Buy Dow Chemical: A Dividend Dog Trading At Cheap Valuations

Jul. 5.12 | About: Dow Chemical (DOW)

The general concerns about the macroeconomic environment, particularly the worsening of the eurozone debt crisis and slower growth pace of China, have hampered consumer confidence and the overall situation in the global equity markets. Still, chiefly due to the shale gas boom, chemical industries' stocks have performed fairly well on a YTD basis, particularly Dow Chemical Co. (NYSE:DOW).

Dow Chemical derives its competitive advantage from its diverse product mix, its ability to continuously innovate and come up with new and value-adding products, and high dividend and free cash flow yields. For long-term investors, it is a definite buy, given its lucrative growth potentials and relatively inexpensive valuations. Short-term risk-averse investors might want to wait for improvements in the general economic outlook before taking a position.

Upcoming Catalysts

Innovative Products in the Pipeline

The management is currently focused on capturing the benefits of innovative products and technologies, such as POWERHOUSE® and EVOQUE®. If these new products initially receive positive market feedback, it can have a positive impact on DOW's share price.

Recovery in Construction Market

The Architecture Billings Index (ABI), the leading economic indicator of construction activity, dropped to 45.8 in May from 48.4 in April, showing a recent dip in construction activity amidst the ongoing uncertainty in the economic outlook. In addition, the fact that construction projects slow down in summer has further contributed to this decline. However, we expect construction activity to accelerate once macro conditions improve and winter arrives.

Resolution of Arbitration with Kuwait Petroleum Corporation (KPC)

K-Dow Petrochemicals was going to be a joint venture between Dow Chemical and Kuwait Petroleum, specializing in the manufacture of plastics. However, the Kuwaiti government scuttled this partnership due to a global recession in 2008. DOW has a currently pending arbitration against Kuwait Petroleum; the resolution will likely impact its share price. However, the uncertain timing of the resolution makes it the least important upcoming catalyst.

Industry Introduction

The shale gas boom has given the U.S. Chemical Industry with the so-called feedstock advantage, as it has resulted in a humongous decrease in the prices of natural gas, and more recently, natural gas liquids (NGLs). One of those NGLs is ethane, which is used to manufacture ethylene. Ethylene, an organic compound widely used in the Chemical Industry, is also manufactured from oil-based naphtha. However, the relative inexpensiveness of ethane as against naphtha has benefited U.S. chemical companies in general and DOW in particular, as it is the second-largest ethylene producer worldwide.

Company Description

Dow Chemical is a leader in specialty chemicals delivering products and solutions to different sectors. It has six major product segments: electronic & functional materials, coatings & infrastructure solutions, agricultural sciences, performance materials, performance plastics, and feedstock & energy.

Market Performance

Dow Chemical's YTD stock price has experienced an upsurge of almost 10%, primarily due to lower gas prices as a result of the shale gas boom. However, its peers have also undergone similar huge shifts, chiefly due to this reason.

Dow Chemicals believes that as a result of a recent decline in key petrochemical prices, buyers are holding off purchases and waiting for further price declines. However, it is very bullish about long-range improvement, and so continues to deploy capital investments. If management's expectations are met, its share price would record a further increase.

Latest Earnings Review

Dow Chemicals reported a 1Q2012 adjusted EPS of $0.61 versus $0.82 last year, and bet Credit Suisse's (NYSE:CS) expectations of $0.56. It would have been $0.26 higher, if the company was able to avoid restructuring charges, as well as a charge related to an early retirement of debt.

Its balanced portfolio enabled it to deliver sustainable growth for the tenth consecutive quarter. Especially, its Agricultural Sciences portfolio was able to capture record sales and EBITDA.






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Dow Chemical Co has a dividend yield of 4%, which is the highest in its peers. Its forward price-to-earnings ratio of 10x and EV/EBITDA of 9x is one of the lowest among its peers. However, its long-term growth rate of 6.8% is relatively less than its peers. Still, the 11% expected free cash flow yield in 2013, along with the current high dividend yield, makes it an attractive option for an investor.

Sell Side Expectations/Review

Credit Suisse has dropped its 2Q earnings estimate for DOW from $0.66 (in-line with consensus) to $0.60 and 2013 estimate from the overall consensus of $3.20 to $3.16. The estimates have been revised due to a weaker macro environment, weaker electronics market, slow recovery in construction markets, and de-stocking in some commodities.

The Bullish Thesis

Morgan Stanley's (NYSE:MS) target price of $55, in case of a bullish scenario, represents an upside of more than 65%. It attributes such a high price to an increase in crude to ethane ratio, gains in agriculture and electronics, along with the successful commercialization of new products.

The Bearish Thesis

The bear case target price is close to $27, in case of a reduction in coal to ethane ratio, further contraction in global growth, and disappointing feedback from new products.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.