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Introduction

Dow Chemical (NYSE:DOW) provides chemical products to be used as raw materials to customers in approximately 160 different countries worldwide. We suggest buying the stock below $20 and selling the stock over $28. With the current stock price around $30 this puts DOW at a "Sell." In this article we will look at how our price target analysis forecasts DOW's future growth and revenue, we will consider DOW's P/E in order to determine its current and future valuation, and we will also explore DOW's role in the natural gas market, a role that could be very crucial for the company's overall growth. We will show you how all these elements work together to validate our "Sell" rating.

Profile

The Dow Chemical Company manufactures and supplies raw material chemical products in the US and around the world. DOW is comprised of a number of segments. The Electronic and Functional Materials segment produces materials for mechanical planarization and materials for industrial applications. The Coatings and Infrastructure Solutions segment provides construction chemical solutions like insulation, house wrap, sealants, adhesive products and systems, as well as building and purification and separation technologies. The Agricultural Sciences segment offers crop protection and plant biotechnology products alongside urban pest management solutions. The Performance Materials segment produces materials for automotive systems, formulated systems, and oil and gas industrial applications. The Performance Plastics segment offers wire and cable insulation, semiconductive and jacketing compound solutions, and bio-based plasticizers. Lastly the Feedstocks and Energy segment provides raw material chemicals like ethylene and chlorine. DOW was founded in 1897 and holds its headquarters in Midland, MI.

Thesis

Valuation -

DOW is currently valued with a 44.1 P/E and a 10.6 future P/E. Compared to the industry average, 25.7, DOW is valued high for the market. A drop in P/E suggests the company will grow and increase earnings. If this is the case, what justifies our "Sell" rating?

DOW experienced a 1% decrease in fourth quarter sales for 2012 YoY. During this same time period DOW reported a loss of $0.61 per share, or an adjusted earnings of $0.33 in 2012 compared to a loss of $0.02, or an adjusted earnings of $0.25 per share in 2011. The most successful segment was Agricultural Sciences with increases in Electronic and Functional Materials, Performance Plastics, and Coatings and Infrastructure Solutions. These increases were counteracted by declines in Feedstocks and Energy as well as Performance Materials. DOW's competitor, Celanese Corporation (NYSE:CE), reported a 7% decrease in sales YoY for the fourth quarter. During this same time period CE's EPS increased from $0.58 to $0.67, an increase of 15.5%. Albemarle (NYSE:ALB) another market competitor to DOW reported a 2.7% decrease in sales during quarter four YoY. ALB also saw a decrease in EPS from $1.12 in 2011 to $0.75 in 2012, a decrease of 33%. Across the market chemical companies have seen decreases in earnings and revenue. DOW is among these companies with lowered sales and EPS. Chairman and CEO commented on DOW's outlook stating, "…we have deployed $2.5 billion of cost reductions and cash flow improvements, and are aggressively managing our portfolio-by prioritizing our growth programs and driving selective, non-core divestitures." The company is dedicating its efforts to better managing its finances in order to spur growth in the coming year.

Other key metrics to look at are ROE, ROA, and ROIC. These ratios standardize figures in order to provide a better comparison between companies of different sizes and types. DOW ended the fiscal year with ROE at 4.8%, ROA at 1.2%, and ROIC at 0.01%. CE reports ROE at 39.4%, ROA at 6.9%, and ROIC at 9.4%. Finally ALB ended the year with ROE at 18.2%, ROA at 9.4%, and ROIC at 11.7%. DOW definitely stands at the bottom of the comparison in terms of key ratios with barely any returns at all for the company. The future fiscal year points to better metrics and growth for DOW but the amount of opportunity does not match the current P/E at over 40. We see this company as overvalued without a justified amount of growth forecasted for the future fiscal year, again confirming our "Sell" rating.

Catalyst -

In their fourth quarter earnings report DOW also spoke about what they believe will influence their value in the new fiscal year in stating, "We have the right catalysts firmly in place. Our feedstock advantage, particularly as the ethylene cycle unfolds, and the commercialization of our technology pipeline, as well as our integration investments in the U.S. Gulf Coast and Sadara as a whole differentiate Dow, and will continue to propel our strategy to deliver higher earnings growth and increasingly reward shareholders." One of these initiatives that DOW refers to in its statement is a plan to build several new specialty material production units aligned to its high value Performance franchise on the Gulf Coast. This will take advantage of the increasing supplies of shale gas in North America and deepening DOW's presence in the market all while creating thousands of jobs. This individualized plan is all part of DOW's Front End Engineering and Design (OTC:FEED) phase that will be completed in 2014. While DOW has announced this project on the Gulf Coast, this larger FEED phase will take place in North and South America, and DOW is currently in the process of investigating and finalizing other investment locations. Overall the company is investing a large amount of resources in natural gas given the current notion that the world's dependence on oil is near and that natural gas is expected to be the next big energy source. While DOW could see huge revenues from what some are predicting as the natural gas "renaissance" for domestic manufacturers there are also very high marginal costs for production, something that may balance out their high revenue.

Economic Moat -

DOW is a highly diversified company that has the advantage of offering many different products to their customers in many different sectors. If one sector suffers there is always the hope that another sector will make up for these weaknesses. DOW also boasts customers in approximately 160 countries worldwide. This large customer base also gives them a certain amount of security, though both of these aspects do not constitute a strong economic moat. In contrast to these strong points for DOW this company has big competition to deal with domestically and abroad. US and Russia have been identified as the two countries with the largest reserves of natural gas. This being said the US has a huge amount of development to undergo before being named one of the natural gas powerhouses of the world. Presently Russia, Qatar, and Canada are the main producers. DOW's diversity and global presence are strengths of the company but overall we believe they have a fairly light economic moat.

Revenue and EPS Outlook -

Our price target analysis anticipates an 11.4% growth in revenue for 2013. Their current EPS, 0.70, is predicted to growth to 2.35 by December of 2013. Alongside these numbers we have to consider their current P/E, 44.1, and their future P/E, 10.6. DOW is overvalued and is predicted to drop significantly in the next year. In order for the company to instead reach a fair valued P/E, 20-25, their stock price will either have to rise to approximately $47 or EPS would have to decrease to around 0.64. Our price target analysis predicts that instead of increasing to such a high level the stock price will almost maintain itself around $32. This means that DOW's EPS would have to decrease instead of the increase we are anticipating. According to these figures we believe that DOW will underperform the market, justifying our "Sell" rating.

Price Target Analysis

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

4600

4830

4960

5300

5860

Taxes

1564

1642

1686

1802

1992

Depreciation

2940

3140

3260

3170

3200

Capital Expendit.

-2160

-2220

-2425

-2980

-3100

Working Capital

1080

1080

1080

1080

1080

Available Cash Flow

2736

3028

3029

2608

2888

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for DOW: 9.04%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9171

0.8411

0.7713

0.7074

*

PV of Available Cash Flow

2509

2547

2336

1845

*

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher P/E ratios. We will give you cap rate. Cap Rate for DOW: 2.45%

2016

Available Cash Flow

$2888

Divided by Cap Rate

2.45%

Residual Value

52123

Multiply by 2016 PV Factor

0.7074

PV of Residual Value

$36871

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

$9237

PV of Residual Value

$36871

Cash/Cash Equivalents

4318

Interest Bearing Debt

18554

Equity Value

71462

Step 5.

Divide equity value by shares outstanding:

Equity Value

71462

Shares Outstanding

650.79

Price Target

$28

Profit/Value Industry Comparisons

Profitability:

Q1-Q4 2012

Q1 - Q4 2011

Operating Margin

3.3%

6.7%

Gross Margin

15.8%

14.9%

Return on Equity

4.8%

13.3%

Comparing the full 2011 fiscal year to the full 2012 fiscal year DOW has seen a decrease in operating margin from 6.7% to 3.3%. Their gross margin increased from 14.9% to 15.8%, and their ROE decreased from 13.3% to 4.8%. Let's compare DOW's profitability ratios to competitors.

CE's operating margin decreased from 10.2% to 8.0%. Their gross margin decreased from 21.2% to 18.6%. Their ROE also decreased from 45.3% to 35.0%. ALB saw a decrease in all of its profitability margins. Their operating margin decreased from 20.5% to 14.8%. Their gross margin decreased from 34.1% to 33.1%, and their ROE decreased from 29.0% to 18.2%. E. I. du Pont de Nemours and Company (NYSE:DD) saw a decrease in operating margin from 11.1% to 8.8%, a decrease in gross margin from 28.2% to 27.5%, and a decrease in ROE from 39.4% to 30.1%. Lastly, Rockwood Holdings, Inc. (NYSE:ROC) saw a decrease in operating margin from 15.5% to 12.9%, a decrease in gross margin from 35.1% to 32.9%, and a decrease in ROE from 34.1% to 25.4%. Across the market we see decreased profitability margins. DOW has a comparatively low operating margin, their gross margin is fairly low as well, but their ROE is among the highest.

Value:

Current

Industry Average

P/E

44.1

25.7

Future P/E

10.6

N/A

As formerly discussed DOW has a 44.1 current P/E and a 10.6 future P/E. Compared to the industry average DOW is highly valued and is predicted to drop below a fair valued range.

CE has a current P/E of 11.3 and a future P/E of 8.6. ALB's current P/E is 17.8 and their future P/E is 10.8. DD's current P/E is 16.5 and their future P/E is 11.0. ROC has a current P/E of 12.5 and a future P/E of 12.3. This comparison confirms that DOW is high valued and also shows us that almost all of the companies in this market are predicted to drop in P/E to the 10-12 range.

Variant

What could go wrong in this argument? It is possible that DOW could see revenues from natural gas initiatives that raise the price of the stock in order to give the company a more fairly valued P/E, and overall affecting the value of the company. Although these initiatives connected to natural gas are very preliminary and there are a lot of steps before becoming an established natural gas provider, they could outperform market competitors.

The Bottom Line

Overall we see that DOW is an established and diverse company that serves customers around the world. They are currently highly valued and are predicted to drop drastically in valuation over the 2013 fiscal year. DOW is investing heavily in natural gas production, given the projected importance of this energy source in the future. DOW has a large amount of competition to work against, as well as a lot of work in establishing themselves as a natural gas powerhouse. Given these factors we believe that DOW will underperform the market and deserves a "Sell" rating.

Source: Dow Chemical - Sell It