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Quarter-End Insights

Our Outlook for Basic Materials Stocks

Falling commodity prices and rising costs could crimp margins.

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Concerns about a slowdown in the global economy have taken a toll on many basic materials companies' shares over the past three months. For the most part, second-quarter results from these companies were strong, as the longer-term themes of developing-market industrialization and a constrained resource base (causing a tight supply/demand balance for commodities) continued to play out. Bright spots included coal, where demand from developing economies drove spot prices for Central Appalachian coal from under $60 per ton at the end of 2007 to $120-$130 today, and agricultural products (such as fertilizer and crop protection chemicals), where spot prices for standard potash rose from $175 per metric ton to $775. On the other hand, weak demand from the North American and European construction industries did impact some chemical companies' earnings.

Looking ahead, though, it's possible a global economic slowdown could begin to impact more of the companies that produce materials such as steel, metals, chemicals, or coal. For example, in China, where strong incremental demand has driven prices for many materials higher over the past several years, we saw that passenger-vehicle sales began slowing in April and actually fell year-over-year in August, according to the China Association of Automobile Manufacturers. We've also seen spot prices for many commodities fall in recent weeks--prices for copper, lead, zinc, and nickel have all decreased dramatically from the highs reached earlier this year. Meanwhile, we expect many producers' input costs to continue increasing, which will likely squeeze margins in the coming quarters. Although higher energy prices have recently abated, producers can still expect to spend more than they did in the past on electricity, transportation, raw materials, oil-based feedstocks, and wages.

Two factors could damp the impact of economic weakness for commodities producers, and we'll keep our eye on these dynamics in the coming quarters. First, a confluence of weaker near-term commodity prices, equipment delays, infrastructure issues, and possible financing concerns could delay or table capacity expansion projects. As a result, future commodity supplies could fall short of expectations, which should serve to bolster prices. Second, successful consolidation in industries such as paper and steel could give producers more pricing power in a downturn. We'll watch for signs that consolidation in these industries is affording producers greater pricing power than in past economic downturns.

Valuations by Industry
As of Sept. 18, 2008, we have a handful of 5-star gold miners including  Barrick Gold (ABX),  Anglogold Ashanti (AU), and  Gold Fields (GFI), although we continue to emphasize that individual gold miners' shares provide exposure not only to gold prices, but also to other uncertainties such as geopolitical risks, exchange-rate risks, and operational risks. Gold exchange-traded funds or gold mutual funds provide more diversification to blunt these risks. At the other end of the valuation spectrum, chemicals companies such as  DuPont (DD) look the most fairly valued.

Basic Materials Stocks for Your Radar
We've picked five stocks from our coverage list to keep on your radar. Three of our picks have exposure to agricultural:  Compass Minerals (CMP),  Monsanto Company (MON), and  Potash Corporation of Saskatchewan (POT). We are also highlighting coal miner  Peabody Energy (BTU) and  Freeport-McMoRan Copper & Gold (FCX).

 Stocks to Watch--Basic Materials
Company Star Rating Fair Value Estimate Economic
Moat
Fair Value Uncertainty

Consider Buying at

Compass Minerals  $83.00 Wide Medium $62.30
Freeport-McMoRan $129.00 Narrow High $83.90
Monsanto Company $145.00 Wide Medium $108.80
Peabody Energy $74.00 Narrow High $48.10
Potash Corporation $210.00 Wide High $136.50
Data as of 09-18-08.

 Compass Minerals (CMP)
Compass Minerals is a wide-moat producer of highway deicing salt and sulfate of potash specialty fertilizer and has unique, world-class, low-cost resources. We think the current stock price discounts the lower end of likely outcomes for long-term specialty fertilizer profitability (holding all other factors constant). Based on our calculations, a stock price of around $50 probably assumes sulfate of potash prices of roughly $250 (without shipping), versus current list prices of $1,000 per ton and realizations above $250 since the fourth quarter of 2006. In contrast, we think many powerful trends should support higher long-term prices and profitability, such as declining arable land per person, changing diets, and biofuel production. On the highway deicing salt side, we think the fundamentals are strong and getting stronger. Supplies in the Great Lakes region are tight assuming normal winter weather, and Compass is a dominant player able to expand low-cost production capacity. Shorter term, we're seeing anecdotal stories that municipalities are short salt for the coming winter, and with a scarcity premium, salt could change hands at three times Compass' average contracted price.

 Freeport-McMoRan Copper & Gold (FCX)
Freeport's stock price has fallen precipitously over the past few weeks in response to a decline in gold and copper prices, bombings at the company's Indonesian operation, as well as concerns surrounding its ownership stake in its Tenke Fungurume project. Despite these short-term challenges, we believe Freeport's long-term story remains strong. It operates mines that produce more copper and molybdenum than any other publicly traded company in the world. In particular, Freeport's Indonesian mine, Grasberg, boasts the longest reserve life of currently operating copper mines, in addition to one of the lowest operating costs. These low operating costs have allowed the company to average 20% returns on invested capital the past seven years, which include periods of copper prices below $1. Furthermore, copper has one of the most compelling supply-side dynamics of the commodities we cover. Among the positive fundamentals for the copper market are the absence of new projects, continued supply constraints, and urbanization in China and other developing economies.

 Monsanto Company (MON)
Monsanto is a wide-moat producer of agricultural seed and associated biotechnology traits. We think that the market is overestimating the effects that falling commodity grain prices could have on the firm. We believe that Monsanto's entrenched position at step one in the global food chain along with the incremental value its products create for growers through reducing their input costs and boosting their yields will ultimately serve to preserve the firm's pricing power--even in the face of falling grain prices.

 Peabody Energy (BTU)
Peabody Energy is the largest private sector coal miner in the world, possessing a gargantuan reserve base and some of the best coal assets in the U.S. Its Wyoming Powder River Basin mines, in particular, have some of the lowest marginal costs in the world, and are greatly benefiting from record global pricing. As coal prices retreated with the broader energy market, Peabody shares have been badly bruised. We think our consider buying price discounts the lower range of possible future outcomes. Further, Peabody's advantageous position on the cost curve should help insulate the company in a downturn. As many of Peabody's legacy contracts are in the process of repricing, we think earnings will surge for the next two years. Given our knowledge of its contract positions, we think the company is trading about 5.5 times EV/2009 EBITDA, and as contracts finish repricing in 2010, that year's earnings should be even brighter.

 Potash Corporation of Saskatchewan (POT)
With control of 22% of global capacity, Potash Corp. is the world's largest potash producer. The potash market enjoys high barriers to entry, as economically recoverable potash reserves are scarce and greenfield expansion requires substantial time, and physical and financial resources. As demand for potash grows over the coming years--primarily on the back of increased potash use in less mature nutrient markets--Potash Corp. is poised to supply the majority of the world's growing needs by bringing idle capacity online and investing in low-cost brownfield expansion projects.

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Elizabeth Collins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.