Much of the reason why contrarian investing has paid off is because investors tend to overly discount higher risk stock. In this bear market, few sectors are hurting as badly as chemicals. They have lingered in low multiples and have continued to lose shareholder value in the high double-digits while the Dow Jones gained 7.7% in the last twelve months. With the economy heading in the right direction, I recommend investors take on the risk and back Huntsman (HUN), Dow Chemical (DOW) and Du Pont (DD). Below, I review the fundamentals of each company.
A lot of the near-term performance of this stock will depend on shareholder confidence in margins, Ti02 profitability, and the construction market. 30% of business comes from Europe. With the Euro-area now reporting record unemployment north of 11%, the market is not looking too hot in that respect. A majority of the firm's EBITDA growth has come from TiO2 sales since 2009. Volume warnings from producers in this field have struggled, which will be a major headwind for Huntsman. Where I disagree with market assessment is the bearishness over Asia, which represents 20% of Huntsman's business. I see the market as myopically concerned over recent signs of weakness when the secular trends in Asia are still stronger than ever.
Perhaps most importantly, Huntsman is an attractive takeover target. With valuable assets at just a fraction of Du Pont and Dow's market cap, Huntsman could provide accretive expansion for suitors. Moreover, the company offers a 3.2% dividend yield and has generated north of $500M, on average, in free cash flow over the last four years. This free cash flow machine thus trades at less than 6x the 4-year average annual free cash flow generation. While net debt is high at around $3.4B, the EV-to-EBITDA multiple stands at 5.1x - within takeover range.
Dow is forecasted to have half of the annual EPS growth that Huntsman will have over the next 5 years. Under a sluggish 6.8% annual EPS growth projection, investors are feeling a bit of fatigue with an unneeded amount of risk. Much of the downside is reduced by a 4.4% dividend yield, but the stock sill trades at a 15.5x multiple and a beta of 2.33. If Dow could acquire Huntsman, it will be able to dramatically increase scale and better compete against leader Du Pont. Investor reentry will, moreover, be encouraged from the faster growth.
The market reacted negatively to a second quarter 14% miss - falling 4%. Cautious guidance for the second half of the year didn't exactly help either. Europe had the toughest market with sales down 10% while Asia held up comparatively well (down "just" 4%). Operating rate fell to 78% with much of the decline coming from turnarounds. With the company's perception of a resiliency wearing thin, early 2013 will serve as inflection point for the company to change the tide. Delay in near-term earnings goals has put a damper on the bull case that the inflection point will be a favorable one.
To hedge against macro instability, management is focusing on trimming costs. Interventions have been increased $500M to $1.5B. Thus far, $600M worth of interventions have been taken, but the stock has gone nowhere but down. Sure, they might have limited some of the depreciation, but investors are mainly focused on the industry trends. Basic materials can be very volatile and unpredictable outside of corporate control. But, with greater scale, Dow could have better pricing power to secure higher margins.
As the leader of chemicals with a top brand, Du Pont trades fairly low at a respective 13.4x and 10.7x past and forward earnings. With a dividend yield of 3.5% and a beta of 1.5, Du Pont is also one of the safer chemical producers. It is forecasted for 7.7% annual EPS growth over the next 5 yeas.
Analysts currently rate the stock a "hold" according to data sourced from FINVIZ.com, but I am slightly more optimistic about room for upside. At a 15x multiple on consensus growth estimates, the stock should be worth $87.20 by 2016. Discounting backwards by 10% yields a present value of $54.14. This doesn't leave too much room in terms of margin of safety, but it makes Du Pont a credible investment for high risk investors. It is important to remember that the firm also has a cost advantage against competitors. Accordingly, I recommend investors buy shares to capitalize from overly bearish economic forecasts.
During the second quarter, revenues grew 7% - benefiting from 6% higher pricing that offset lower volume. Asia revenue rose 5% while the EMEA rose 12%. Particularly strong momentum was seen in Performance Chemicals. In fact, 2Q results were better than expected with adjusted EPS of $1.48. The disappointment mainly came from management guiding towards the low-end of previous 2012 range.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.