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Few Catalysts for Specialty Chemicals

By Richard O'Reilly The specialty-chemicals industry will continue to face challenging conditions in 2003. While we at Standard & Poor's predict that overall economic growth -- and by association, demand for the industry's products -- will be greater than in 2002, higher commodity chemicals and energy costs will continue to squeeze the group's profit margins.

For specialty-chemical manufacturers, S&P expects costs for two key inputs, commodity chemicals and energy, to remain high well through 2003. In particular, higher energy prices are biting into the earnings of chemicals makers and could slow economic growth, reducing consumer demand for chemicals and their derivative products.

Average energy prices in early 2003 were higher than we had expected, due in part to concerns over a U.S.-led war with Iraq. If the current conflict lasts longer than is commonly assumed, it could keep oil prices at their current highs, while dampening spending and consumer confidence (already at its lowest point in nine years by some surveys).

LAG TIME. Costs of commodity chemicals used in the production of specialty chemicals have also risen since 2001. In both January and February, 2003, the producer price index (PPI) for industrial chemicals was at an all-time high, with the latter month 23% above its year-earlier level. We expect the specialty industry to experience higher chemical costs until energy prices stabilize.

Specialty companies typically experience a lag between the time their raw material costs rise and the moment they are able to raise their own prices. This lag is largely due to sales contracts that do not allow specialty prices to change as frequently as costs do. In times of rapidly rising costs, such as early 2003, specialty margins are squeezed until prices can catch up. However, in periods of declining raw material costs, these contracts may allow specialty companies to retain any cost savings until price reductions are implemented by the terms of the contracts.

Many chemical companies in 2003 will be faced with higher expenses for pension and other post-retirement benefits, due to lower pension-assets results from declines in the stock markets since early 2000 and low interest rates. Expenses for insurance and employee benefits will also be higher.

POTENT COMBINATIONS. On the positive side, the U.S. dollar has declined in value over the past year vs. the euro. This should help boost reported sales and net income from companies' foreign operations, while improving the competitive trade positions of U.S. producers in the longer term.

While the industry's prospects remain less than stellar, we still think there are some attractive values. Our top picks in the group are Ecolab (ECL), International Flavors & Fragrances (IFF), RPM International (RPM), and Sigma-Aldrich (SIAL), each of which is ranked 4 STARS (accumulate). Analyst O'Reilly follows chemicals stocks for Standard & Poor's

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