Earnings Growth Accelerates

Chemical company results for the third quarter of this year look very good, at least on paper. But delving into the data yields a somewhat different story of higher costs, hurricanes, and lower volumes.

C&EN's survey of 24 major chemical companies that derive more than 50% of their sales from chemical operations shows that earnings from continuing operations, excluding significant one-time items, increased an aggregate 23.0% compared with that of the third quarter of 2005, to $3.32 billion, on an 11.4% rise in sales to $49.1 billion. The overall profit margin for the group was 6.8%, compared with 6.1% a year ago.

The strong third quarter bolstered chemical company results for the first nine months of 2006. During that period, combined sales at the 24 firms rose 7.2% to $146.2 billion and earnings grew 5.3% to $11.1 billion. Profitability, however, was higher for the nine months than it was for the third quarter alone. The aggregate profit margin in the nine months was 7.6%, down slightly from 7.7% in the same period a year earlier.

Comparisons of third-quarter results with those of a year ago are heavily influenced by Hurricane Katrina, which hit the Gulf Coast in late August 2005, disrupting a large portion of the chemical industry and the transportation infrastructure in the region. This situation, of course, crimped production, shipments, and sales, especially of basic chemicals for more than one-third of the quarter. Earnings also were lowered. Thus it is telling to compare the third quarter's year-over-year changes with those of the second quarter.

Total sales for the 24 companies rose 11.4% in the third quarter versus the year-earlier period, but the same comparison for the second quarter shows only a 6.6% gain. And the 23% earnings increase in the July-to-September period was ever-so-much better than the 0.4% year-to-year increase seen for the same companies in the second quarter.

Undoubtedly, the discrepancies will continue in the fourth-quarter comparison. In the 2005 fourth quarter, the effects of Katrina were still being felt, and the industry also had to bear the consequences of Hurricane Rita, which struck at the end of September.

Production data for the chemical industry, especially for basic chemicals, also tell the story of recovery from the depressed conditions after the storms. According to Federal Reserve Board data, total chemical production, which includes pharmaceuticals, rose 4.0% in the third quarter to an average index of 105.3 (2002 = 100). But the index for basic chemicals jumped 7.8% over the comparable hurricane-affected, quarter period in 2005.

One would think that the loss of chemical production in many areas last year would have caused prices to jump during that time, then moderate or even fall after plants came back onstream and infrastructure was repaired. The Labor Department's producer price index for chemicals did rise during the latter part of 2005. But rather than leveling off after the storms' effects subsided, prices have continued to increase as a result of rising energy and raw material costs. Thus, the third-quarter producer price index for all chemicals was up 9.2% over the comparable 2005 period to 208.9 (1982 = 100), and basic chemical prices jumped 17.3% to an index of 219.9.

Demand for chemicals showed relatively modest third-quarter growth, most of which came from the pharmaceutical sector. The value of total chemical shipments for the quarter rose 6.9% to $147.9 billion. Pharmaceutical shipments increased 16.4% to $39.8 billion, and demand for products for the remainder of the industry was up a modest 3.8% to $108.0 billion.

The chemical operations at major U.S. oil companies generally had higher earnings, sometimes with a vengeance, in this quarter compared with the same period last year. Chief among the five oil producers surveyed was Chevron, where earnings from its chemical business rose to $168.0 million from just $6.0 million-a 2,700% increase from third quarter last year.

Other oil companies also performed well. ExxonMobil's chemical earnings were up 186.2% to $1.35 billion; Occidental Petroleum increased 47.9% to $247.0 million; and ConocoPhillips rose 37.9% to $142.0 million. The only decline was at Sunoco, where earnings fell 78.3% to $5.0 million. The company says high prices for propylene feedstock resulted in lower margins and sales volumes for both phenol and polypropylene.

As in the oil group, about four out of five chemical companies reported earnings gains, and 16 had double-digit or better earnings growth during the third quarter; one, Albemarle, even showed triple-digit growth. And half the firms had double-digit growth in sales.

Price performance helped pull the fortunes of the industry up considerably. At the end of the second quarter, six-month earnings for the same group of 24 companies were down 0.7% from the same period in 2005. But increased prices in the third quarter, along with the lack of natural disasters, pulled the aggregate earnings increase for the nine months to 5.3%.

One of the beneficiaries of this scenario was U.S. industry leader Dow Chemical. At the end June, the firm's earnings for the first six months were down 14.6% from the same period the year before. This caused Dow's chief financial officer, Geoffrey E. Merszei, to warn that it would be difficult for the company to meet its earlier expectations that earnings for all of 2006 would be better than in the year before.

Now, however, Dow's 18.6% earnings increase in the third quarter has brought its earnings decline for the first nine months to just 2.8%. It only has to score an increase of some 10% or better in the fourth quarter, not out of the question, to have higher year-over-year results, excluding one-time items, for all of 2006.

How does Dow now see its future? "Looking ahead," Merszei says, "we expect the solid demand seen by many of our businesses in the third quarter to continue into the fourth quarter, although the ongoing volatility in feedstock and energy costs creates some uncertainty in relation to customer buying patterns." Given relative price stability and falling raw material costs so far in the fourth quarter, he expects margins of Dow's performance chemicals and plastics businesses to recover. "2006 is turning out to be another tremendous year for the company," Merszei adds, "and we have every reason to believe that 2007 will be another very good year for Dow."

Number two DuPont had the second-largest dollar increase in earnings after Dow's improvement of $149.0 million. DuPont's earnings rose $119.0 million, or 35.7%, to $452.0 million, on a 7.5% increase in sales to $6.31 billion. This brought its profit margin for the quarter to 7.2%, compared with 5.7% in the same quarter last year.

Chief Executive Officer Charles O. Holliday Jr. says, "Continued pricing momentum, customer-driven product innovations, and cost-control-generated revenue gains, profit growth, and margin expansion. We are on track for a strong second half."

The industry's largest percentage increase in earnings was at Albemarle, where quarterly earnings jumped 130.8% to $60.7 million, on a 20% sales improvement to $607.8 million. Profit margin for the company almost doubled, rising to 10.0% from 5.2% in the third quarter a year ago.

Albemarle CEO Mark C. Rohr says, "Our strategic focus on improvements to our fine chemicals segment allowed us to complete the disposition of our Thann, France, facility and acquire additional cGMP [current Good Manufacturing Practices] capacity through our DSM fine chemicals acquisition. Both of these were critical steps to improve the profitability and sustainability of this segment." Rohr also notes that "overall, demand and pricing for our products remain strong."

Nalco Holding and Celanese, two old-line companies that went public in the past two years, had major improvements in the quarter. Earnings at Nalco increased 92.6% to $39.1 million, on a 9.6% rise in sales to $915.4 million. Profitability remained fairly low at 4.3%, but it was up from 2.4% in the comparable quarter last year.

Costs are still a concern. Nalco says price improvement played the primary role in expanding margins at its energy services and industrial and institutional services businesses. Since costs began escalating in the third quarter of 2004, the firm says, purchased material and freight increases have totaled about $270 million across the company. Price increases during that time recovered only about $261 million. During the third quarter, in contrast, increased prices contributed about $31 million to improvement over the 2005 quarter, and purchased material costs increased about $18 million.

At Celanese, third-quarter earnings rose 61.9% to $136.0 million, while sales improved 10.4% to $1.69 billion. The company's profitability rose to 8.1% from 5.5%. According to Celanese, the sales improvement came from increased volumes and pricing. It adds that improved earnings in specialty businesses combined with higher pricing and increased volumes to more than offset higher raw material costs.

It was not all glory during the quarter. Five companies-Chemtura, Eastman Chemical, Georgia Gulf, Huntsman, and Terra Industries-had earnings declines.

Chief among these was Chemtura, where earnings fell 55.0% to $18.3 million, on a 0.2% sales decline to $917.0 million. A few days before the company announced third-quarter results, CEO Robert Wood said, "Despite aggressive actions on multiple fronts to reshape the portfolio and strengthen businesses, our earnings have not yet caught up with our actions. In part, there is a longer-than-expected lag between volume recapture and margin recovery."

When earnings were released, Wood noted, "crop protection results were negatively impacted by high bad-debt reserves and lower sales in Latin America and competitive pressure in the U.S. mite market." He added that Chemtura continued to struggle in rubber additives and ethylene propylene diene monomer rubber, businesses that the company is selling. Wood noted solid performance in flame retardants, consumer products, lubricant additives, and urethanes.

Two other companies had double-digit earnings declines. Georgia Gulf saw its earnings fall 18.6% to $22.7 million, on a 9.7% increase in sales to $576.3 million. The drop primarily came from higher raw material costs, which more than offset higher overall sales prices and lower natural gas costs. "For the fourth quarter, we are experiencing continued softening in demand as we enter into the seasonally slow part of the year," says CEO Edward A. Schmitt.

And Eastman's earnings dropped 16.3% to $103.0 million, despite an 8.3% increase in sales to $1.97 billion. Again, higher costs were among the problems. The company says the year-over-year earnings decline was due to increased raw material and energy costs and minor operational disruptions, partially offset by higher selling prices. According to Eastman, its third-quarter raw material and energy costs were about $175 million more than they were in the comparable period a year earlier.

The companies that had a good third quarter are expecting continued improvement in the fourth quarter. Perhaps Nalco CEO William H. Joyce sums it up as well as any: "In addition to not repeating raw material cost spikes and sales losses from last year's hurricanes, we expect real growth, price, and cost improvement programs to help us reach our fourth-quarter and full-year targets."