Most Chemical Stocks Look Corrosive. These 3 Might Be Buys. — Barrons.com

By Jack Hough

Something stinks in the chemicals industry, and it isn't just the hydrogen sulfide. While S&P 500 investors have nearly doubled their money over the past three years, shares of Dow and LyondellBasell Industries, big players in plastics and packaging, have lost 42% and 29%, respectively. CF Industries, a fertilizer giant, is down 9%.

Many specialty chemicals companies are underperforming, too. PPG Industries, which makes paint and other coatings, has lost 3% over three years, and International Flavors & Fragrances, whose hits include 3,7-dimethyl-2-methylene-6-octanal for making detergents smell like citrus, is down 22%.

Without dividends, these returns would be worse. Some payments raise eyebrows. Lyondell yields around 12%. Lyondell and Dow, plus fellow petrochemical operators Huntsman and Westlake, all have dividends that aren't currently covered by profits. Dow cut its dividend in half in late July. Its shares lost 17% that day and have slid another 13% since. That's a harsh response, but not an unusual one. S&P 500 companies that cut their dividends typically trail the index by about 15 percentage points over the following five years, according to BofA Research.

Why are so many different types of chemical companies doing poorly, at a time when stock indexes and house values are riding high? Is it a sign of trouble or a buying opportunity? My chemical curiosity was bubbling over, so I checked in with Matthew DeYoe, who covers the industry for BofA. Companies face a cluster of challenges, he explained. They won't all be easily fixed, but they aren't necessarily warning signs. For now, the best bet for investors is to stay "downstream" with a handful of companies making specialty products. Three picks in a moment.

One problem for U.S. chemicals is China, which is pushing for self-sufficiency, and has added many new oil refineries in recent years. "Chemicals became a sink for a lot of the byproducts off the back of the refinery," says DeYoe. "So, we had a big wave of chemical capacity expansions." U.S. chemical producers now seem to be playing polyethylene chicken, holding off on production cuts for the packaging staple, and adding to oversupply.

Housing is a big market for chemicals: polyvinyl chloride pipes, polyurethane for floors and bedding, resins for paint, and so on. But the construction market is slumping in China due to falling house prices, and in the U.S. from just the opposite — unaffordability. Meanwhile, the chemicals industry has been coming down from a Covid boom. "Living from home is a very plastics-intensive life," says DeYoe. "We had this false sense of really strong demand that has since ebbed."

A tariff war isn't helping, including for farmers. China has stopped buying U.S. soybeans as trade leverage, just as Brazil has produced a big crop. Meanwhile, prices have jumped for seeds, fertilizer, and machines, and there is a shortage of farmworkers. With demand taking a hit, DeYoe expects fertilizer prices to fall next year.

The stickiest of these challenges might be China, which has a record of basing industrial production more on employment than profits, but which has also said it wants to peak its carbon emissions by 2030. "It seems like for now there's a bit of a green light to build what you can and get in the ground," says DeYoe of conditions there. That could be bad news for upstream companies, or ones selling commodity chemicals. "There are a lot of attractive yields, but we're also forecasting a few additional dividend cuts," says DeYoe.

Downstream, there are some sturdy, growing specialty companies that have sharply underperformed the broad stock market over the past year. DeYoe likes Element Solutions, RPM International, and Axalta Coating Systems.

Element makes chemicals used for circuit boards and other electronics components. It's benefiting from strong growth in data centers, while working through a slowdown in personal devices. Shares go for 17 times this year's earnings forecast. Wall Street expects low-double-digit earnings growth over the next two years.

RPM, at 20 times earnings, makes coatings and sealants, including Rust-Oleum spray paint and DAP caulk. It stands to benefit from a construction rebound. Earnings growth next fiscal year is pegged at 10%.

Axalta, 11 times earnings, makes paint and coatings for vehicles, pipelines, and more. Pricing power is strong, and while the new car market isn't bustling, an aging fleet of cars on the road suggests solid future demand. Earnings growth is expected to accelerate from 8% next year to 10% the following year. DeYoe predicts that Axalta will initiate a dividend.

Element and Axalta, along with upstream giants Dow and Lyondell, report quarterly results this month.

Let's turn briefly to the artificial-intelligence investment spree, and the debate over whether it will pay off in customer revenue, and not just the AI giants spending money with each other.

Deutsche Bank offers a useful way to think about the numbers in terms of something more familiar to most consumers: streaming. OpenAI is the cornerstone of customer-facing companies selling subscriptions; its ChatGPT has a free base version and premium tiers costing $20 to $200 a month. Company revenue is expected to reach $13 billion this year, versus $45 billion for Netflix. This is an excellent start in AI moneymaking. But competitors loom, including Anthropic's Claude, Perplexity, and Google's free AI mode. A recent funding round for OpenAI put its market value more or less equal to that of Netflix, at $500 billion.

Deutsche Bank recently analyzed proprietary spending data for five markets in Europe: the U.K., France, Germany, Spain, and Italy. It found that OpenAI spending there has stalled since May. The past two years have seen summer slowdowns, too, as student superusers went on vacation. But the overall growth trendline has been decidedly falling. As Deutsche Bank's analysts put it: "The poster child for the AI boom may be struggling to recruit new subscribers to pay for it."

Write to Jack Hough at jack.hough@barrons.com. Follow him on X and subscribe to his Barron's Streetwise podcast.

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