Dow Chemical: A Strong Buy As Share Price Approaches $40 A Share

| About: DowDuPont Inc. (DWDP)
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Summary

An activist investor had been pressuring Dow management to move swiftly to divest lower-return operations.

The company is now implementing divestitures of about $7.0 billion to $8.5 billion of lower-return operations to improve profitability.

The company recently increased their dividend by 14 percent and their share buyback by $5 billion.

A company insider recently purchased $1 million of DOW shares on the open market.

Shareholders are rewarded with a substantial dividend yield while waiting for the company's transformation to increase profitability.

Dow Chemical's (DOW) shares have been volatile over the last few months as the company's shares fell during the sharp overall market sell off in October 2014 from about $53.50 in September 2014 to an intra-day price of $41.45 on October 2014. The shares then rebounded, but have since fallen again to near their October 2014 lows. Earnings estimates have fallen in the last 3 months as the company has continued its transformation towards higher-return operations. We believe that as DOW shares approach the $40 level, potential investors should initiate a full position in the company's shares for the intermediate and long-term.

DOW is in transition as it is in the midst of implementing modest divestitures of its lower-return operations that will total $7 billion to $8.5 billion by mid 2016. In addition, an activist investor had 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, however, has entered a comprehensive agreement with the activist investor to add four new, independent directors to the company's Board of Directors in 2015. We recommend DOW's shares, as we believe the company's transformation will reward investors in the intermediate and long term. Also, we should note that a DOW insider purchased $1 million of DOW shares on the open market at about $46.5 a share, a price higher than the current price of DOW shares. Potential investors now have the rare opportunity to invest in DOW shares at a price lower than a substantial insider purchase of a DOW insider. While we believe there is a chance that DOW shares could break below the $40 level, a price we paid for our first purchase of the shares several years ago, a potential investor purchasing shares slightly early will be rewarded with a 3.6 percent dividend yield to reinvest even if their purchase price was not optimal.

Background

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.

Third quarter earnings

In October 2014, DOW announced increased earnings over the year ago third-quarter given strong results in the performance plastics and electronic and functional materials divisions. Profits for the company were $852 million or 71 cents per share in the quarter, a 43 percent increase from $594 million or 49 cents per share in the year earlier quarter. 
DOW's revenues increased 5 percent from the year earlier quarter to about $14.40 billion in the quarter on gains across performance materials, performance plastics and electronics, assisted by increased pricing. Sales rose in all geographic regions in the quarter. Sales in the emerging markets increased 6 percent on strength in plastics business in Latin America. The North American region recognized a 7 percent increase.

The company indicated that it would continue to take aggressive action to improve returns on capital and increase the company's cash flow through effective management of the business portfolio. In addition, the company reiterated its commitment to ongoing cost reduction and efficiency programs. Subsequent to the earnings announcement, the company increased the divestiture goal to $7 billion to $8.5 billion of proceeds from asset sales by mid 2016.

DOW and the activist investor reach agreement

Dan Loeb, an activist investor from Third Point investors, acquired a billion dollar position in DOW shares within the last year. Mr. Loeb has been pushing DOW management to separate the 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 their petrochemical rivals. Such "weak performance," DOW had rejected Mr. Loeb's breakup proposal and began implementing more modest divestitures, totaling $7.0 billion to $8.5 billion of lower-return operations.

In late November 2014, DOW and Third Point LLC (the investment vehicle for Dan Loeb) entered a comprehensive agreement to add four new, independent directors to DOW's Board of Directors start on January 1, 2015 and in May 2015. The agreement also provides that: 1) the four independent directors will be included in DOW's nominees for election at the 2015 Annual Meeting; 2) Third Point will vote in favor of the company's nominees at the 2015 Annual Meeting; 3) thirteen directors will stand for election at the 2015 Annual Meeting, but DOW agreed to reduce the size of their Board to twelve members before their Annual Meeting in 2016; and 4) Third Point agreed to a one year customary standstill and voting agreement. DOW and Third Point made no further public comment on the agreement.

Divestitures continue towards company's goal

In December 2014, DOW entered into an agreement to sell the global Sodium Borohydride business to Vertellus Specialty Materials LLC (Vertellus) and the polyolefin films plant to Valfilm North America, Inc. (Valfilm), a wholly-owned subsidiary of VALGROUP Packaging Solutions. Both transactions are expected to close in the first quarter of 2015 pending regulatory approvals. Combined proceeds from the transactions total approximately $225 million. DOW had previously announced the intent to divest the Sodium Borohydride business earlier in 2014, as part of their ongoing plan to maximize value across its integrated portfolio by reducing exposure to non-strategic businesses and assets. Both transactions are part of the company's ongoing drive to deliver $7 billion to 8.5 billion in gross proceeds by mid-2016.

DOW insider's million-dollar share purchase

In late October 2014, several days after the company's latest earnings announcement, a DOW insider Paul Polman purchased $1,001,040 of the company's shares on the open market at a price of $46.56. This insider purchase is a significant sign that the current price of DOW shares discounts the value of the company's shares. DOW shares are now $3 lower than this insider's purchase, and, as a result, non insiders have the opportunity to purchase DOW shares cheaper than such insider's purchase. This significant insider purchase is a sign to us that the current price of DOW shares significantly undervalues the intermediate and long-term value of the company.

Our view

DOW's cash generation should be strong in the near and mid-term, giving the company financial flexibility to maintain focus on organic growth. In addition, 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, the company's continued divestitures are likely to boost DOW's profits over the intermediate and long term.

DOW is expected to earn $3.31 a share in 2015 (down over the last 3 months), while the shares currently yield 3.60 percent. The forward price-to-earnings ratio based on such earnings estimate is almost 13.10. With the strong price decline in the company's shares and the increase in the overall market's volatility, we recommend that potential investors who are more cautious establish a half position in the company's shares now and establish a full position if the company's shares approach the $40 to $42.50 price range. For less patient investors with a very long-term time horizon, a full position may be established now, and such investors will be rewarded with a 3.6 percent dividend yield to reinvest even if their purchase price was not optimal.

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.