Summary Introduction to Basic Chemicals. Industry overview. Top Companies in this industry by the numbers. Conclusion. Introduction to the Basic Chemicals Industry There are three distinct Industries that fall into the category of Chemicals: Basic, Diversified and Specialty. It depends upon what the primary focus, or the main source of revenue and earnings, is as to which category a company belongs. Basic chemicals are best defined as commodity chemicals. This group is primarily made up of polymers (about 33%), petrochemicals and intermediates (about 30%), other derivatives (about 20%), inorganic chemicals (about 12%) and fertilizers (about six percent). As a group the average annual growth rate is generally only a fraction of overall GDP growth. Petrochemicals, which are made primarily from liquid petroleum gas, crude oil and natural gas. There are usually used as feedstock to manufacture polymers and other more complex chemicals. Polymers are primarily used to make plastics and man-made fibers. Other derivatives includes resins, dyes, synthetic rubber, pigments, turpentine, carbon black and explosives. Fertilizers include phosphates, ammonia and potash. Inorganic chemicals include salt, chlorine, caustic soda, hydrogen peroxide, soda ash, titanium oxides and acids. Some of the companies in the basic chemicals industry contain smaller divisions that involve the life sciences, specialty chemicals, and consumer products. But the key to being classified as a basic chemical company is having the majority of product, revenue and earnings from those chemicals that fall into the basic or commodity chemical category. One might argue that huge chemical companies like Dow (NYSE: DOW ) and DuPont (NYSE: DD ) should be relegated to the diversified chemicals industry. But one would be mistaken since both companies derive the majority of revenue and income from basic chemicals that are generally used as feedstock to be made into other products. Both companies do make a variety of products that could be considered specialty chemicals or, in the case of DD, consumer products, but that does not preclude the fact that most of the revenue and earnings come from basic chemicals. Diversified chemical companies are what the name implies: more diversified and usually with a stable of products that could fit in either basic or specialty chemicals or as non-chemical products that are derived from using chemicals as a feedstock. These companies generally do not derive a majority of revenue or earnings from any one category. Specialty chemical companies derive the majority of revenue and earnings from more complex chemicals such as industrial gases, solvents, coatings, adhesives, cleaning chemicals and catalysts. The growth rate of demand for these products is generally much higher than the rate of GDP growth. These chemicals are used to make paints and other surface treatments, adhesives, sealants, pigments, inks, advanced polymers, and additives. But today I am focusing on the basic chemicals industry. It may grow slowly but it generally offers the highest average dividend yield. Industry Overview Most basic chemicals companies have fallen hard due to lower demand which led to lower revenue and earnings than expected. Several of the major companies in the industry are near 52-week lows. This factor caught my eye, along with the above average yields, and enticed me to dig deeper into future prospects for the industry. This spring witnessed a global bumper corn crop which, in turn, reduced demand in the short term for fertilizers. Global industrial demand has softened as well with the deceleration of China and many emerging markets. Growth in Europe is tepid and the U.S. is stuck in low gear as well with below average two percent GDP growth. The strength of the U.S. currency has also created a headwind for chemical manufacturers that are domiciled in the U.S. and derive a significant portion of revenue from exports. The recent market volatility in equities has been overly harsh on the companies in this industry. It appears that by bidding these shares lower many investors seem to expecting a recession. It should be noted here that even the companies in this industry considered to be of the best quality can get hit very hard during a recession. In 2008-09, the stock of DOW fell by some 87 percent; DD fell by 70 percent and Potash (NYSE: POT ) fell 80 percent. Thus, it is important to not buy stocks in this industry at or near the top. I expect additional headwinds to keep growth slow for much of this industry at least into early 2016. If the U.S. economy slides into a recession, which seems a possibility at this point, waiting for a better entry point would be warranted. I will discuss my plans and expectations for the industry in the conclusion. But there is also a very, very good side to this story that is coming in the not too distant future. With the prices of much of the basic feedstock for the basic chemicals industry near multi-year lows and likely to remain depressed compared to the highs reached in 2014, input costs are falling also. Those costs should remain low globally, but due discrepancies between U.S. energy prices and most global prices the producers with large capacity domiciled in North America should have a decided cost advantage. Secondly, when companies in this industry recover, the stock prices tend to rebound much faster than the broader market. POT rose by 200 percent in less than a year off its 2009 low. DOW jumped 600 percent in just two years. DD required two years and two months to rise just over 250 percent. POT and DD never cut dividends but DOW did, significantly. But the dividend is now above where it had been prior to the financial crisis. One more positive for some of the companies here is that the global population is expected to continue to grow and that will require more food productions. Companies that make and market fertilizers should amass revenue growth faster than overall economic growth over the long term. The point to this monologue is simply that finding the best entry point can be very important and, with yields well above the average for the S&P 500, this industry can offer a solid combination of great income and rock solid appreciation. Top Companies by the numbers This list does not constitute a recommendation to buy any of these companies at current prices. I make this statement in each of my industry analysis articles because this process is meant to provide a list of candidates for further inspection. I will write focus articles on my favorite company(s) when I believe the value proposition is most favorable. Also, I should make clear that I update my analysis on each industry only once a year and generally use audited year-end data with the exception of current price, dividend and yield. I prefer not to rely on data from quarterly reports since it is not audited and is often presented in an adjusted format that does not comply with GAAP which reduces comparability. Remember, I am not trying to make final picks here; I am trying to winnow down the list for consideration. With that said: Let’s look at the metrics for the leaders of the industry in no special order. Dow Chemical Metric DOW Industry Average Grade Dividend Yield 3.8% 4.2% Neutral Debt-to-Capital Ratio 46.9% 39.4% Fail Payout Ratio 54.0% 57.6% Pass 5-Yr Average Annual Dividend Increase 22.9% 18.7% Pass Free Cash Flow per Share $2.78 N/A Pass Net Profit Margin 7.0% 16.0% Fail 5-Yr Average Annual Growth in EPS 37.6% 3.9% Pass Return on Total Capital 10.9% 10.8% Pass 5-Yr Average Annual Growth in Revenue 5.2% 7.1% Fail S&P Credit Rating BBB N/A Pass DOW receives a report card with six Pass ratings, one neutral and three Fail ratings. I consider a reading within ten percent of the industry average to be neutral; below that is a fail. In the case of debt-to-capital, ten percent of 39.4 equals 3.9 percent. Dow’s ratio is 7.5 percent higher, thus it fails the category. I like DOW in many ways but cannot get too excited about the company since it did cut the dividend during the last crisis and I would prefer to not to have to endure such an event if a similar event occurred in the future. The net profit margin is much below the industry average. Expectations are higher for DOW than many of its peers as the current price (as of the close on Friday, August 28) of $44.00 is already more than 25 percent above its 52-week low and only 20 percent below its high. This is not a bad company, but it does not make my list for further review this year. The current price is slightly below its fair market value of $45.09 using the dividend discount model. E.I. DuPont de Nemours and Company Metric DD Industry Average Grade Dividend Yield 3.7% 4.2% Fail Debt-to-Capital Ratio 43.8% 39.4% Fail Payout Ratio 48.4% 57.6% Pass 5-Yr Average Annual Dividend Increase 3.4% 18.7% Fail Free Cash Flow $3.59 N/A Pass Net Profit Margin 10.7% 16.0% Fail 5-Yr Average Annual Growth in EPS 14.5% 3.9% Pass Return on Total Capital 17.1% 10.8% Pass 5-Yr Average Annual Growth in Revenue 5.8% 7.1% Fail S&P Credit Rating A N/A Pass DuPont receives only five pass ratings and five fail ratings. The first two fails are not horrible nor would those misses cause me to keep DD off the list. But, the average annual dividend increase is too low as there are far better options to consider. The current price of $51.84 is well above the estimated fair value of $21.80 using the dividend discount model. The low value is primarily due to very low expectations for future dividend increases that are likely to continue at the slow pace of the past five years. It is another huge company with a very stable and predictable future, but it is not among the best, in my humble opinion. Potash Corporation of Saskatchewan Metric POT Industry Average Grade Dividend Yield 5.9% 4.2% Pass Debt-to-Capital Ratio 32.3% 39.4% Pass Payout Ratio 83.1% 57.6% Fail 5-Yr Average Annual Dividend Increase 63.5% 18.7% Pass Free Cash Flow $1.33 N/A Pass Net Profit Margin 21.7% 16.0% Pass 5-Yr Average Annual Growth in EPS 10.5% 3.9% Pass Return on Total Capital 13.6% 10.8% Pass 5-Yr Average Annual Growth in Revenue 13.9% 7.1% Pass S&P Credit Rating A- N/A Pass POT receives a glowing report card by the numbers: 9 Pass and 1 Fail ratings. The one fail is a concern to the extent that it means that future increases in the dividend will necessarily be more muted than in the past five years. But when we start so near six percent it is less of a concern. Potash has potential for the long term. I think we may be able to get a better entry price sometime over the next six to nine months, but the current price ($25.95) is only pennies above my estimated fair value of $25.33. The current price is also just 8.6 percent above its 52-week low and a full 31 percent below the 52-week high. The long-term prospects are also very good as fertilizer, the main business of POT, will continue to grow in demand as the world population expands. The Mosaic Company (NYSE: MOS ) Metric MOS Industry Average Grade Dividend Yield 2.7% 4.2% Fail Debt-to-Capital Ratio 26.3% 39.4% Pass Payout Ratio 41.0% 57.6% Pass 5-Yr Average Annual Dividend Increase 40.6% 18.7% Pass Free Cash Flow $2.31 N/A Pass Net Profit Margin 11.4 16.0% Fail 5-Yr Average Annual Growth in EPS -8.9% 3.9% Fail Return on Total Capital 7.6% 10.8% Fail 5-Yr Average Annual Growth in Revenue 1.2% 7.1% Fail S&P Credit Rating BBB N/A Pass MOS receives five Passes and five Fails. While the long-term prospects are bright, management failed to respond as well to adverse circumstances as did rival POT. While that may be more a matter of product mix, that would suffice as an explanation but not dismiss the relative lackluster results. On the other hand, MOS is trading at a considerable discount to estimated fair value ($66.70) with a current price of $41.04. That is based primarily upon significantly higher expectations for future dividend growth. The higher rate of growth is possible due to its relatively low payout ratio compared to the industry and future EPS growth prospects from a modest 2104 base. It is about ten percent above its 52-week low and nearly 24 percent below its high. MOS does not make the list for further review. CVR Partners, LP (NYSE: UAN ) Metric UAN Industry Average Grade Dividend Yield 14.1% 4.2% Pass Debt-to-Capital Ratio 23.2% 39.4% Pass Payout Ratio 151.5% 57.6% Fail 5-Yr Average Annual Dividend Increase 12.3% 18.7% Fail Free Cash Flow $1.12 N/A Pass Net Profit Margin 25.5% 16.0% Pass 5-Yr Average Annual Growth in EPS -17.1% 3.9% Fail Return on Total Capital 15.0% 10.8% Pass 5-Yr Average Annual Growth in Revenue -5.5% 7.1% Fail S&P Credit Rating NR N/A Fail UAN receives five Pass and five Fail ratings. Since it is a limited partnership created primarily to provide income in the form of dividends to its unit holders, I would not be too concerned about the payout ratio in and of itself. However, no matter how enticing the yield may be, negative growth in EPS and revenue per share are red flags. But the current price ($11.04) seems to already reflect many of the problems and looking to the future the prospects begin to show signs of hope for future growth. Long-term, fertilizer will be in greater demand and prices should rise with demand while input costs remain relatively low. Fair value for UAN is estimated at $22.59, more than double the current share price. But the price is already nearly 20 percent above the 52-week low and 31 percent below the high. This is a very volatile stock, so if you find yourself enticed by the yield consider waiting for a better entry price closer to the low of $8.52 and do not forget that this issue carries higher risk. Terra Nitrogen, LP (NYSE: TNH ) Metric TNH Industry Average Grade Dividend Yield 8.7% 4.2% Pass Debt-to-Capital Ratio 0.0% 39.4% Pass Payout Ratio 78.2% 57.6% Fail 5-Yr Average Annual Dividend Increase 13.5% 18.7% Fail Free Cash Flow 17.47 N/A Pass Net Profit Margin 57.1% 16.0% Pass 5-Yr Average Annual Growth in EPS 17.5% 3.9% Pass Return on Total Capital 121.4% 10.8% Pass 5-Yr Average Annual Growth in Revenue 5.0% 7.1% Fail S&P Credit Rating NR N/A Neutral TNH has no debt so the neutral rating could easily be a Pass. In all, it receives six pass, one neutral and three fail ratings. EPS growth is an aberration since it was calculated from the base year of 2009, a year in which EPS dropped from $14.90 to $5.40 per share. Growth has not been steady. That is a problem for me. But the margins are consistently among the highest in the industry. I like the yield and lack of debt, but not the inconsistent results. The inconsistency of the dividend, similar to the case of UNH, results from this company being structured as a limited partnership design to provide as much income as possible to unit holders. For this reason the payout ratio does not concern me. This is another stock for those seeking yield and able to withstand the rollercoaster ride. It does not make my list for further review. Conclusion For those who are wondering why I did not include Compass Minerals (NYSE: CMP ), Axiall Corporation (NYSE: AXLL ) or Olin Corporation (NYSE: OLN ), it is because the credit ratings on debt issued by these companies is below investment grade. That is one of my thresholds. CF Industries (NYSE: CF ) and FMC Corp (NYSE: FMC ) yield too far below the industry average and below my 2.5 percent threshold, so those companies were also not included. Agrium (NYSE: AGU ) and CF also missed the list because both companies have negative free cash flow. Positive free cash flow is a must for inclusion. I believe that share prices for this industry could go lower from here and test the 52-week lows again, so I plan to wait for better entry prices on my favorite companies in this industry. I will write focus articles on each when I believe the worst is behind the industry and greater future opportunity exists. I do not believe that the volatility is over, but we will see. If I am proven wrong this coming week I could be kicking myself for not pulling the trigger. But I need to invest according to my convictions and from what I am reading in this market I expect more volatility and another opportunity to buy at better values. I would like to explain a little about my investment philosophy: My focus is to add income when it is cheap enough. In other words, I like to determine the ideal yield I would accept from a stock as my target for entering a new position. I rely on my patience that took some time and age to develop. A good example that illustrates these principles, if you are interested, is a recent article that I wrote about XOM. If you are not familiar with how I analyze companies and industries please consider my age-old favorite, ” The Dividend Investors’ Guide to Successful Investing ,” where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do. I have made one primary adjustment from that earlier set of rules regarding the debt to total capital ratio. While I remain very cautious regarding free cash flow and companies’ ability to service and repay debt if the economy experiences another financial crisis, which I believe is still possible, I place an emphasis on debt levels relative to a company’s industry peers. But I have adjusted my calculation to be more in line with traditional convention and now use the total of debt plus equity to represent total capital. It is easier to understand and there is really very little difference from my earlier method, so the variance is of little consequence. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I intend to start a position in POT, but probably not within the next 72 hours.