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Pursuing The Pliable Cutting Edge

Tap an iPad, swallow an aspirin, drive a car or build a house and you've used some form of specialty chemical or plastic. The companies that make the coatings, coverings and parts found in every cranny of our materialistic world continue to see a steady increase in opportunities.

Some of those also translate into opportunities for investors.

"Buying chemical companies may be similar to owning stock in Levi's during the San Francisco gold rush," said Mark Elliott, president of Elliott Asset Management in Las Vegas.

The Levi's brand made its name selling denim jeans to that era's prospectors. Today, trends like the tablet-computing gold rush demand specialized glass and plastics produced by only a handful of companies in an industry with high barriers to entry.

"Why buy the solar-wafer manufacturer, LCD (liquid crystal display) glass producer or chip producer when you can buy the company providing the basic building blocks for those products to those companies and their competitors, and achieve growth at a lower cash-flow multiple and lower risk?" said Elliott, who manages $25 million in assets.

Those suppliers are often at the forefront of innovation. U.S. chemical companies spend about $56 billion annually on research and development and own one in five U.S. patents, according to the American Chemistry Council.

A number of those innovators are included in the 13 stocks in IBD's Chemicals-Plastics industry group, which has rallied 33% year to date vs. 14% for the S&P 500.

The biggest gainer is a thinly traded stock, AEP Industries (AEPI), which soared 132%. Its plastic packaging wraps everything from Oreo cookies to industrial warehouse pallets.

PolyOne (POL) of Avon Lake, Ohio, vaulted 73% this year. It makes plastic, vinyl, latex, printing ink, engineered resins and compounds for clients including Dow (DOW) and Exxon Mobil (XOM). It holds 7% of the $44 billion global plastic additive market, according to Jefferies.

Eastman Chemical (EMN) of Kingsport, Tenn., sells fibers and specialty chemicals in about 100 countries. Shares climbed 53% year to date.

Here are five different views into the industry and its stocks.

Earnings Outpace Sales Growth The value of U.S. plastic shipments has grown a meager 17% since 2002, according to the Society of the Plastics Industry, or SPI. Production climbs just above 2.3% annually, slightly faster than the growth in overall U.S. manufacturing.

But PolyOne grew earnings by 12% to 27% the past four quarters on sales growth of only 1% to 4%. It's targeting 3% sales growth in 2012 and 5% in 2013. European sales, 20% of total sales, remain weak. Sales growth in North America and Asia is modest, say Wells Fargo Securities analyst Frank Mitsch and his colleagues.

"While the headlines suggest an improvement in consumer confidence, we are cautious of how this realistically translates into demand for PolyOne's higher-end thermoplastic elastomer products," Mitsch wrote in a September client note.

Analysts see PolyOne earnings up 18% this year and 13% in 2013.

The two analysts following AEP expect earnings to grow 90% year-over-year in 2012 and 26% in 2013. Projections see sales slipping 17% this year, then recovering 5% in 2013.

Low Natural Gas Prices Chemical producers demand vast amounts of natural gas, used both as an energy source and a raw material.

The recent rise of "fracking" techniques has been generating record levels natural gas production, creating a glut that sent gas prices to a 13-year low in April.

"Cheap domestic natural gas has re-energized stocks that use it as a raw material input," said Dave Carlsen, Mission, Kan.-based co-manager of Buffalo Growth Fund with $475 million in assets. "Stocks within the chemicals and materials sectors, whose margins are benefiting from the lower cost inputs, have been the primary beneficiaries.

In addition to higher profits, lower costs have given U.S. producers a price advantage on international markets. But the gas glut has also reduced incentives for gas producers. That raises the risk of higher gas prices for plastics producers. There is also regulatory risk, Elliott says.

"Any regulations limiting fracking in the natural gas industry could lead to a sudden spike in natural gas prices," a severe negative for the petrochemical sector, he said.

Streamline, Acquire, Diversify Acquisitions, automation and aggressive streamlining of operations have helped drive employment down 30% in the plastics industry since 2002, according to SPI.

"Plants have been closed, corporate restructuring has taken place, and cost-cutting measures have been implemented industrywide," said Andrew Schrage, co-founder of Money Crashers Personal Finance in Piscataway, N.J.

AEP acquired Webster Industries, a private-label food bag and trash bag maker, for $25.9 million in October 2011. That added $30.7 million in net sales in Q3 2012.

In October, PolyOne bought plastic products maker Spartech (SPAR) for $246.3 million. In May, it projected revenue of $5 billion by 2015, up 58% from 2012's estimated total. The numbers assume two or three more buyouts.

"It should give PolyOne access to new technologies for the aerospace, security, packaging and health care markets," Jefferies' equity analysts Lucy Watson and Laurence Alexander wrote in a client note Oct. 24. "The combined businesses should generate significant cost synergies as well as cross-selling opportunities." They estimate each $100 million in acquisitions adds roughly 5 cents to earnings per share annually.

Eastman acquired Solutia in July for $4.8 billion and debt, aiming to broaden to emerging markets and expand its product line. With the buyout, Eastman expects to grow earnings 10% annually for the next several years in Asia. It is also buying out small polymer producers in China. In the past two years, it's bought a facility in Korea, acquired a plastic producer in Brazil and entered joint ventures in China.

Investment Risks Raw material price increases: Higher prices for resin, oil and gas used in manufacturing would drive up production costs and cut into profits unless manufacturers are able to pass on cost increases to customers.

For PolyOne, a 1% rise or drop in raw material prices amounts to a 15-cent per share bonus or hit to earnings, according to Jefferies.

Integration problems: These companies are all partly growing sales through acquisitions. How well they combine operations and manage the newly acquired companies could make or break their success.

Higher interest rates: These chemical companies are highly leveraged. An increase in interest rates could raise borrowing costs and cut into earnings. The Fed has pledged to keep interest rates low through mid-2015, so this shouldn't be an immediate concern. AEP owes $350 million in loans and bonds, nearly equal to its $358 million market value. PolyOne's debts, $1.01 billion, amounts to 75% of its $1.77 billion market cap. Eastman's $8.65 billion in debts exceeds its market value of $8.27 billion.

Global slowdown and uncertainty in end markets: These companies all depend heavily on foreign sales. Eastman substantially increased exposure to China by acquiring Solutia. Low demand in end markets such as home construction and electronics would dampen demand for raw materials.

On the upside, PolyOne estimates every 100,000 new housing starts should contribute about 3 cents to EPS, according to Jefferies.