By Richard O'Reilly, CFA
Standard & Poor's Equity Research believes that profits at FMC (FMC ; recent price, $42) a midsize diversified chemical company with annual sales of nearly $2 billion, should rebound sharply this year and post another strong gain in 2005, driven by its industrial-chemicals segment. Despite a recent run-up in the shares, we believe the stock remains attractive, as it sells at a discount to its peer group based on price-earnings (p-e) multiple comparisons.
We see other bullish factors for the stock. FMC's two largest commodity product lines are experiencing their best industry fundamentals in a number of years, in our view, and the company has been able to implement price hikes. We think FMC's balance sheet should also continue to improve, helping to reduce interest expense. FMC carries Standard & Poor's highest investment recommendation of 5 STARS, or buy.
FMC operates through three business units: industrial chemicals, agricultural products, and specialty chemicals. The industrial-chemicals segment (40% of sales in 2003) manufactures soda ash and hydrogen peroxide. It includes a Spain-based chemical company and the 50%-owned Astaris joint venture, one of the two top U.S. makers of phosphorus chemicals. FMC is the largest North American producer of soda ash and hydrogen peroxide. Plants for both products are operating near capacity, and producers have successfully raised prices this year.
One negative factor for the segment: Export prices for soda ash declined between $1 and $2 a ton in 2003 due to greater competition in Asia from Chinese companies, and FMC expects export prices to decline again in 2004. However, we believe that Chinese production will be absorbed by growing domestic demand, and as a result FMC's export prices will begin to strengthen in 2005.
In October, 2003, FMC announced a restructuring of the Astaris joint venture, designed to achieve annual cost savings of up to $50 million by 2005. It recorded related pretax charges of $53.3 million in 2003. The restructuring includes the closure of four facilities, which will help increase industry operating rates for phosphorus and should make selling prices get firmer, in our view. We estimate that FMC's share of equity income from Astaris declined by about $20 million from 2002.
For FMC's industrial-chemicals segment overall, we expect a profit rebound of about 50% from 2003, to just over $50 million in 2004, followed by a near doubling in 2005, to $92 million. Profits dropped 53% in 2003 due to the lower earnings at Astaris and lower sales of soda ash and domestic peroxyen.
The agricultural-products segment (33% of sales) consists of insecticide (about 75% of segment sales) and herbicides for crop protection and pest control. We expect a sharp profit increase for agricultural products in 2004, a better outlook than we anticipated earlier in the year. The segment should have strong first-quarter results, in our view, reflecting better-than-expected sales in Brazil. We believe that this represents a fundamental strengthening in demand, rather than a seasonal upturn in sales tied to the end of the Southern hemisphere's growing season.
According to a forecast from the U.S. Agriculture Dept., U.S. farmers plan to increase the amount of planted acreage of cotton by about 7% while increasing corn acreage fractionally this year. Cotton and corn cultivation are the two most important uses for FMC's agricultural products. We also expect FMC to benefit beyond this year from new labels for existing products and the introduction of new products.
The specialty-chemicals segment (27% of sales) includes the biopolymer (about 70% of segment sales) and lithium businesses. Biopolymers make microcrystalline cellulose, carrageenan, and alginates used in food, beverages, and pharmaceuticals applications, while lithium is used in pharmaceutical synthesis, specialty polymers, and batteries. Despite a forecast for a flat first quarter due to the timing of orders, we expect the segment to have mid-single-digit percentage gains in both sales and profits for all of 2004 compared to 2003. Longer term, the pharmaceutical and battery markets for lithium are projected to grow at high single-digit rates.
FALLING INTEREST EXPENSE.
We expect FMC's overall financial profile to improve. During 2003, net debt declined by $47 million. At yearend its net debt-to-capital ratio was 52%, down from 54% a year earlier. FMC was able to cut its debt in 2003 despite several large cash outlays, including a $32 million deferred payment for an acquisition made in 1999 and $62.8 million of "keepwell" payments sufficient to make up one-half of the shortfall in Astaris's earnings below certain levels. In 2004, it expects to make a $40 million payment to Astaris and spend $35 million for remediation work at a closed phosphorus plant.
Despite these unusual outlays, we expect FMC to be able to reduce debt modestly in 2004. Also, payments to Astaris should end in 2004 as the joint venture's debt is projected to be close to zero, and spending on the closed plant is budgeted to drop significantly in 2005. In late 2003, FMC repriced a $247.5 million term loan, resulting in annual interest savings of $5 million. We expect interest expense in 2004 to drop by $10 million, to about $88 million, with a smaller decline in 2005.
Overall for FMC, we see operating earnings per share (EPS) of $2.70 for 2004, up from $1.90 for 2003, led by gains in the industrial-chemicals and agricultural segments and lower interest expense. We expect a strong first-quarter EPS gain to 30 cents, up from 5 cents in the 2003 period. The operating EPS figure for 2003 excludes restructuring charges of 78 cents, largely related to Astaris. In 2005, we see EPS climbing to $3.60, mainly due to a strong gain in the industrial-chemicals segment.
TRADING AT A DISCOUNT.
Our Standard & Poor's Core Earnings estimate for 2004 is $2.38 a share, compared with our operating EPS estimate of $2.70. The difference between our operating EPS and S&P Core Earnings estimates is largely due to stock-option expense of 11 cents and a 16-cent adjustment to pension income. Core Earnings for 2003 were 60 cents a share, vs. reported EPS of $1.12, which includes special charges, mainly for the Astaris restructuring. Core Earnings for 2003 also excludes a gain of 22 cents a share from the sale of real estate.
The shares recently sold at about 16 times our 2004 EPS estimate, a discount to FMC's peer group of comparably sized chemical companies. Despite a narrowing of the discount since the beginning of the year as result of the stock's nearly 25% climb through Apr. 16, we expect FMC to continue to outperform the S&P 500-stock index over the next 12 months. Our target price of $54 assumes a smaller discount based on our 2005 EPS estimates.
Risks to our investment opinion and target price, in our view, include unexpected softening in the U.S. economy and foreign economies in which FMC operates; unexpected increases in industry production capacities for its commodity chemical products; FMC's inability to maintain or increase selling prices for key products; a failure to achieve approvals for use of new agricultural products, or to develop or introduce new specialty chemicals products; and the introduction of new products by competitors. Rivals in a number of product lines are larger in terms of total sales than FMC, with potentially greater financial resources.
Analyst O'Reilly follows stocks of chemical companies for Standard & Poor's Equity Research