Warren Buffett and Dow Chemical's (DOW) recent buyout of Rohm & Hass (ROH) was a game-changer in the chemical sector. The deal, which valued Rohm & Hass with a current EV/EBITDA of around 16, is nearly twice as high as the average EV/EBITDA of the sector, showing that Buffett and Dow Chemical are convinced that value for the sector is a whole lot higher.

That said, the chemical sector as a whole was hit extremely hard as input costs (mostly oil, natural gas and coal) ramped to all-time highs last month, forcing investors to dump their stock amidst fears of substantially weaker profit margins. It is natural to assume, then, that as commodity prices have their biggest monthly decline in almost 30 years, investors have already started flocking back to the sector -- but they haven't. And here is why they should.

Our favorite name in the space is Eastman Chemical (EMN), which is currently $4 off its 52-week low, trading with a forward P/E of 11, a PEG ratio of 1.8 and EV/EBITDA of 5.9.

Eastman recently said that it expects earnings to more than double in the next five years, going from roughly EPS of $5 to $6 in 2008 to a whopping $10 to $11 in 2012. The company should see higher margins this quarter as input costs tank. Operating margins went from 4% in 2003 to north of 12% in the first quarter of 2008, with operating earnings going from $205 million in 2003 to $700 million in 2007, showing management's ability to increase the profitability of the company amidst rising input costs.

Eastman's management sets this $10 to $11 goal with the following equation: $5 2008 projected EPS + $3 growth initiatives in existing businesses + $2 industrial gasification = $10 EPS by 2012. If that's true, Eastman should trade north of $110 by 2012.

Another name we like in the space is Huntsman (HUN), which is in the middle of a nasty $3 billion lawsuit against private-equity firm Apollo, as well as its founder, Leon Black. Huntsman agreed last year to be purchased by an Apollo subsidiary for $28 a share, and Apollo recently invoked an "adverse change" clause and walked away from the deal, thus creating a nasty lawsuit.

Huntsman currently trades with a forward P/E of 15 and an EV/EBITDA of 9.1.

Last quarter, Huntsman's revenue rose to $2.9 billion from $2.47 billion during the year-ago period, helped by higher selling costs. Revenue from the company's polyurethane segment increased to $1.16 billion from $1.01 billion during the second quarter last year. Materials and effects revenue increased to $688.8 million from $621.5 million.

Performance products revenue jumped to 725.1 million from $548.4 million, while pigments revenue increased to $320.7 million from $293.2 million

Of course, you can always play the safest name in the chemical space, which is Dow Chemical. The largest chemical producer in the world trades with a forward P/E of 12.01, a PEG ratio of 2.22 and EV/EBITDA of 6.807. The company also sports a huge dividend of 4.9%.

As commodities prices pull back, chemical companies should see increased margins and profitability due to lower input costs.

It's time to consider these names.

Posted on Sept. 8, 2008