners have been reluctant to remodel or have put off repairing existing homes. On the other hand, industrial demand is fairly strong at the moment, but production of chemicals remains below pre-recession levels.
One advantage this group has over other industries is the barriers to entry and heavy capital investment required to become a player. A company cannot just decide to enter this field overnight, because a high degree of technical knowledge and experience is required do so. Many industry leaders have been around for a century or longer and have grown through consolidation and by diversifying their capabilities. Indeed, larger companies are better-capitalized and may have an easier time tapping a global market or capturing a new trend due to their scale and vast resources. Still, the competition is growing. Most specialty chemicals manufacturing used to be done in the United States or Europe. Today manufacturers are showing up in China and other parts of Asia, to supply that regions tremendous appetite for consumer goods, which means that pricing pressure could be something the industry has to contend with in the future.
The bottom line is driven by highly volatile commodity prices and global demand dynamics for specialty chemicals. Major inputs into specialty chemicals are gas- and petroleum-based derivatives. Traditionally, operating margins have been quite high, since these companies enjoy limited competition. But profits have been known to plummet when commodity prices rise unexpectedly or the economy sours.
Specialty chemicals companies are fragmented between those that offer growth and those that offer income, although some offer both. Some of the smaller players like Solutia, mentioned above, choose not to pay investors a dividend because they are investing all of their capital back in the business. Other, more established, companies, such as Dow Chemical (DOW), pay a healthy dividend (4.3% dividend yield), but also offer decent growth prospects, due to their highly diversified range of products and exposure to different geographies. Overall, we think that global trends in new product innovation and high demand from emerging markets give this industry a bright future.
At the time of this report's posting, the author did not have positions in any of the companies mentioned.