TWST: Please begin by telling us about the way that you look at this very heterogeneous group. What approach do you take to the specialty chemicals?

Mr. Begleiter: There are a few key framework considerations I try to apply. First, I look for hard-to-replicate franchises, companies with a real competitive advantage in technology, distribution and product breadth. I want to own companies that are number one or two in their marketplaces. Specialty chemicals is a technology industry, and innovation sells. Innovation is the only way for a company to get higher prices and to increase its market share. I want companies with technology and a great global franchise.

TWST: What's an example of one that meets those criteria?

Mr. Begleiter: W.R. Grace (GRA) is the leading supplier of refinery catalysts in the world. Grace operates in a business (catalysts) with high barriers to entry and good global growth characteristics. Grace's franchise is unique with a great deal of technology and knowledge embedded in its products.

TWST: What else goes into your approach?

Mr. Begleiter: Value creation is a critical element in our work. Earnings growth is important, but only in the context of how much capital is required to generate that growth. Beyond having a great franchise and great technology, companies need to focus, because of the difficult top-line fundamentals in the industry, on costs and being disciplined in their capital allocation. These variables funnel into my return-on-capital analysis, which we believe is the key metric to look at in this sector. Investors do pay for return on capital, and that's what the correlations prove. Value creation should be the ultimate goal of any management team.

TWST: What do higher interest rates mean for this group?

Mr. Begleiter: No question ,this is an industrial-sensitive group. Any slowdown in economic activity from interest rate changes will have an impact on this group. Debt is not a large issue here. In terms of fixed or floating rates, it's not a huge impact.

TWST: Interest rate increases would then affect the customer rather than the specialty chemicals company.

Mr. Begleiter: Yes, it will have a minor impact on earnings.

TWST: David, for the most part, does each of these companies march to its own drummer, or are there some overriding themes or trends that you can apply to the group as a whole or to segments within the group?

Mr. Begleiter: This is a very heterogeneous group, and it's hard to make macro calls. Many of these companies are mini-conglomerates, with a wide range of technology, applications and end markets. The framework we have developed enables investors to intelligently invest in this sector by focusing on global franchises with leading technologies, product breadth and cost-and-capital controls. That's the framework I try to apply to this essentially industrial group.

TWST: What do you see for the end markets that many of these companies in your universe target? Which will be the strongest in 2000, 2001?

Mr. Begleiter: First by region: Asia is recovering from its problems of 1998 and early 1999; Europe, as well, is beginning to show some strength; North America continues to have solid growth rates, although the expectation is that it will slow down; Latin America is still difficult. On an end-market basis, housing and automotive, which have been key drivers in the US, continue at very strong rates. But the expectation is that they will slow down later in the year. Polymer additives, fine chemicals, electronic chemicals are the fastest-growing sectors in specialty chemicals, due to the good growth characteristics of their end markets those being plastics, electronics and pharmaceuticals.

TWST: Have raw material costs stabilized, or perhaps even embarked on a downward trend?

Mr. Begleiter: They will shortly. As crude rolls over, it will have an impact throughout the supply chain. The Q1 earnings period will be difficult for these companies because they have not been able to fully implement price increases to offset higher raw materials costs. Typically, there is a one to two quarter lag between the start of raw material cost increases and the implementation of price increases by the companies. Longer term, raw materials do not impact the overall health or the investment trends of the sector. Customers are willing to accept the pass-through of higher raw material costs. They also expect and demand that when these costs do roll over, companies lower their prices accordingly. So while there is margin expansion when raw materials weaken, typically it lasts for only a quarter or two.

TWST: Beyond pricing related to raw-material costs, how successful have these companies been in raising their prices?

Mr. Begleiter: Pricing is in a deflationary environment, and that should continue, going forward. I do not believe you will see positive pricing in the absence of visible raw materials increases. The power has shifted to the customer. Customers are larger, more global, and they want to be served by similar type companies. That said, they will give these large, global suppliers more business, but at lower price points. On the flip side, the smaller competitors that supply these larger global customers can't compete with the product breadth, technology or the global capabilities of their larger competitors, and they are fighting back with the only weapon available to them, which is pricing. So you have price pressure from the weaker competitors as well as pricing pressure from large global customers. The result is that price pressures, in the absence of sharp increases in raw materials, will continue on an annual basis.

TWST: How do you see e-commerce playing out for the specialty chemical companies?

Mr. Begleiter: There will be some supply-chain savings through the use of e-commerce initiatives, but there's also pressure on pricing from exchanges as well as online competitors, from the laboratory chemical area, like SciQuest (SQST), to new entrants in water chemicals. So net net, I look at e-commerce as being flat to slightly negative for pricing in the sector.

TWST: And yet do the companies have to be in it if they're going to survive?

Mr. Begleiter: No question. Customers are demanding it, and you need to have an online presence to be a viable supplier long term. It's clearly a cost of doing business.

TWST: David, as I understand it, for the most part, these stocks have not rewarded investors well over the past couple of years. Are there any signs that 2000 could shape up to be a better year?

Mr. Begleiter: Yes, there are. These companies are at historical low valuations on a relative basis (relative to traditional p/e multiples) and are well below their intrinsic value as calculated by a discounted cash flow analysis. We're going to see low double-digit earnings in this sector in 2000 and 2001. We believe the combination of low valuations and improved earnings will result in share price outperformance in 2000.

TWST: Is this a good time to put money into the stocks?

Mr. Begleiter: I think you still need to be selective here. It's still a stock-picking sector. Overall, I would say this is as attractive an investment environment as we've seen in three-plus years for the sector.

TWST: What are you saying to investors? Which are the stocks that investors should be buyers of today?

Mr. Begleiter: My top pick is Cytec (CYT). They are benefiting from an improved outlook in aerospace markets. They are a leading supplier of advanced materials to Boeing (BA), Airbus and the military. They are seeing strong demand in specialty chemicals along with improved pricing, and they are seeing an improvement in their commodity chemicals business, which is bouncing off a trough. They have extremely strong cash flows and a focused management team that is streamlining the portfolio. They're in the process of divesting two of their weaker divisions, Criterion Catalysts and paper chemicals. There is substantial upside to consensus estimates of $2.85 for 2000 and $3.15 in 2001, and I think there is at least $0.10 of upside to 2000 estimates, and $0.15- $0.25 upside to 2001 estimates, both driven by improved demand from the aerospace industry.

TWST: Is there any risk that they may be too closely tied to the aerospace cycle? What happens in a down cycle for aerospace?

Mr. Begleiter: No question, that's one of the issues that has impacted the stock as Cytec's top-line sales in their aerospace business declined 10% last year. Despite that, aerospace operating profits increased 6% due to plant closures and improved efficiencies. No question, the aerospace cycle is cyclical. That said, Cytec is reducing the cyclicality of that impact by greater growth into the regional and corporate jet market, which is somewhat less cyclical, as well as increased supply into the military segment, which is picking up as we speak, particularly the F-22 program. So we have hit the trough in the aerospace cycle. Cytec is a year ahead of commercial aircraft build rates, so the big decline, the 22% decline you're seeing this year in Boeing build rates, was reflected in Cytec's sales last year.

TWST: David, what's the time frame an investor should have in mind if he or she were to buy Cytec today?

Mr. Begleiter: I think you're going to have a very strong second-half earnings year in 2000, so I would be positioned in the stock before heading into the summer. This stock was one of the real success stories in the group in mid-1990s, rising from $4 to $58 between 1993 and 1998. It peaked in April 1998 at $58. It was $15 five months later, due to a slowdown at Boeing. I think the stock has the potential to generate $4 in earnings in 2002, and it could easily double from current levels over the next two to three years.

TWST: So it sounds as if this is a stock to buy and hold for a few years?

Mr. Begleiter: Exactly. Last year, essentially two of the three businesses were in a cyclical trough. I'm expecting all three business segments specialty chemicals, special materials and building blocks to have positive years this year and even stronger ones next year.

TWST: What's your next pick?

Mr. Begleiter: W.R. Grace again, the premier catalyst supplier in the world. They have beaten earnings expectations for seven straight quarters. We are heading into a refining cycle that has the best fundamentals of the past three-plus years. This company is likely to beat earnings again over the next three quarters, going forward. That said, it's one of the cheapest stocks in the group at 4 times cash flow, due to concerns over the company's asbestos liability. This liability has a net present value of approximately $350 million, which, relative to the size of the market cap (under $1 billion), is relatively large. That said, the liability is very well managed; it's fully reserved for, and the annual cash flow of $50 million that the liability entails is supported by cash flows from operations of $200 million. So there's plenty of cash to fund the cash outflow of the liability. Investors have been unwilling to give this company credit, given the concerns over asbestos. Management has stated that they have considered an LBO, that if the public market is unable to fully recognize the value, given this liability, the management team is prepared to give investors liquidity and take the company private. Grace has just unveiled a new, more aggressive strategy for dealing with investors in terms of asbestos, in terms of explaining the liability, quantifying it for people and discussing how it's funded. If this more aggressive asbestos strategy, combined with what should be excellent results over the next two or three quarters as Grace benefits from a very strong refining cycle, isn't enough to raise the stock into the mid-to-high teens, where it would at a minimum belong, given relative peer-group valuations I think, come year-end, the company would seriously explore the option of taking the company private. At $12.5 today, the stock, at peer-group multiples, should be $18-$19 a share; a private take-out value would be in the low $20s. So I think either way you're going to see a stock price approaching $20 a share by year end by organic or inorganic means.

TWST: How much of a pure specialty chemicals company is W.R. Grace these days? Has it divested all the other businesses?

Mr. Begleiter: It has. It's really about $1.5 billion in sales today, and all that's left is their catalyst business. They are a leading supplier of construction chemicals. Also, they are the world's largest supplier of container sealants and coatings. So it's now a pure-play specialty chemical company with what I think is one of the highest- quality asset portfolios in the industry.

TWST: And what's your third choice?

Mr. Begleiter: My third choice? H.B. Fuller (FULL). It's the second- largest industrial adhesives maker in the world, behind National Starch and ahead of Henkel (HENKY). They have gone through a massive restructuring of the company: they closed a quarter of the production plants, removed a lot of the inefficiencies from the infrastructure. As a result, earnings have gone from $2.80 in 1998 to close to $4.85-$4.90 this year. What the company lacks is top-line growth and again, that's the result of their walking away from some low-margin business as well as their exposure to Latin America, which has obviously been negative, due to the weakness down there. Plus, there's the weakness in the euro, down 15% year over year, and that's hiding some of the organic growth they're achieving. Adhesives are growing 2-2.5% globally on a volume basis. Fuller should grow two to three times that. So again, there are a lot of competitors out there, and in the adhesives business, only two or three have the global scale, the technology and the product breadth that an H.B. Fuller does. And increasingly their suppliers, like GM (GM), like International Paper (IP), are global, and they want to be supplied by the people with the best technology and the broadest possible product lines. So I suspect Fuller will be gaining share at the expense of smaller regional competitors. They're building a great deal of operating leverage into their infrastructure through this really massive restructuring, and they have very high income at the margins and additional dollars of business. So I expect we'll see top-line growth reappear in the second half of the year, and that could result in earnings upside for both this year and next. At current levels, it's less than 8 times current year earnings, which is extremely inexpensive. And it has a management team that's proven its ability to dramatically restructure. The goal and the challenge is top-line growth, and I think they can meet that challenge.

TWST: What are some of the more successful strategies that managements have been deploying to enhance shareholder value?

Mr. Begleiter: An enhanced focus on R&D. I believe lack of innovation has been one of the key problems in this sector. For the most part, these companies are excellent technologists but poor marketers, and the ability to meld marketing with R&D to ensure that a product has a customer on day-one, as opposed to day-180, is the key here. Innovation? You know, a lot of guys discover compounds in labs, but how many can meld this into a vital business strategy? So companies that are focusing on innovation and product commercialization are the ones that will be successful long term as well as those that have a disciplined approach to capital. Again, capital allocation has been an issue in this sector. Companies have spent too much money. They have not managed their working capital nearly aggressively enough, and they have not run their assets hard enough overall.

TWST: Are there any managements that you would highlight that are setting the bar for the rest of the industry?

Mr. Begleiter: I think the three companies I mentioned, for those reasons Grace in particular I think, has a phenomenal management team led by Paul Norris, who came from AlliedSignal. And I think David Lilley, as well, is one of the premier managers in the sector, the manager of Cytec. And Al Stroucken has proven he can run a business very efficiently; now he has to prove that he can grow it.

TWST: What are the characteristics of the companies that you would stay away from, avoid, de-emphasize, whatever euphemism you prefer?

Mr. Begleiter: Companies with more commodity-ish product lines that are selling less on technology and are more supply/demand related in pricing. Some of the flame-retardant producers like Great Lakes (GLK) and Albemarle (ALB) have a good portion of their product lines in those types of products, although they are making a great effort to move away from the pure commodity products and head more toward the specialty area. That's a battle they need to win.

TWST: Isn't there a new CEO at Great Lakes?

Mr. Begleiter: Well, he's been there about a year and half right now, Mark Bulriss.

TWST: How is that working out?

Mr. Begleiter: I think it's very positive for the company, I think he's done an excellent job there. Results have not been proven yet due to some very aggressive pricing in flame retardants, which goes to the fact that it's primarily a commodity business. He's cut costs, he's focused on innovation, he's looking at more high-growth specialty businesses. But he's had a severe headwind from some real pressure in his commodity business.

TWST: Thank you.

Note: Opinions and recommendations are as of 4/14/00.

DAVID BEGLEITER Credit Suisse First Boston 11 Madison Avenue New York, NY 10010-3629 (212) 325-2000

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