Shares of Dow Chemical (DOW) ended the week with losses of nearly 3% after the company reported a soft third quarter earnings report.
Despite the transformation efforts, the current valuation remains too rich to my opinion, especially when taking the rather high net debt position into account.
Third Quarter Results
Dow Chemical generated third quarter revenues of $13.73 billion, up 0.7% on the year before. Revenues fell short compared to consensus estimates of $13.99 billion.
Net earnings rose by 19.5% to $594 million. GAAP earnings per share rose by seven cents to $0.49 per share. Adjusted earnings came in a penny higher, but missed consensus estimates of $0.54 per share.
CEO and Chairman Andrew Liveris, commented on the third quarter performance, "Dow continued to demonstrate positive momentum with our drive to execute self-help measures in a slow-growth world, achieving strong cash flow, as well as year-over-year earnings growth for the fourth consecutive quarter."
Looking Into The Results
Reported sales growth came in at just 0.7% as adjusted sales rose by a rounded 2%. Growth was driven by prices which were up by 3% across the board as volumes fell by 2%.
Notably Coating and Infrastructure Solutions, Agricultural Sciences and the Performance Plastics unit performed solid. This was offset by weakness in the Performance Materials, and Feedstock and Energy business.
In terms of profitability, the Performance Plastics unit had a very strong quarter, offset by lower earnings at the Performance Materials unit.
In terms of performance across the globe it were the Latin American and North American businesses performing well, offset by weakness in Europe, Middle-East, Africa and the Asia-Pacific region.
Dow ended the third quarter with $5.27 billion in cash, equivalents and short term investments. The company operates with $18.62 billion in total debt, for a net debt position of around $13.35 billion.
Revenues for the first nine months of the year came in at $42.69 billion, down 0.4% on the year before. Net income rose by 123% to $3.48 billion, aided by a $2.16 billion pre-tax gain awarded in the K-Dow arbitration proceeding. At this pace annual revenues are seen around $56-$57 billion as earnings excluding one-time charges could come in around $2 billion.
Trading around $39.50 per share, the market values Dow Chemical at $47.8 billion. This values the equity in the firm at 0.85 times annual revenues and about 24 times adjusted earnings.
Dow Chemical currently pays a quarterly dividend of $0.32 per share, for an annual dividend yield of 3.2%.
Some Historical Perspective
Over the past decade investors in Dow Chemical have seen nothing but stagnation, although they have seen their dividend income over the time period. Shares traded around $40 in 2004, peaking at $55 a year later. Shares fell to lows around $7 in 2009 to recover to current levels at $40 per share.
Between 2009 and 2012, Dow Chemical has increased its annual revenues by a cumulative 26% to $56.8 billion. The shareholder base of Dow Chemical has increased by a cumulative 15% over the past four years.
Dow Chemical has quite diverse operations, yet commodity and price swings at its major units still result in large fluctuations in quarterly earnings.
As such, the company has upped its divestment plans, aiming to sell $3 to $4 billion worth of assets within two year's time. Earlier this month, Dow Chemical divested its global Polypropylene Licensing & Catalysts business to W.R. Grace (GRA) for $500 million.
Dow is the largest chlorine producer of the globe, and is now aiming to sell many of its assets which use chlorine as raw material. Dow believes focused owners can extract maximum value of some of its chlorine assets, including epoxy resins chlorinated organics, among others. If no sales for the epoxy unit materializes, Dow aims to cut some $100 million in costs within the unit.
The freed up capital will partially be used to invest up to $4 billion in ethylene and propylene plants in the US Gulf Coast, taking advantage of cheap natural gas. The company also has a major joint venture with Saudi Arabian Oil, starting production at its $19.3 billion complex in Saudi Arabia in the second half of 2015.
The continued divestments will be used to please shareholders through dividends, regular capital expenditures and to reduce the net debt position which is still quite sizable.
As such Dow Chemical is trying to gradually transform the business into higher margins operations which display less volatile earnings in the short term. The focus on Dow will be on electronics, packaging and agriculture going forwards, as well as the performance plastics business. Te company continues to focus on the return on capital, through its entire portfolio of assets, taking actions to liberate cash, operate with an optimal capital structure, and focus on shareholder value creation after investors have seen lackluster returns over the past decade.
I remain quite bearish on Dow Chemical. While the transformation makes sense, the current valuation is already quite high compared to adjusted earnings. With a focus on debt reduction, shareholders have little to look forward to besides the relative rich dividend yield of 3.2%, as prospects for capital gains are not great in my opinion.
I remain on the sidelines.