This article focuses in at three drivers of corporate value at Dow Chemical (NYSE:DOW): revenue growth, profitability, and investment efficacy. Investors interested in a more in-depth of Dow are invited to download our recently-published 1% Focus Report on Dow (email sign up required).
Growth in the five-year rolling aggregate sales change (thick blue line) shows the ups and downs inherent in this business that is so tied to the larger business cycle. The past five years' revenue growth have been depressed in part due to continuing weakness in consumer end demand, but also due to divestitures the company has had to make to pay down debt incurred in the 2009 acquisition of specialty chemical firm, Rohm & Haas.
On conference calls, the management team talks about the higher growth potential of specialty chemicals, but our analysis suggests that most of the specialty business -- while growing faster than commodity chemicals -- is still not much of a growth story. The best hope Dow has for more rapid revenue growth comes from its Enlist product line of defoliant/defoliant resistant GMO seeds.
Dow's co-producer of the now-infamous defoliant Agent Orange, Monsanto (NYSE:MON), has transformed itself from a specialty chemical manufacturer into what might be called a biotechnology IP (intellectual property) firm.
At the core of its biotechnology juggernaut is a defoliant known commercially as "Round-Up" -- a bog standard agricultural chemical which, when sprayed on plants, blocks the plants' production of growth hormones, causing them to die.
This product would simply be another specialty chemical if it was not for parallel developments in genetic engineering. Monsanto's scientists realized that they could engineer the genetic material of certain important cash crops (soy, corn, and cotton in particular) so that the resulting seeds would be immune from the defoliant effect of Round-Up (these seeds are known as "Round-Up Ready").
Dow's Enlist product suite works in basically the same way as the Round-Up suite, but because it uses a different defoliant, will allow farmers to kill weeds that have evolved a natural resistance to Round-Up.
However, just because Dow has a product to compete against Monsanto's does not necessarily mean that it will succeed commercially. Monsanto has an almost monopolistic hold on the market for genetically modified seed technology, so Dow will be fighting an expensive, uphill battle against an entrenched competitor in its attempt to commercialize Enlist. If successful in this battle, there is a lot of upside, and Dow's owners stand to enjoy much more robust revenue growth over the next 5-10 years.
Our valuation screen likely picked up Dow due to a one-off boost to income during 2013. Dow had originally planned to sell its half of a joint venture to the Kuwaiti Petrochemical Industries Company (PIC) to partially finance the 2009 acquisition of Rohm & Haas. However, in the midst of the global economic meltdown, PIC backed out of the deal and left Dow scrambling to scrape up the money to buy Rohm & Haas (to which it had a contractual obligation to purchase).
Finally, in 2013, an arbitration resulted in PIC paying Dow $2.2 billion in cash. Those funds boosted Dow's Net Income and Owners' Cash Profits. Note, however, that after adjusting for this payment, Dow's 2013 OCP margin is only at the 6% level -- hardly higher than Dow's profit margin before the Rohm & Haas merger.
In our full report, we take a look at Dow's profits versus several other commodity and specialty chemical producers and find ample evidence that the firm could do a better job of converting revenues into profits.
We believe one possible key to better profitability at Dow lies in Enlist. Monsanto's transformation from a chemical manufacturer to an IP firm has allowed it to generate an OCP margin of 16% over the last 10 years -- a full five times greater than that of Dow's over the same period.
The active ingredient in the Enlist defoliant has been approved for use in Brazil and is on the verge of being approved in the U.S. This is important because those two countries represent the second-largest and largest markets for genetically modified agricultural commodities in the world.
Dan Loeb at Third Point Investments thinks Dow management has not been doing a good job at investing its shareholders' capital. This graph is a good demonstration of that contention. It tells us that, over the period covered, Dow has not been able to consistently increase its wealth at a rate faster than nominal GDP. In effect, Dow has been running to stand still for the past generation.
By far, the largest expansionary cash flow in the last generation was Dow's 2009 purchase of Rohm & Haas for roughly $15.5 billion. In the subsequent four-year period, the firm has only generated an estimated $6.3 billion in OCP; at current revenue and profitability levels, it would take nearly 10 years before this acquisition begins to generate cash flow for its owners.
In addition, the most attractive part of Rohm & Haas's business -- the agricultural chemicals business -- had already been acquired by Dow in 2001 for roughly $1 billion. Considering these points and others raised in our full report, we do not believe the 2009 acquisition was a wise use of owners' capital.
Cash Flow Generation
Because its expansionary expenditures are such a modest portion of its profits and are often cash inflows rather than outflows (i.e., it is selling off more assets than it is buying), a good guess for normalized Free Cash Flow to Owners (FCFO) margins for Dow is around 6%, judging by the recent past.
As Dow Chemical closes in on its 120th anniversary as a company, it finds itself in the midst of a major transition -- a reduction in its dependence on the commodity chemical business and an increase in emphasis on its specialty chemical line.
Our analysis of Dow indicates that hedge fund manager and acerbic letter writer, Daniel Loeb, is likely correct in his contention that Dow could stand to improve efficiency, but our view of his recommendation to split Dow into two firms -- one commodity producer and one specialty producer -- is mixed.
Dow is an interesting story -- especially with respect to its nascent GMO biotechnology business -- and a potentially attractive investment, though not one without a healthy degree of uncertainty.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.