Where the Chemistry Is Right

By VITO J. RACANELLI | MORE ARTICLES BY AUTHOR

Akzo Nobel, an Amsterdam-based specialty-chemicals company, produced sharply improved first-half results and the outlook is bright even without a strong rebound in U.S. and European economies.

• Article
• Comments

 

IF YOU WERE TOLD OF A COMPANY that is a global leader in the three sectors it plays in, with leading market shares, about 40% of its sales from growing emerging markets, a solid balance sheet, a 3% dividend yield and an undemanding valuation that isn't overly dependent on a global economic recovery, chances are you'd be interested.

It's a chemicals company. Wait. Really. Come back.

Apart from the early phases of an economic recovery, this cyclical sector typically isn't well-liked, and with the current abounding "double dip" jitters about the U.S. economy, few investors want to hear about chemical stocks, regardless of their particular attractions.

Akzo Nobel (ticker: AKZA.Netherlands), whose three main businesses are decorative paints, industrial coatings and specialty chemicals, is worth a second look. The Amsterdam-based company announced dramatically improved first-half results July 23, and the shares duly rose some 5% to 46.75 euros the same day. However, since then the stock has eased back to €42.75 on global macroeconomic worries, roughly where it was in April. Sporting a $13 billion market cap, Akzo Nobel (AKZOY) also trades over the counter in the U.S., closing Friday at about 54.45.

The bears on Akzo point out that the U.S. housing market hasn't rebounded, notes John Goetz co-chief investment officer at Pzena Investment Management (PZN). That's true, but the company put together a strong first half anyway, he observes. "The bear case is the one we are already in." There's more upside than downside here, he avers.

Akzo reported revenues that rose 10% to €7.2 billion in the first half, while net income jumped to $354 million, or €1.52 a share, from €148 million or 64 euro cents. Earnings before interest, depreciation and amortization soared 27% to over €1 billion, and the Ebitda margin hit the company's target of 14%.

All that, as the company noted, came with still "weak revenue developments" in the mature parts of its global decorative paints markets—mainly the U.S. and Europe. Yet that division, which is exposed to the housing market, still managed an 8% revenue rise, helped by favorable currency translations. Meanwhile, the industrial-coatings and specialty-chemical divisions, where barriers to entry are high, are humming along and posted strong double-digit revenue gains in the first half, Goetz points out.

"It's a great business with high return on investment, a good balance sheet and high market shares," he adds "If you didn't call it a chemicals company," investors would be more interested in Akzo, he says. It's one of the biggest holdings in Pzena's international funds.

Perhaps most important about the second quarter: Volume sales for decorative paints were up 1%. That's down from a 5% rise in the first quarter but it's far above the double-digit volume drops one year ago.

Though not a household name, Akzo is the largest global supplier of decorative paints with a 15% market share, and many of Akzo's products, like Dulux paint, are strong brands in countries around the world. The company owns the No. 1 or 2 position in many countries, Goetz observes.

With the ordinary shares trading at 11 times next year's analyst consensus earnings estimates of €3.88 a share and five times Ebitda, the valuation is relatively low for one of the premier companies in the sector and already seems to discount a slow recovery in the West.

Akzo's outlook was upgraded last week to Stable from Negative by both Moody's and Standard & Poor's, and the latter notes Akzo benefits from significantly lower cyclicality than other chemicals businesses.

No stock is without caveats, and Akzo faces a few. It does have pension deficit of €1.8 billion, but that appears less worrisome after noting that Akzo's net debt position of €2.3 billion will likely fade to under €1biillion after the proceeds come in from the sale of its National Starch unit. And the shares won't be helped by a drop back into recession by the U.S. or Europe. But then what stock would be?

From here, a total return of 10% seems doable even with developed economies' slow recovery, but it could perhaps be as much as 20% if things pick up in the U.S. and Europe.

THE STOXX EUROPE 600 index fell about 0.7% Friday and lost 1.3% on the week, to finish at 252.15, its lowest close in a month. As noted above, investor worries about an economic recovery in the U.S. and Europe continue to take a toll, and were strong enough to overcome some bracing merger and acquisition news last week, such as Intel's (INTC)) $7.68 billion offer Thursday to buy computer-security software maker McAfee (MFE). The Stoxx 600 index is essentially unchanged for the year.

European bank and oil company stocks took the brunt of the hit for the week, with both sectors down over 2% since the previous Friday. Meanwhile, at around 1.27 late Friday, the euro ended flat on the week but fell from highs of $1.29 midweek.