Dow: Our Top Pick In This Inflationary Environment

Apr. 26, 2022 4:40 PM ETDow Inc. (DOW)7 Comments
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Summary

  • A new revenue recognition model that will lead to a multiple arbitrage opportunity.
  • The finance lesson on economies of scale is now disrupted by a new oligopolistic order.
  • Strong company performance and solid balance sheet do the rest.
Ingegnere maschile che usa laptop durante il turno di notte.

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Dow Inc. (NYSE:DOW) provides materials science solutions through the following three business units:

  1. Packaging & Specialty Plastics supplies ethylene, propylene, polyethylene, polyolefin elastomers, ethylene vinyl acetate and ethylene propylene diene monomer rubber, it also provides aromatics products; (17% of turnover).
  2. Industrial Intermediates & Infrastructure provides ethylene oxides, propylene oxide, propylene glycol and polyether polyols, aromatic isocyanates and polyurethane systems. This segment also supplies caustic soda and ethylene dichloride and vinyl chloride monomers and many other items; (30% of turnover).
  3. Performance Materials & Coatings offers architectural paints and coatings and industrial coatings used in the maintenance and protective industries, wood, metal packaging, traffic marking, thermal paper and leather; high-performance monomers and silicones; independent silicones; and solutions for home and personal care; (53% of turnover).

The company that we know today is the result of the spin-off of DowDuPont. Dow was incorporated in 2018 and is headquartered in Midland (Michigan). This snapshot below gives a clear presentation of Dow at a glance, we can immediately note that the company is well diversified across the Globe and is positioned to create shareholder value across the cycle.

Dow at a Glance

Dow at a Glance

Source: Dow 2021 results

Why do we consider Dow our value pick in this inflationary environment?

First of all, chemistry is everywhere. Basic chemicals are present in all products of our daily life. But aside from this very basic but important consideration, we also have a top-notch analysis that will get investors on board. We have done an intensive Q&A session with the small-medium enterprise chemical CEOs and we have now some intellectual property to share with our readers. We now know that Dow will benefit in an exponential way from inflation. Inflation will lead to more inflation and the company is set to be a key value driver for the future. These assumptions are based on the two following new approaches that we see in the chemicals space:

  1. New revenue model
  2. The economy of scale disruption

New revenue model and new sales contracts

Our main investment thesis is based on a major change in the contractual terms related to chemical sales contracts. The chemical market is characterised by large players, and these are companies that operate in what we call the first value production chain, ie the "producers" of basic chemicals. However, the subsequent processing of the product is usually done by other players belonging to specialised verticals, companies which, unlike the former, are usually smaller in size, making these markets extremely competitive and fragmented. This context has left large companies such as Dow to operate in an oligopoly regime, with inelastic demand, in which the price depends mainly on supply.

Until now, product sales contracts between Dow and its clientele were based on half-yearly or annual contracts and also based on volume purchased. We could call it usual wholesale logic. Following the pandemic and the subsequent inflationary environment, companies like Dow have been starting to sell their products through contracts that we could call spot price contracts because they are based on very short periods. This means that the price negotiated between the counterparties is extremely volatile, following the movements in the prices of materials, thus reaching a market logic, independent of the quantity purchased.

Furthermore and more importantly, these contracts contain clauses that provide for an increase in the sale price when the spot price of the raw material increases, and at the same time, in case raw material prices or energy prices are going down, the new contract provides no possibility to be decremental. This change, allowed by the strongly oligopolistic regime in which Dow operates, will allow the chemical company to regulate its prices, making the company much less cyclical and consequently guaranteeing stable revenues and cash flows over time. This change will make Dow an excellent shield against inflation as, under these new contracts, Dow's revenues will be linked to the increase in the prices of the raw materials it produces, benefiting almost instantly from their sudden increase.

The economy of scale disruption

In addition, all this was coupled with another logic that we can derive from day-to-day life. The more you buy, the less you pay (proportionally). Financially speaking, this is called economy of scale (one of the first lessons in finance). Lately, what we have seen is that large chemical customers who until now have enjoyed considerable economic privileges by buying large product slots are not benefitting from discounts. The new logic is the following:

The more you buy, the more you pay.

Dow will benefit from the fact that most of its goods will be sold at the same price, consequently increasing margins and profit over time.

Dow's valuation: from a cyclical company to margin moat valuation

COVID-19 outbreaks have reshaped a few industries and a huge imbalance between supply and demand in the chemical sector has greatly increased Dow's pricing power. A very similar case happened for Maersk, another company that operates in an oligopolistic market. In the case of the Logistics sector, where there are huge barriers to entry both in terms of time and capital, and both are extremely vital and necessary sectors for the real economy, Maersk has been priced in by the market. Precisely for the above reasons, we believe that Dow is extremely undervalued, and compared to Maersk the market has actually not discounted all these positive factors within the price.

Our valuation is primarily based on the qualitative business changes just described. Dow's growth is mainly based on price increases rather than volume growth which can be considered almost stable over time. In the past, this assumption has always made Dow a highly cyclical company dependent on the commodity prices trend and also linked to the macroeconomic cycle. For these reasons, Dow's margins and profitability have always followed these macro-variables and analysts were discounting its valuation. After having discussed with many CEOs, and understood the magnitude of these new contracts, we think that these major changes will result in much greater stability in Dow's revenues, margins and profitability over time. We are essentially estimating that Dow will be much less cyclical and less sensitive to sudden changes in the cost of goods sold price. Despite the increase in margins and a considerable debt reduction, Dow is currently trading at an "end-of-cycle" market valuation with an EV/EBITDA 2021 of just 5.15x.

Dow

Dow's Valuation

Source: Mare Evidence Lab analysis

For the above reasons, we think that the current valuation significantly underestimates the new intrinsic company value. To find a proxy of our expected value, we considered Dow's 2019 valuation. In that year, the company was not undergoing favourable momentum and it was priced at an EV/EBITDA value of 7.99x, well above the current valuation of 5.15x. Therefore; based on our internal forecast of 2022 EBITDA, we value Dow with an EV/EBITDA target equal to that of 2019. Adjusting for debt obligations, we value the basic chemical player with a market cap of about $76B, implying a 53% upside of its current valuation.

Dow

Dow's Valuation

Source: Mare Evidence Lab analysis

If we also include a juicy dividend policy in this valuation, with yields above the sector average and the conspicuous share buy-back program in place, we can only confirm our thesis that sees Dow as an excellent inflation shield.

Moreover; we also performed a quantitative analysis thanks to a linear regression between Dow Inc's monthly capitalization and monthly inflation in the United States. We found direct proportionality between the two variables. Furthermore, the adjusted R^2 is close to 60% showing how inflation has excellent explanatory power with respect to Dow's market cap.

Quantitative Model Dow

Quantitative Model Dow

Source: Mare Evidence Lab analysis

Conclusion and risks

Solid balance sheet, strong performance quarter by quarter, compelling valuation, tasty dividend yield and buy back in place, quantitative analysis supported by a qualitative Q&A, we say no more.

Dow is definitely our pick for a high-inflation environment.

The major risks that could affect Dow's stock price are:

  1. Reduced global macro demand for chemicals
  2. Prolonged and new COVID restrictions
  3. Polyethylene margin decrease
  4. Lack of a recovery in industrial intermediates
  5. Potential for M&A
  6. FX exposure
  7. Failure to improve cash generation

This article was written by

Mare Evidence Lab profile picture
2.52K Followers
Buy-side hedge professionals conducting fundamental, income oriented, long term analysis across sectors globally in developed markets. Please shoot us a message or leave a comment to discuss ideas.DISCLOSURE: All of our articles are a matter of opinion, informed as they might be, and must be treated as such. We take no responsibility for your investments but wish you best of luck.

Disclosure: I/we have a beneficial long position in the shares of DOW either through stock ownership, options, or other derivatives. 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.

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