But there was one big outlier, as Dow Chemical (DOW) shares have shed nearly 40% of their value in the past 6 weeks. I’ve been following this stock for many years, even going so far as to conduct a breakup analysis of the company in early 2007. Most of the assumptions in my breakup model were based on historical norms for fundamental metrics, norms that we’ve blown past on our current race (spiral?) into uncharted market waters.
The most interesting part about the breakup analysis was a single comment made by Dow’s CEO in early 2007:
“We are no longer a cyclical company”.
I certainly wasn’t ready to concede that at the time, and neither was the market. Dow shares never got above a multiple of 11x forward earnings, although the company was rumored to be a buyout candidate at the peak of the private equity roadshow.
Fast forward 16 months, and Dow still looks and quacks like a cyclical company. But to be fair, most every company is cyclical this time around, given the depth of the trough earnings we’re about to start seeing.
What surprises me most about the recent collapse of Dow shares is the fact that CEO Andrew Liveris is adamant he will not cut the dividend, which currently offers a downright sexy 9.6% yield. The company’s balance sheet is solid, with a Price/Book of .84, $2.5 billion remaining in credit facilities, and a 1.4 current ratio. Even Warren Buffett has committed $3 billion in capital as Dow looks to complete the acquisition of Rohm & Haas (ROH), a specialty materials & electronics supplier, for over $15 billion.
So are shares being tossed out unfairly, or is more deterioration in store? A closer look at the various margin pressures can help us shed some light on a murky earnings picture going forward.
Major Earnings Headwinds - No Demand, R&H Poorly Timed
While Dow reported a 15% rise in sales for the 3rd quarter, the number belies the true operating weakness of the core businesses. Were it not for price increases of 12-25% realized in the quarter, revenues would have fallen year-over-year. The volume declines for Basic Plastics and Basic Chemicals were 18% and 20%, respectively.
The recent price increases look to have been eradicated as quickly as they were implemented. In a November 14th interview, CEO Andrew Liveris stated that plastics prices have fallen 40% since September as “global demand” seems to have become a paradoxical statement.
Earnings Tailwinds - Lower Inputs, Agriculture Chemicals, Synergies
If there is one major catalyst for EPS improvement over the next few quarters, it’s got to be the pass-through of rapidly falling feedstock prices, specifically crude oil and natural gas. As recently as the 3rd quarter, Dow’s feedstock costs added 27 cents per share in sequential costs, and rose by 47% YoY - a $2.6 billion increase. As current contracts come off, Dow should begin to see major relief on the input side.
Liveris has been outspoken in his contention that roughly $900 million in cost savings & synergies can be achieved from the Rohm & Haas acquisition, which is set to complete in Jan. 2009. From Liveris in the Q3 conference call: "..we remain very confident in our ability to deliver total savings of at least $910 million and do it quickly after close.”
The financing prospects for R & H seem secure, as Dow is set to divest a 50% stake in its commodity plastics business to Kuwait Petrochemical Industries Co. for $9.5 billion, in a deal that should close by year end.
Crosscurrents Abound
This is a really hard company to model, and it starts with the overall breadth of the product line. Add in a presence in over 150 countries, a myriad of joint ventures, and large-scale operational endeavors (plant closings, Kuwait JV, R&H integration), and getting a clear picture on 2009 is damn near impossible. Obviously demand is going to deteriorate further, but how much would put the tentative earnings target of $2.25 - $2.75/share in danger?
Some back of the envelope calculations point to massive swings about to occur on both sides of the margin coin. I’ll start with a conservative estimate of feedstock savings over the next four quarters. Given the $2.6 billion YoY increase seen in the 3rd quarter, I’m going to back these out over the next four quarters. This is conservative simply because we’re already at or below average prices for all of 2007 and 2008 on oil & gas. The Q3 comparisons are on Q3 of 2007, when crude oil, for example, traded above $80/barrel.
As the lower feedstock costs pass through the supply chain, Dow should realize between $8-$10 billion in COGS savings over the next four quarters. More upside is possible, but being overzealous is not a trait we should be incorporating for quite some time.
As to the top line trends, Q3 obviously doesn’t reflect the global seizing that began in October. I’m happy to take a chainsaw to the sales estimates and call for a 30% dropoff in combined volumes and prices for the commoditized plastics and chemicals segments, which make up about 2/3 of Dow’s $60 billion in annual sales. The other third is comprised of segments with strong growth profiles, like the Agriculture chemicals and seeds segment and the various JVs, which have provided growing earnings for the past two years.
A 30% top line reduction in the largest segments, netted out with 10% growth in the Agribusiness unit and flat earnings from JVs, would reduce gross profits by $10-$11 billion. If we add back in our COGS reduction midpoint ($9B) and include half of the potential synergies from the R&H deal ($400m), we’re left with an operating income shortfall of around $1 billion.
Given the current run-rate of $3.9 billion in operating profits, we could see a 25% reduction in ‘09, and a similar reduction in EPS from the current rolling EPS of $2.77. This would imply a forward multiple on Dow Chemical of right around 7x, far below historical trough ranges. The key question, of course, is whether 2009 will actually be a trough.
Final Thoughts
If Liveris can honor his word to hold the dividend steady, getting paid 9.5% to wait for the economy to turn around seems like a very attractive proposition. Dow is still quite leveraged to the early stages of the business cycle, so any type of infrastructure stimulus could quickly add to demand for chemicals and plastics.
The Rohm & Haas acquisition remains the wildcard - any purchases made with credit in 2008 are absolute red flags, and despite management’s attempt to justify the purchase and the timing, this fact will weigh over shares in the short term. I expect to be able to re-visit Dow shares in the spring and find they have underperformed the S&P 500. If we can see some tangible & sizable cost reductions starting to appear by then, Dow shares could be an attractive portfolio addition.
Cash flows should remain solid enough to support the dividend and the debt servicing, and Dow could use its superior footprint to pick up global market share during the ensuing shakeup in the sector. On any potential sign of a trough in the global economy, Dow shares could have little trouble getting back to the $30 mark.
Disclosure: Author does not hold a position in DOW
http://seekingalpha.com/article/107539-crosscurrents-at-dow-chemical-make-a-clear-forecast-impossible?source=yahoo
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