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The Materials Sector Keeps Delivering

By Matthew Morrow Amid rising commodity costs and a firming economy, the materials sector, which includes aluminum, chemicals, diversified metals and mining, forest and paper products, and steel companies, reported mixed results for the fourth quarter of 2004. S&P continues to recommend that investors maintain a market weighting of this sector, which makes up 3.1% of the S&P 500 index.

Michael Jaffe, group head of materials-sector equity research for S&P, says that outlook reflects S&P's forecast of an ongoing moderate economic recovery and continued pricing strength in several commodities, such as diversified chemicals and steel. However, Jaffe notes that S&P's overall investment stance on the sector is limited by its outlook for moderately higher interest rates and its belief that strong upturns have put pricing near the cycle peak in certain segments, such as forest products.

Chemical companies generally reported fourth-quarter profits that were "pretty much as expected or slightly better," according to Richard O'Reilly, S&P's chemical analyst. For the commodity petrochemical companies in particular, price increases offset higher raw-material costs, as producers were seeing price momentum driven by tighter supply-demand conditions, not just by higher raw costs, as was the case in 2003 and early 2004.

BUBBLING ALONG. Earnings for the fourth quarter were better than expected on the whole. S&P carries a 5-STARS (strong buy) ranking on Dow Chemical (DOW; recent price, $53), which beat O'Reilly's fourth-quarter operating earnings estimate by more than 20 cents a share, aided by sales that rose 31%.

Inorganic commodity chemicals, such as chlor-alkali and soda ash, saw real price momentum. FMC Corp. (FMC

; $48), the largest maker of soda ash when the industry is operating at full capacity, beat S&P's earnings forecast for the quarter, as industrial chemicals profits doubled on higher soda ash volumes and prices. O'Reilly maintains a 5-STARS ranking on FMC.

Specialty chemicals companies reported results that were generally close to S&P estimates. Many of these companies were hurt to various degrees by higher raw-material costs, but 5-STARS ranked Cytec Industries (CYT

; $49), a global specialty chemicals and specialty materials company, beat S&P's estimate, mostly because higher-than-expected shipment volumes boosted revenues.

STEEL'S EDGE. One materials group that exceeded expectations in the fourth quarter was steel. During the earnings reporting season, S&P steel and precious metals analyst Leo Larkin upgraded several players in the group because of strong earnings growth and generally optimistic guidance about future profitability from company management. Recent upgrades include Carpenter Technology (CRS

; $64), which was raised to 5 STARS from 3 STARS (hold); AK Steel Holding (AKS

; $17), which Larkin boosted to 4 STARS (buy) from 3 STARS because of its valuation and its more positive earnings outlook for 2005; and Nucor (NUE

; $59), also raised to 4 STARS from 3 STARS.

Larkin said he revised upward his earnings-growth estimates for steel companies in the first half of 2005, since prices for the metal seem to be firming after declining in the fourth quarter. S&P believes that the higher prices should enable steel producers to generate higher profits. Longer term, S&P believes the steel industry will benefit from greater pricing power as a result of recent consolidation, a lower cost structure, and a cyclical decline S&P's economists are forecasting for the U.S. dollar.

Aluminum prices rose in the fourth quarter, but per-share earnings fell short of S&P's estimates, partly because raw-material costs were higher than expected and also partly because of currency conversion. Aluminum producers have been warning that they expect continuing pressure on their margins from high raw-material costs.

MORE STABILITY. Copper prices probably peaked in 2004, according to S&P estimates. However, Larkin is not predicting a significant drop in 2005, due to very low levels of inventory and continued strong demand. S&P recently raised its investment opinion on Phelps Dodge (PD

; $99), the world's second largest copper company. Larkin upgraded this company, which is a major component of the diversified metals and mining sub-industry index with a market cap of nearly $9 billion, to 4 STARS from 3 STARS on a more optimistic outlook for earnings and free cash flow growth.

The paper-products industry reported mostly in line with expectations, and there were no major surprises in the forest products group. S&P paper- forest-products analyst Bryon Korutz raised his ranking on MeadWestvaco (MWV

; $30) to 4 STARS from 3 STARS, mostly on valuation and the company's previously announced sale of its coated papers business. This sale now makes MeadWestvaco a company less prone to economic up- and downcycles, Korutz says.

Investors wishing to gain broader exposure to the materials group may wish to look at sector-specific exchange-traded funds such as Select Materials SPDR (XLB) and Vanguard Materials VIPERs (VAW). Morrow is a reporter for Standard & Poor's Global Editorial Operations

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