The Imperial strikes back

Investors in chemicals and paints business, Imperial Chemical Industries (ICI), have endured a rollercoaster ride in the recent years. In 2002 the company was forced into a £800 million rights issue at 180p in order to reduce debt levels. The shares subsequently reached a low of 82p in March 2003 after the company announced a severe profit warning due to raw materials cost pressures and customer service problems at food and fragrances unit Quest. The shares have since recovered although the market remains somewhat concerned that the high price of oil (a significant component of raw materials costs) will weigh on earnings.

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"ICI's balance sheet is becoming increasingly more robust, and we are confident that margins can be maintained as increases in raw materials costs are passed on to customers. "

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However we believe that ICI may well have 'turned a corner' and we are encouraged by the most recent quarterly result. We believe that the company is emerging from a period of rationalisation as a much leaner and more efficient business. ICI's balance sheet is becoming increasingly more robust, and we are confident that margins can be maintained as increases in raw materials costs are passed on to customers.

ICI was formed in 1926 through a merger of the four largest chemical companies in the UK at the time. More recently, the company has increasingly sought to concentrate on chemicals and paints, and in 1993 demerged the bioscience business (now AstraZeneca). ICI's transformation from a bulk chemical producer to a speciality products and paints leader was accelerated in 1997 with the £4.9 billion purchase of four Unilever businesses (National Starch and Chemical, Quest, Unichema, and Crosfield). In the last five years the management has signalled an intention to insulate the business from cyclical shocks further, by selling the bulk chemical operations.

ICI's international division is comprised of National Starch, Paints, Quest, and Uniqema. The biggest contributors to total group turnover are the Paints and Starch businesses at around 40 and 33 percent respectively. ICI's other division is a minor regional and industrial business which serves local markets in India, Pakistan and Argentina.

Less than a decade ago, ICI was a market favourite, trading at an all time high of 1034p in May 1998. However in our experience the time to be most cautious is when investor optimism is at its highest. In the case of ICI, a healthy degree of caution proved well warranted as the company battled an economic downturn that cut demand, as well as operational issues at key businesses. ICI's troubles culminated in a profit warning last year and the sacking of then Chief Executive, Brendan O'Neill.

From the 1998 record high, a protracted bear market saw ICI's valuation decline by more than 90 percent. However just as investors were overly optimistic at the highs, we believe they have become excessively negative now that the stock is trading at historically low levels.

We were heartened by the company's recent third quarter results with trading profit rising 8 percent on last year to £138 million, on sales of £1,439 million. We regard this performance as particularly resilient, given current raw materials costs pressures (petro-chemicals account for around one third of ICI's inputs). Earnings were boosted by strong underlying sales growth and benefits from restructuring with pre- tax profit before exceptions rising 11 percent to £117 million.

Core sales growth was driven by the group's international businesses in both Asia and Latin America, where comparable sales increased 18 and 17 percent respectively. Growth in the US and Europe was more modest at 4 and 3 percent respectively.

ICI paints continues to benefit from a leading position in many countries, with strong brands such as 'Dulux' in the UK and 'Glidden' in North America. Underlying sales grew 6 percent with the UK particularly robust. Reported trading profit grew 3 percent to £71 million.

National Starch has an immense product range across markets as diverse as food, healthcare, automotive and construction. The business delivered a stellar performance with 10 percent comparable sales growth for the quarter. Most notably the Adhesives division (of which ICI is one of the world's largest producers) exhibited double-digit sales growth. Reported trading profit grew 4 percent to £54 million. We were highly encouraged that more than 60 percent of petrochemical cost increases were offset by price rises. We believe this bodes well for ICI's ability to pass on further cost increases.

We are heartened by the improvements at Quest following the divestment of the food ingredients business earlier this year. Underlying sales increased 6 percent with gross margins particularly robust. Uniqema, which provides customised chemicals to variety of industries, also experienced a solid quarter with underlying sales increasing 3 percent. The group's regional and industrial business is also on the mend, paring trading losses to £4 million from £7 million last year.

The solid operating result also boosted ICI's cash flow performance, with inflows of £101 million before financing, a £37 million increase on last year. In addition to an improved trading performance, liquidity was also boosted by select divestitures. Robust cash flows have allowed ICI to markedly increase balance sheet strength, with net debt falling 49 percent on last year to £1,105 million. Interest cover is now extremely solid at around 6.3 times.

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"Robust cash flows have allowed ICI to markedly increase balance sheet strength, with net debt falling 49 percent on last year to £1,105 million."

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The balance sheet is set to strengthen further as the company continues to pursue a strategy of select disposals where it believes growth opportunities are more limited. Recently the company sold the Vinamul Polymers business of its National starch unit, netting around £85 million.

We are heartened by management comments that the overall sales outlook remains strong despite some signs of lower growth in electronics and reduced demand for paint in North America. In our opinion the main challenge facing the company is the ability to pass on raw materials cost increases to customers.

In our opinion, the extent to which ICI has already successfully increased prices bodes well for the future. The company has raised prices by up to 15 percent in the National Starch adhesives and polymers operation. Significantly ICI has also begun to raise prices in paints in the last quarter. ICI has been successful in raising prices in Asia/Latin America. We are confident that the quality and strength of core brands will facilitate necessary price rises in Europe and North America in 2005.

We are also pleased that the company's restructuring programme is progressing steadily under new CEO John McAdam. ICI has already realised £45 million of cost savings this year through plant closures and staff reductions, and is on track to achieve a further £35 million in the fourth quarter.

From a charting perspective ICI has recovered some of the ground lost since reaching a low of 82p in March 2003. With a solid base now established, we believe that an enduring recovery is underway. This view is supported by the recent breakout from a 'triangle' trading range that had originated in February. Triangles are common chart patterns that often form during a pause in an upward trend. In the case of ICI, the upward break suggests the recovery has regained momentum and that higher levels are likely.

In our opinion ICI is firmly in recovery mode, and we regard the current valuation fundamentals as compelling, with the shares trading on a 2004 price earnings multiple of 11 times and yielding 3 percent. Accordingly, Fat Prophets recommend ICI to all Members as a buy up to 237p. An initial target is resistance around 270p, however in time we believe higher levels are achievable.