Dow Chemical's (DOW) shares are up about 20 percent this year and over 50 percent from a year ago. DOW is a company in transition that has begun implementing more modest divestitures of lower-return operations. In addition, an activist investor has been publicly urging DOW management to separate its commodity-petrochemical and specialty chemical businesses to maximize shareholder value. To-date, DOW has rejected this suggestion, but the pressure remains on DOW management to perform at least in line with the company's peers in its industry.
DOW is the largest U.S. chemical company. Revenue from outside of North America accounted for 64 percent of 2013 sales. The following are the six divisions of the company and their percentage of DOW's overall 2103 sales: 1) electronic and functional materials (8 percent of sales); 2) coatings and infrastructure accounted (12 percent of sales); 3) performance materials (for 23 percent of sales); 4) performance plastics (26 percent of sales); 5) agricultural sciences (12 percent of sales); 5) feedstocks and energy (17 percent of sales); and 6) the energy business that primarily supplies power, steam and other utilities for use for DOW's global operations.
In late July 2014, DOW reported better-than-expected second-quarter earnings of 74 cents a share, and showed signs of greater operating efficiencies. This compares with adjusted earnings of $0.64 per share -- representing an increase of 16 percent year-over-year. Sales were $14.9 billion, up 2 percent versus the year-ago period, or 3 percent on an adjusted basis. Gains were reported in all operating segments, led by performance plastics (up 4 percent) and electronic and functional materials (up 5 percent). Agricultural sciences also increased sales, rising 3 percent in the quarter and achieving a first-half sales record of $4 billion. Cash flow from operations was $1.4 billion for the quarter. To-date, DOW has returned $3 billion to shareholders through declared dividends and share repurchases. Another $2 billion of buybacks are expected in the second half of 2014.
The CEO of DOW indicated that the company achieved its results even though it was facing "a continued slow growth environment and with some meaningful headwinds from purchase feedstocks and energy costs as well as planned and unplanned outages." The CEO summarized the growth catalysts for DOW that would benefit its near- and intermediate-term results:
"We have described a number of near-term growth catalysts in our portfolio, including an industry-leading performance plastics franchise with best-in-industry R&D and a low cost position which is being further enhanced in 2015 with our Sadara and U.S. Gulf Coast investments; our strong set of integrated franchise businesses such as Dow AgriSciences, electronic materials, professional materials and coatings that will yield results from key investments; and a recovering set of value-driving businesses such as polyurethanes all contributing to the bottom line, plus the investments made in the 2010-2014 time frame will begin benefiting these investments in 2015 and beyond. All of these catalysts plus our focused productivity actions would generate strong cash flows in 2015 and beyond. Simply put, the early stages of this cash flow have been put to use to accelerate our cash flow story in the back half of this decade. In the meantime, we have aggressively returned cash to you, our shareholders, with $3 billion in the first half of 2014 alone through declared dividends and share repurchases, and another $2.1 billion in share buyback due yet this year."
Activist investor pressures
An activist investor named Dan Loeb of Third Point investors acquired $1.3 billion of DOW shares within the last year. Subsequent to such acquisition, Mr. Loeb began pushing DOW management to separate its commodity-petrochemical and specialty chemical businesses. He also criticized DOW by stating that management had a "poor operational track record" and margins, which have been weaker than those of petrochemical rival LyondellBasell (NYSE:LYB). Such "weak performance," Mr. Loeb indicated, was "even more surprising" given that DOW has benefited from a North American energy surge that has led to cheap natural gas and natural gas liquids. He argued that DOW's petrochemicals business would earn "at least $2.5 billion" more annually under the proper managerial circumstances. DOW has rejected Mr. Loeb's breakup proposal and has begun implementing more modest divestitures, totaling $4.5 billion to $6 billion of lower-return operations.
Relief from expensive preferred shares payouts
If DOW's share price remains at its current levels, the company may be able to retire about $4 billion of high-cost convertible preferred stock, issued to Berkshire Hathaway (NYSE:BRK.A) and Kuwait Investment Authority during the credit crisis in 2009, to finance DOW's $18 billion purchase of specialty chemical maker Rohm & Haas. During the 2009 credit crisis, BRK.A negotiated favorable loan terms, an 8.5 percent dividend. The Kuwait Investment Authority also received the same 8.5 percent dividend. According to the terms of that deal, the preferred shares may be redeemed if DOW's share price exceeds $53.72 for any 20 trading days within a 30-day period.
If DOW's share price exceeds the price stated for the required time period, DOW would likely take advantage of such redemption of the preferred shares to eliminate about $340 million in non-tax deductible annual dividend payments. The amount of dividend payments equals about 30 cents a share in earnings. DOW will not save the entire $340 million benefit upon the redemption of the preferred shares, because to redeem such shares, the company will have to issue about 96.8 million common shares to Berkshire and the Kuwait Investment Authority shares, according to terms in the chemical maker's most recent annual report. That is about 8 percent of the weighted-average shares outstanding. DOW would benefit, however, because the common shares would pay a lower dividend. DOW indicated during its last earnings report that the company has repurchased about 51 million shares for $2.4 billion as part of a $4.5 billion program to reduce the impact of the preferred share conversions.
The industry that DOW participates in is capital-intensive and annually spends almost $50 billion on research and development. The industry is cyclical and affected by costs for basic commodities, especially oil and gas. Price fluctuations also impact dependent industries such as resins, plastics, synthetic fibers, etc. Further, high crude oil prices may raise production costs, and lackluster demand in emerging economies may offset certain positives. The industry may also see increased consolidation due to intense competition, the need for cost efficiencies, and economies of scale.
Analysts' views and our view
More optimistic analysts believe that DOW shares will continue to rise, even though they have quietly surged almost 50 percent over the past year. Some analysts believe that the stock will rise an additional 26 percent over the next year, as DOW indicated that it can double earnings before interest, taxes, depreciation, and amortization - over the medium term. One analyst indicates that with "cash generation expected to be strong in the near and mid-term, the company's financial flexibility will help maintain focus on organic growth. At the same time, management expects to return $4 billion to shareholders via buybacks, and $1.8 billion via dividends." In addition, analysts also believe that DOW's profitable agriculture business could be valued at up to $15 billion if the division were spun off or sold off. Whether DOW decides to divest its agricultural business or not, analysts believe that continued divestitures are likely to boost DOW's profits over the intermediate and long term.
We generally agree with analysts' views. DOW is expected to earn $3.59 a share in 2015, while the shares currently yield 2.80 percent. The forward price-to-earnings ratio based on such earnings estimate is almost 15. We believe, however, that investors interested in establishing a full long-term position should wait for a pullback in the share price to the range of $47.50 to $51.50 (which would represent a forward price-to-earnings ratio ranging from about 13.25 to 14.35). The shares have run up over 50 percent in the last year, and the overall market is near record highs, so caution is warranted even though analysts are optimistic. We should note also that DOW shares have been attracting a large amount of interest from mutual funds of late.
Disclosure: The author is long DOW. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.