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Our Outlook for Basic Materials Stocks

With demand weakening, input cost relief is the only hope for many basic materials companies in the first quarter of 2012.st

Elizabeth Collins, 12/28/2011

--The outlook for the next long-term highway bill has gotten slightly more positive in the last three months, but our politicians still have a lot of work to do before the current continuing resolution expires in March 2012.

--Easing in raw-material cost inflation is the main hope for earnings improvement at many chemical companies in the early part of 2012.

--Persistent weakness in developed-market economies' demand for metals throughout 2011 put the onus on China to boost demand and prices for iron ore, metallurgical coal, and copper. Now that we see mounting signs of weakness in Chinese real estate markets, it's possible that the one leg of metals demand that had been relied upon for the past several years is finally beginning to shake.

There's no doubt now that many basic materials companies are facing weakening demand for their commodities. For example, higher prices to recoup higher input costs--rather than stronger demand--were the key driver of chemical companies' revenue growth in the third quarter of 2011. Even fertilizer companies, which had benefited from strong agriculture fundamentals through most of 2011, are beginning to see signs of risk-averse inventory management on the part of distributors.

Whether demand weakness for basic materials companies is a sign merely of destocking along various supply chains or a real indication of weakness with end-market demand, the effect on our companies is the same in the near term. We see relief on the input cost front as the only real opportunity for positive momentum in the very near term.

Industry-Level Insights
With crop prices weakening recently, the stock prices of many agriculture companies, particularly fertilizer producers, have also come down, despite another recent quarter of robust profit generation. Earlier in the year, fertilizer prices followed crop prices up and up, as tight supply impacted both markets. It seems prices marched high enough to create a measure of demand destruction for crops, as the U.S. Department of Agriculture has been lowering its demand numbers for corn, wheat, and soybeans over the last several months.

Fertilizer prices have yet to follow crop prices south, but we're expecting some easement in potash, phosphate, and nitrogen prices going into 2012. As crop prices drop, farmer revenues decline as well. With less money in their pockets, growers are more likely to skip fertilizer application of potash and phosphate, especially at current high prices. This dynamic holds not only for individual farmers, but also for large importing countries. A fertilizer official in India recently commented that the country's potash imports may drop by 30% to 35% this financial year because of higher prices.

While crop prices may drop further, we don't think prices will fall off a cliff anytime soon. Stocks-to-use ratios for crops are still at low levels, which should provide a floor to prices. Additionally, less-than-ideal growing conditions have led to declines in expected yields in North America for corn, wheat, and soybeans. While we'll be keeping an eye on crop and fertilizer prices, we're still expecting the string of strong results for fertilizer producers will continue in the fourth quarter. And with subpar yields in 2011, we're also expecting strong planted acreage in the 2012 North American growing season, which is a good volume indicator for crop inputs.

Elizabeth Collins, CFA, is an associate director of equity research with Morningstar.

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