Evaluating Dow Chemical's Dividend In Advance Of Merger

| About: Dow Chemical (DOW)

Summary

Dow Chemical's and DuPont's moves will provide improved top-line growth, and synergies of approximately $3 billion are expected by the second year after close.

Assuming synergies are extracted, we like what the deal means for future dividend potential of the combined companies.

We like management's intense focus on return on capital, as well as its focus on EBITDA improvement, which will help drive free cash flow generation and improve its dividend prospects.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

Click to enlarge

By The Valuentum Team

The demand in agricultural chemicals has shifted. Dow Chemical (NYSE:DOW) and other agricultural chemical companies have been forced to find sources of growth outside of their organic opportunities, which has led to increased M&A activity and added a degree of uncertainty to Dow's dividend prospects. Material synergies are expected in the deal with DuPont (NYSE:DD), but if these targets are not reached, the pace of dividend growth could be affected. We're not going to spend much time concerning ourselves with the regulatory pressures on the deal, specifically in Europe, as the regulatory environment continues to evolve. We are aware, however, of the increased uncertainties that come with the EU's ongoing probe into the merger.

The moves will provide improved top-line growth, and synergies of approximately $3 billion are expected by the second year after close. Assuming such synergies are extracted, we like what the deal means for future dividend potential of the combined companies. We don't have major concerns over the safety of the payout of Dow or DuPont prior to the merger, and the firms plan to maintain a policy consistent with their current policies. Dow's strong yield (~3.5%) stretches its Dividend Cushion ratio (1.3), but as its coverage remains near parity, we are confident that the firm will be able to cover its payout until its merger with DuPont. We like Dow's focus on EBITDA improvement, which will help drive free cash flow generation and improve its dividend prospects.

While the merger is expected to make the combined entities more competitive, it could also lead to increased deal making among rivals, which could negate some of the potential competitive advantages to be realized in the combination. We're keeping a close eye on the dividend implications of the Dow-DuPont merger. Let's now shift our focus to the remainder of Dow Chemical's investment considerations, as they are what drives the attractiveness of its dividend profile.

Image source: Valuentum

Image source: Valuentum

Dow Chemical's Investment Considerations

Image source: Valuentum

Investment Highlights

• Dow Chemical's specialty chemicals, advanced materials, agrosciences and plastics businesses deliver a broad range of technology-based products and solutions. By revenue, its 'Performance Materials' and 'Performance Plastics' operations are its two largest segments. The firm is laser-focused on reducing costs and prioritizing growth.

• Dow Chemical has agreed to a merger of equals with DuPont in an all-stock transaction. The new company will split into three separate entities roughly 18 to 24 months after the deal closes. Synergies could be as high as $3 billion within 2 years of closing, which is expected to come in fall 2016.

• We like management's intense focus on return on capital. The executive team's decision to return cash to shareholders via higher dividends/repurchases while reducing debt has also been well-received. Adjusted EBITDA margins in its 'Performance Plastics' and 'Consumer Solutions' segments are north of 20%. These are impressive levels.

• Water needs, which are expected to grow ~50% by 2030, GDP growth that will drive energy demand higher by ~30% in the next 15 years, and global food demand that will increase ~70% between 2000 and 2050 are key demand drivers behind Dow Chemical's operations. The firm's science-driven solutions are poised to meet such needs.

• The deal with DuPont is subject to customary regulatory approvals, and some believe the largest risk may come from Chinese regulators. EU antitrust regulators have opened an in-depth investigation into the deal, and the US Senate Judiciary Committee has expressed concerns over the deal.

Business Quality

Image source: Valuentum

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Dow Chemical's 3-year historical return on invested capital (without goodwill) is 10.4%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of GOOD.

In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. A focus on improving ROIC gives Dow an attractive Economic Castle rating.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

Image source: Valuentum

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Dow Chemical's free cash flow margin has averaged about 7.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Dow Chemical, cash flow from operations decreased about 4% from levels registered two years ago, while capital expenditures expanded about 61% over the same time period.

Valuation Analysis

We think Dow Chemical is worth $48 per share with a fair value range of $38-$58.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 2.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -4.9%.

Our model reflects a 5-year projected average operating margin of 14.7%, which is above Dow Chemical's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Dow Chemical, we use a 9.7% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Click to enlarge

Image source: Valuentum

Margin of Safety Analysis

Image source: Valuentum

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $48 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Dow Chemical. We think the firm is attractive below $38 per share (the green line), but quite expensive above $58 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

Image source: Valuentum

We estimate Dow Chemical's fair value at this point in time to be about $48 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Dow Chemical's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $59 per share in Year 3 represents our existing fair value per share of $48 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.