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A Young Investor Analysis: Dow Chemical

|Includes: DowDuPont Inc. (DWDP)

This week, I will stay with a basic material company like last week but I will go toward the chemical industry. I will talk about The Dow Chemical Company (DOW). As usual, I will talk about what the company does, what were its 2016 results, why I choose it and talk about the big elephant in the room talking about this company, the merger with Dupont (DD).

What is Dow Chemical Company?

The Dow Chemical Company is a chemical company based in Midland, Michigan and founded by Herbert Henry Dow in 1897. From a company selling bleach, it became the second biggest chemical company in the world behind BASF AG (OTCQX:BASFY). It has activities in 175 countries in the world and employ around 56 000 persons in the world. The company takes raw materials and transform them into chemicals, plastics and agricultural products. It reports in 6 segments: Agricultural Sciences (12.82% of sales), Consumer Solutions (11.33%), Infrastructure Solutions (17.9%), Performance Materials and Chemicals (19.16%), Performance Plastics (38.22%) and Corporate (0.57%). The CEO of the company is Andrew N. Liveris since 2004. Dow Chemical sells the majority of its products directly to other companies and industries like automobile, electronics, agriculture and others. In 2008, they bought Rohm and Haas Company for $15.4 billion including $3 billion in preferred shares from Berkshire Hathaway (BRK.A, BRK.B) and $ 1 billion from the Kuwait Investment Authority. Those preferred shares were converted into equity in January 2017, giving Warren Buffett around 6% of the company. By doing this, Dow Chemical reduced the amount of dividends the company pays and can put more money into a dividend increase in the future.

What were the results of Dow Chemicals?

As usual, we will look first at the 10 year results of the company

Year

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Revenues

(in millions $)

49124

53513

57361

44875

53674

59985

56786

57080

58167

48778

48158

Net Income

3724

2887

579

648

2310

2742

1182

4787

3772

7685

3978

EPS

3.82

2.99

0.62

0.32

1.72

2.05

0.70

3.68

2.87

6.15

3.52

Free Cash Flow

2171

2379

2372

-48

1927

1049

1461

5521

2930

3644

1696

Source: Morningstar

One of the first thing that we can see is that the company is far from stable on its revenues and earnings, going back and forth depending on economic conditions. Raw materials prices can have a big impact on earnings of Dow Chemicals. We can see that in good times, the free cash flow and the earnings are great but in time of commodities price drops, Dow Chemicals must lower their prices to their customers even with volumes up because of the fragmented market. It we look at the market share of Dow Chemical and comparing it to BASF AG, we can see that Dow Chemical have a 2.6% market share against 1.66% for BASF AG in the basic chemical industry. When the two biggest players have such a low market share, it means that the market is fragmented and many players are there to lower their prices to undercut the major players. The brand names can help keeping a market share but it is very difficult and can lead to overcapacity.

If we look at the FY2016 results of Dow Chemicals, we can see a drop of 1% of sales compared to 2015. Volume was up by 5% for the year, with a strong performance in Consumer Solutions and Infrastructure Solutions segments, but drop in prices of 6% made the revenues drop. Also, on net income and EPS, we must consider that Dow Chemicals had gain on divestments on a spinoff of some of its business for a total of $4.592 billion compared to $1.202 billion in 2016. The net income this year shows more what the company really earned than last year with all the spinoffs. So, in a turbulent year, Dow Chemicals had a good year with increasing operating earnings.

How about Dow Chemical in history?

The first thing to check about a company is its historical data, especially in the case of the dividend. Here, we can be a little bit disappointed. In 2009, with the financial crisis and after a big acquisition, Dow Chemical decided to cut its dividend by 65%. Since then, the dividend was put back at its previous level but it is a disappointment to see that they didn't even considered to keep the dividend at its level. We can also see that the dividend yield is below its average level historically. The last increase of the dividend was in September 2015 with a dividend increase of 9.52%. They didn't increased it in 2016, mostly because of the Dupont merger, but it should increase soon.

Source: Bloomberg

The shares were rewarding for shareowners since 1980. The total return is 3484% or 10.15% per year, which is on par with the performance of the S&P 500. The chart shows a big drop in the 2008 financial crisis but they have recovered since then.

If we compare the last ten years of Dow Chemical, we can see that they have overperformed the S&P 500 and their industry in general. Dow Chemical had a total return of 109.41% in the last decade compared with 94.52% for the S&P 500 and of 44.14% for the Materials Sector. But most of its overperformance is due to the performance of the stock since the announcement of the merger with Dupont at the end of 2015.

If we compare now to its closest competitor, BASF AG, we can see that BASF AG had a better performance in the last ten years than Dow Chemical. This can be explained by the fact that BASF didn't cut the dividend by much during the financial crisis and that they performed better than Dow Chemical on earnings during that period.

The Elephant in the room: The merger with Dupont

In December 2015, Dow Chemical and Dupont announced a merger between the two companies where the two companies would be equals in the new company, DowDupont. Also, they would split the company in 3 after 18 months to appease the regulators. The three sectors would be Agriculture, Material Sciences and Speciality Products. The biggest company of the 3 would be the Material Sciences with $48 billion in sales.

Source: Dow Chemical 2015 Annual Report

After the transaction is completed, the shareowners of Dupont would receive 1.282 shares of DowDupont for each share of Dupont. The ratio for Dow Chemical would be 1 for 1. This would give the company around 2.282 billion of shares for the whole company. Bloomberg compiled a pro forma earning sheet if the combined company was existing today with Dupont as the target and Dow Chemical as the acquirer.

Source: Bloomberg

If we calculate the EPS of the proforma earnings, we would have an EPS of 3.41$ per share. Giving the current P/E of Dow Chemical at 17.4, that would give us a share price of 59.33$, close to the actual price of 61.19$. So, the impact of the new shares given to Dupont investors should be minimal.

Also, the regulators could block the transaction. Two times, Dow and Dupont had to postpone the date of the merger closure because of the EU blocking the hearings on the merger. That could be bad news for the combined company to ever see the light of the day. Especially with the other mergers also in works with Bayer AG (OTCPK:BAYRY) buying Monsanto (NYSE:MON) and ChemChina buying Syngenta (NYSE:SYT) in the agricultural space. That would give a big part of the market in the hands of three companies and regulators could be cold to approve the merger. As we have seen with the blocking of the mergers in the insurance industry, the regulators are not scared to block any deal that could harm the choices of the consumers. This could spell bad news for Dow Chemical and Dupont in the end and the merger could be abandoned.

Conclusion

In the end, Dow Chemical stock price right now is valued toward a successful merger with Dupont and there is a risk that the merger could be blocked in the end. Also, Dow Chemical doesn't have a big competitive advantage somewhere because it makes mostly commoditized products that doesn't bring big barriers to entry. In the plastics division, their biggest revenues maker, it isn't the lowest cost producers, that honor going to LyondellBasell (NYSE:LYB). The stock is too risky right now as an entry point for someone looking for a play in an industrial company.

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