Wednesday, July 14, 2010

Chemicals: Downgrade coverage view to Neutral; PX to Neutral; SHW to Sell - Goldman Sachs

Goldman Sachs is making a significant call on Chemicals this morning downgrading their sector view to Neutral from Attractive as recent global economic data point to a more muted economic outlook heading into 2H2010.

Ratings changes:

- Praxair (NYSE:PX) is downgraded to Neutral from Buy with a $91 target price (prev. $95)

- Sherwin-Williams (NYSE:SHW) is downgraded to Sell from Neutral with a $71 target price (prev. $77)

Recall that they had taken a more pro-cyclical stance on the Chemical space beginning on May 15, 2009 (their “Embrace the Cycle” call) to reflect a constructive outlook for the global economy and upside potential toward mid-cycle valuations. As expected, the global economy bottomed out and a strong cyclical rebound in underlying demand from the depths of the recession took hold with positive macro trends worldwide combined with robust customer inventory rebuilds in early cycle end markets. Those factors along with more favorable developments for raw material costs and product pricing plus extremely aggressive restructuring efforts fueled substantial upward earnings revisions, driving chemical sector outperformance - sector average up 47% versus the S&P500 up 22% since May 15, 2009.

While the 2Q2010 earnings season is likely to show strong results given nearly uniform commentaries by companies expressing little evidence of any slowing, (including positive preannouncements from PPG, EMN and Arkema), the firm sees increased uncertainty surrounding the demand outlook for 2H2010 - early 2011 as a series of data points in past weeks suggest deceleration worldwide: 1) disappointing ISM and employment data in the US; 2) continued weakness in the GS global PMI index; 3) downward revisions of GS China GDP forecasts; and 4) less inspiring trends in key chemical end markets such as auto, semis, and housing.

The market is discounting near-term earnings risk Despite the positive tone from the industry in recent months, the market appears to be discounting a more somber earnings outcome in the near term. Forward P/E multiples for the chemicals group rallied from trough levels of 10X-11X in March 2009 to mid-teens in early April 2010 (vs. the average mid-cycle multiple of 15X-16X). However, since late April-May, as investor confidence has eroded, the chemical sector’s average P/E multiple has dropped to around 13X based on Goldman's current 2011 EPS estimates.

Sherwin-Williams (NYSE:SHW): Source of opportunity
Goldman is adding the US paint producer Sherwin-Williams (SHW) to their Americas Sell list to reflect a cautious view on the domestic residential and commercial construction markets (50% of total sales) where recent macro data point to demand deterioration in coming quarters. SHW trades at 14X their 2011E EPS (vs. mid-cycle 13X-13.5X), at a substantial premium to the peer group (PPG, VAL, and RPM) average of 12X. Since early April, SHW shares have increased 8% versus peer group down 5%. However, considering that almost 90% of the company’s revenues are generated from the US and it has substantial exposure to the construction markets, they believe that SHW is unfavorably positioned compared to other paint names that have more diversified geographic and end market exposure.

To reflect a slowing demand trend in the coming years, the firm has lowered 2010/2011/2012 EPS forecasts to $4.65/$5.25/$6.00 from $4.70/$5.50/$6.15. Their new 12-month price target is $71 (-$6) based on 13.5X 2011E EPS, or about 3% downside from current level (relative to average 11% upside for the sector). Firm believes other names such as Valspar (VAL, Buy) in the paint space offer more attractive investment opportunities.

Notablecalls: SHW & PX should trade down today as Goldman is taking their Chemical chips off the table since turning bullish more than a year ago.

Note that Goldman is also downgrading Homebuilders today (to Neutral from Attractive) as the previously anticipated new home sales pickup following the May drop has not yet materialized;

Given how leveraged SHW is to domestic construction market, the call should add some fuel to the fire. Although, one must admit Goldman throwing in the towel looks more like a contrarian signal. They were quite bullish on Homies all the way down.

As I have already noted this morning the general tape feels over extended so I'd be looking at potential shorting opportunities rather than going long.

Pass the salt, please!

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