Cytec's New Growth Formula


By Richard O'Reilly, CFA Specialty-chemicals outfit Cytec Industries (CYT

; recent price, $47) may have found the right formula for future growth. In early October it agreed to buy the coatings-additives business of UCB Group for $1.8 billion. We at Standard & Poor's Equity Research expect the proposed deal, which should close by yearend, pending necessary regulatory approvals, will add to the company's earnings in 2005 before special items.

The UCB unit is a leader in coatings-additive products, with its lines boasting above-industry-average growth rates, and it has greater global exposure than Cytec. The deal will give Cytec two strong business platforms, in our view, with above-average growth rates accounting for nearly three-quarters of total sales.

Cytec's stock is selling at 14 times our 2005 earnings-per-share (EPS) estimate of $3.30, vs. an average multiple of 17 for the specialty chemicals sector. We believe the shares should trade at a price-earnings (p-e) multiple closer to that of specialty-chemicals' peer group. The stock carries Standard & Poor's highest investment recommendation of 5-STARS, or strong buy.

ADD TO THE MIX. Cytec is a midsize specialty chemicals-and-materials company with projected sales of almost $1.7 billion in 2004. About 57% of annual sales come from its two specialty-chemicals segments, about 28% from a specialty-materials business, and the remainder from a small commodity-chemicals business.

Cytec's two specialty-chemicals segments are water and industrial-process chemicals, which include water-treatment chemicals and mining reagents, and performance products, which consists of coating chemicals, polymer additives, surfactants, and urethane chemicals. Coating chemicals include cross-linking resins, additives, and urethanes.

The business to be acquired from UCB consists of coatings resins and additives and adhesives, which have total annual sales of about $1.3 billion. Product lines include acrylate- and polyester-based resins, acrylics, polyurethanes, and epoxy resins.

The addition of UCB's coatings business would make Cytec the leading global supplier of these products to such applications as radiation-curable coatings, powder coatings, and waterborne alkyds. About two-thirds of surface-specialties sales go to these applications, which have higher-than-average growth rates (5% to 8%) than for the overall paint industry (which typically tracks U.S. GDP growth). The business also has a broader geographic coverage, with manufacturing sites in Europe and Asia. Cytec intends to operate the surface-specialties business as a separate segment, combining it with its existing coatings-additives business.

BROADER EXPOSURE. We think the proposed deal is a good one, and gives Cytec a new strong global business platform with broad geographic exposure. Cytec's annual sales would be about $3 billion, with the new surface-specialties segment accounting for about 55% of the total. Cytec is paying 8.9 times projected earnings before interest, taxes, depreciation, and amortization (EBITDA) of about $200 million for 2004 -- a full price, but not excessive, in our opinion, before any cost savings.

We expect the proposed transaction will add about 25 cents to EPS before transaction and integration costs in 2005. We believe that Cytec will achieve relatively modest cost savings of $15 million to $20 million within 18 months from the closing of the deal. On the negative side, we think the transaction, which will result in Cytec deriving more than half its revenues from the coatings business, would somewhat lessen the appeal of the higher-margin specialty-materials business as a growth story.

The specialty-materials segment consists of structural adhesives and advanced carbon-fiber composites for use in commercial and military aviation, satellite and launch aircraft, and automobile and recreational products. Cytec is the world's largest supplier of these materials. This segment provides its highest margins on an earnings before interest and taxes (EBIT) basis -- 16% in 2003, down from 21.6% in 2001 before the post-September 11 downturn in aerospace markets.

GAINING ALTITUDE. We believe that specialty-material sales will increase nearly 20% in 2004 on growth in military use and increased sales to Airbus. After a severe downturn, commercial and regional aircraft markets (about 50% of use) are slowly improving, and we expect a recovery in deliveries by aircraft makers to begin in 2005, thereby boosting specialty-material sales. For example, Boeing projects that it will deliver 320 commercial planes in 2005, up from 285 expected in 2004, with a further increase expected in 2006. Airbus expects to deliver 315 to 320 planes this year, vs. 305 for 2003, with more in both 2005 and 2006. In addition, newer plane models, such as Airbus's A380 model, have a greater amount of composite materials per plane than older models.

Assuming the UCB coatings acquisition is completed, the specialty-materials segment would account for about 17% of annual sales. We also believe for antitrust reasons that there are no sizable acquisition opportunities available in advanced materials.

Our full-year 2004 EPS estimate for Cytec is $2.88, up from $2.27 for 2003. Sales for the specialty-chemicals segments will likely grow by 12%, with about 5% from acquisitions made in 2003. Specialty-materials sales should grow almost 20%, with profits rising about 30%. We expect the commodity-chemicals business to have a profit decline of about 25% as a result of higher raw-material costs. Overall company results should also be helped by a projected tax rate of 22%, down from 28% in 2003.

EARNINGS BOOSTER. We're keeping our 2005 EPS estimate of $3.30 for Cytec (without reflecting the UCB deal), assuming a continuation of business trends of 2004 and a tax rate of 24%. We believe that the UCB acquisition could add 25 cents per share to our projection, including cost savings, an interest expense on the $1.425 billion of new debt, and a tax rate of 27%, although unspecified transaction and integration costs and purchase-accounting adjustments makes it difficult to project an estimate.

Following the completion of the proposed transaction, Cytec would likely have a debt-to-capital ratio of about 60%, which we feel will be manageable, vs. about 34% at Sept. 30, 2004. We believe that Cytec will repay some of the new debt with the planned sale (for antitrust reasons) in 2005 of the UCB unit's amino cross-linking resin product line, which has annual sales of $140 million. This product line overlaps with Cytec's similar existing business. Cytec will suspend for up to two years its stock-repurchase program, which was running at about $35 million a year.

Our Standard & Poor's Core Earnings estimate for 2004 of $2.14 a share, vs. our GAAP (generally accepted accounting principles) EPS estimate of $2.60, includes an option expense of about 11 cents and a 35-cent adjustment to pension income and post-retirement expense. Using our S&P Core Earnings methodology, we believe the company earned $2.00 in 2003, with an option expense of 16 cents per share.

STEADY GROWTH AHEAD. The stock is selling at about 14 times our 2005 EPS estimate of $3.30. With two business platforms having higher-than-average growth rates, we believe that the discount in Cytec's p-e should narrow against its specialty-chemicals' peer group average of about 17 times. Our 12-month target price is $57.

Our

discounted cash-flow model shows an intrinsic value of $60 a share, assuming annual growth of 10% a year for the first 10 years, followed by 8% for the next five years, and a weighted average cost of capital (WACC) of 7.5%.

Risks to our recommendation and target price, in our view, include the inability to successfully complete the UCB coatings purchase, unexpected slowdowns in the aerospace markets, increases in raw-material costs for specialty chemicals, increases in asbestos liability claims, and possible lead-pigment liabilities. Analyst O'Reilly follows stocks of specialty-chemical companies for Standard & Poor's Equity Research Services


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