One word for investors: Plastics

By Jon Markman

The most famous career advice ever given to the baby-boom generation came in a single word in a 1967 movie: Plastics. It was supposed to be funny, but it turned out to be prescient. Since the premiere of "The Graduate," shares of plastics giant DuPont (DD, news, msgs) are up almost 2,400%, double the return of the broad market.

Thirty-nine years later, strangely enough, you could easily give the same advice, as the makers of everything from MP3 players and golf shirts to cars, corn, computers and container ships are turning to plastics and advanced chemicals to cut weight, extend life and improve durability. The latest blow for the primacy of polymers came last week when federal regulators approved the use of silicone in breast implants after a two-decade ban. It's goodbye wonders of nature, hello miracles of science. Synthetics or bust.

The beauty of plastic is more than skin deep, but it's so ubiquitous that we take it for granted. Consider that when marveling at the iPod, you're apt to praise its rich sound and sharp video. But really, how about that lovely case and vivid LCD screen? The device's smooth finish, light weight, bright color and remarkable strength would not be possible without significant advancements in development of low-cost materials.

Fantastic plastic

It's fashionable in some circles to complain about chemicals in food, water and hair products, but just try to live without them. Engineers in labs have developed new pesticides and seeds that increase crop yields without poisoning the food chain; chewing gum that lasts longer and whitens teeth; soft polyester shirts that wick sweat away from skin at the gym; bombproof glass; and spongy but indestructible turf for kids' soccer games. The Stone Age was cool and everything for Neanderthals, but count me as happy to live in the Plastic Age.

Much of the time, the great work done by chemical companies goes on unnoticed by investors unless a plant blows up and the toxic plume kills a thousand people. Yet every now and then, the leading outfits in the business poke their heads up and get attention. This is one of those times. DuPont, the industry goliath, is one of the leading stocks in the Dow Jones Industrial Average ($INDU) this year, with a 15% advance, while smaller peer Hercules (HPC, news, msgs) is the sixth-best stock in the S&P 500 ($INX, news, msgs) with a 68% gain.

Plastics and chemicals makers are being rewarded this year for a lot of strong product innovation, marketing and cost control, so it's a good time to pay attention. Let's look at a few that are still a good value and have great growth prospects over the next year or two.

Seed money

Consider taking a stake in DuPont, where the story lately focuses on its insect-repelling seed division. The big news in farm country this year is the escalating demand for corn, which is used to make ethanol, a gasoline substitute. U.S. corn acreage is expected to rise by as much as 5 million acres in 2007 from this year's 82 million -- pushing toward levels not seen since the 1940s. DuPont's major new contribution is corn seed with a Herculex-brand trait that guards plant against pests that cause millions of dollars worth of damage a year, including the black cutworm, western bean cutworm, earworm, armyworm and corn borer. DuPont seeds are gaining market share in Asia, Latin America and Europe and challenging the domination of Monsanto (MON, news, msgs) here at home even as prices, and profit margins, are rising.

From a valuation point of view, DuPont shares are trading at 14 times my 2007 estimate that the company will earn $3.22 per share. As more investors come to appreciate its balance sheet strength and innovation, I think it will ultimately trade by the end of next year at 18 times my 2008 estimate of $3.67 per share, or about $66.25, which is 38% higher than the current price. Add the very nice 3% dividend, and it should be a great pick-up right now.

A muscular stock

Next consider Hercules, which despite its big move this year to a $2.1 billion market cap is still trading more than 65% below its 1997 high in the mid-$50s. Best known perhaps for its paper-industry chemicals, Hercules has gained lately on rising demand at its Aqualon division, which makes cellulose-based chemicals used in construction to help cement set faster, in food to make sauces stable, in the medicine cabinet to make toothpaste thick and antiperspirant smooth, in oil fields to lubricate drills, in paint to thicken latex and in drugs to coat pills.

After dumping some money-draining divisions, Hercules' new management team has promised up to 7% revenue growth and double-digit earnings growth for at least the next three years. Now trading at 12 times my 2007 estimate of $1.41 per share, I figure it will come to deserve at least a 15-times multiple on my 2008 estimate of $1.65 per share. That would put the stock at $25 late next year, which would be a 40% advance from here.

Upside: 45%

Next, take a look at Celanese (CE, news, msgs), the Texas manufacturer of synthetic products that are the secret ingredients in many high-performance paints, electronics, detergents, lubricants and even baked goods. The company, which was founded in the 1920s, was taken private in 2003 by Blackstone Group, restructured and then reoffered to the public early last year. It's now well on the path to paying off its heavy debt, earning $492 million over the past 12 months on $6.5 billion in sales. Income is growing at a solid pace in the low double digits. Yet due to its checkered history, the stock trades at a forward-looking price-earnings multiple of around seven. That's the kind of valuation the market typically gives a commodity chemical maker, which is what Celanese was before being reshaped into a specialty polymers manufacturer.

The company has suffered under the impression among many investors that it is overly exposed to the struggling automotive industry, but its largest customer in that industry now is powerhouse Toyota (TM, news, msgs), which has announced plans to ramp up U.S. production. I think Celanese should ultimately trade at a price-earnings multiple of at least 10 by late next year. Apply that to my 2008 estimate of $3.19 in earnings per share, and you have the potential for shares to go to $32, which would be a 45% jump.

Stick with the brand names

There are many interesting microcaps in the chemical business for extreme risk-takers to consider. One is LSB Industries (LXU, news, msgs), an industrial conglomerate that has a large division selling ammonium nitrate and nitric acid to the fertilizer industry and another large division that's a major manufacturer of commercial explosives. Shares are up quite a bit this year, but the stock is still cheap at a price-to-sales multiple under 0.3 and insiders buying heavily in the past month. But with so many inexpensive large caps to buy, it may not pay for most investors to throw dice on the bit players.

DuPont used the slogan "Better living through chemistry" for three decades in the middle of the last century before it was turned on its head by LSD-popping hippies. Maybe it's time to trot it out again, at least for stock-popping investors.

Fine print

To learn more about DuPont's plastics, read here. To learn about its agricultural products, read here. . . . To learn more about the incredible variety of uses of Hercules' Aqualon line of cellulose products, start here or here. . . . To learn about how Celanese products helped Siemens build an automatic home shirt ironing system, read here.

Celanese products also help make hybrid fuel engines work, as you can learn here. . . . Wikipedia has an interesting entry on the "Better living through chemistry" motto here.

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Jon Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman did not own or control shares of companies mentioned in this column.