Published on July 10th, 2019 by Josh Arnold
The current Dow Inc. (DOW) can trace its roots back to 1897, when H.H. Dow founded a one-product start-up. The founder was an electrochemical pioneer who first tasted success when using electric current to separate bromides from brine.
Dow wasn’t an immediate success, as his first company went bankrupt, while control of the second was wrested from him. However, his third, what became today’s Dow, has lived on.
The spirit of innovation has never ceased at Dow throughout the past 122 years and today, the company is worth $36 billion and enjoys nearly $47 billion in annual revenue. It is also a member of the highly respected Dow Jones Industrial Average.
We don’t see a massive amount of growth on the horizon for Dow, but certainly enough to consider the stock based on its low valuation and high dividend. The nearly-6% dividend yield is highly attractive, and together, we see Dow as a compelling opportunity to own a mispriced business with a REIT-like yield.
The current form of Dow is the result of the 2019 separation of the former DowDuPont business, which was created just two years ago when the former Dow and DuPont businesses merged. The combined company virtually immediately set off with plans to separate into three, focused business, one of which is Dow Inc. The new Dow is the former Materials Sciences segment of DowDuPont.
Dow began trading as a standalone company on April 1st, 2019. Prior to that, it was the Materials Sciences division of the old DowDuPont. Today, the company is focused on delivering solutions to customers in packaging, infrastructure, and consumer care.
Dow was still part of DowDuPont at the time of its Q1 report, but the company released standalone earnings on 5/2/19 in anticipation of the spinoff. As such, we received a glimpse into how the new, more focused company is performing.
Total revenue was off by 10% year-over-year to $10.8 billion, which was in-line with prior guidance. Total volume grew 1%, while consolidated local pricing plunged 9%. Currency translation also decreased sales by 2%.
Source: Q1 earnings presentation, page 4
The Performance Materials & Coatings business, which is Dow’s smallest, saw its volume gain of 1% more than offset by weaker pricing, and total revenue fell 2% year-over-year.
However, this was still Dow’s best-performing segment in Q1 on a revenue basis. Operating margins declined significantly thanks to higher input costs and weaker pricing, falling from 25.4% to 21.3% during Q1.
Dow’s second-largest segment, Industrial Intermediates & Infrastructure, saw its volume rise 6% on broad-based strength.
Source: Q1 earnings presentation, page 5
However, local pricing fell 11%, which sent revenue lower by 8% during the quarter, and reported operating margins down 400bps to 13.2% of revenue.
Most of the damage for Q1, however, was done by the company’s largest segment, Packaging & Specialty Plastics. Total sales plummeted 15% year-over-year as local pricing declined 11%, while forex translation reduced the top line by 2%, as did volume.
Excluding equity method earnings, Dow’s “owned” businesses produced operating margins that were 100bps higher-year-over-year, rising to 14.6% of revenue.
Source: Q1 earnings presentation, page 6
Operating margins declined by 220bps on a reported basis to 19.4%, while “owned” operating margins declined 220bps to 18.7%. The performance of this segment significantly impacted the company’s results to the downside given it is nearly half of total revenue.
Despite what looks like a tough quarter on the revenue side, Dow has some positives to celebrate. The company is on track to achieve significant cost savings this year, which was part of the plan when the spinoffs were completed. Indeed, Dow achieved $125 million in savings in Q1 alone, a time when it hadn’t even been spun off yet. Dow reckons it exited Q1 with a $1.365 billion annual run-rate of cost savings, which would be a sizable tailwind for margins should it come to fruition; we believe the company’s Q1 performance and focus on this issue collectively suggest it will.
Our initial estimate for earnings-per-share in the company’s first year as a standalone entity is $4.40. We note that given the rather extreme movements we saw in pricing and currency translation in Q1, however, that there may be some fairly sizable risk to this estimate in both directions. We’ll monitor this and update as needed as the year progresses.
Dow’s first dividend as a standalone entity was 70 cents, good for an annualized payout of $2.80. At this rate, Dow yields 5.8%, which is tremendously strong at roughly three times the yield of 10-year Treasury bonds, as well as about the same margin on the broader stock market. Dow represents a hugely attractive dividend stock today given its well-covered and very high yield.
We believe Dow can grow at an annual rate of 5% in the coming years as the company’s outlook for the segments it serves is collectively bright, but margins can be very volatile. Indeed, Q1 showed this as pricing was down in the double-digits in many cases.
However, management believes pricing for its core products is at or near the inflection point, as it has seen stabilization in a lot of areas. Given the recent declines in pricing, this would be most welcomed, and we see the risk of pricing continuing to move lower as much smaller compared to the risk of pricing rebounding. As such, we see moderate upside to revenue into next year.
In addition, cost savings should be a meaningful driver of margin expansion, with or without revenue growth. The company’s nearly $1.4 billion annual run-rate of savings should help its margins stabilize as Dow is now a fully standalone company, and can focus its efforts on saving money.
Third, the company’s share repurchase program is enormous at $3 billion, which is nearly 9% of today’s float. That sort of tailwind can erase a lot of weak pricing and margins while still moving the needle forward on earnings-per-share, irrespective of whether or not the business improves earnings on a dollar basis. We see this as drastically reducing the risk of Dow missing our 5% growth target.
We also like Dow’s focused exposure to growing market segments that are centered around consumer products.
Source: Q1 earnings presentation, page 6
The company believes its core categories can grow at 1.5 times global gross domestic product over the long-term, and indeed, some of its segments are growing much more quickly than that today.
Combined with what should be better pricing in the coming quarters, we see this long-term tailwind of demand as positives that can drive the next leg of growth. While Q1 was certainly a setback, it was also expected based upon prior guidance, and we believe it is a temporary headwind until normalized conditions return.
Valuation & Expected Returns
We see Dow producing $4.40 in earnings-per-share this year, marking a very profitable year as a standalone entity with about $3.3 billion in net profits. Shares trade today at 11 times that estimate, which is slightly lower than our estimate of fair value at 12 times earnings.
This is based upon the valuations of the former DowDuPont business, the new Dow’s projected growth rate, and the company’s outlook. We think 12 times earnings is conservative for the long-term, but given the obvious lack of positive sentiment on the shares today, we are cautious for the time being.
Total returns should come to 12.5% annually through 2024, comprised of the 5.8% dividend yield, a 1.7% tailwind from a higher valuation multiple, and 5% earnings-per-share growth. That puts Dow firmly into buy territory, particularly since the company’s current results include so much negative news on pricing and margins.
We see upside risk as much greater than further downside risk today. The combination of the very high yield, reasonable valuation, and meaningful growth prospects has us recommending Dow as a buy.
Given that Dow exists as a standalone entity for the first time, we unfortunately do not have any data for how the business would have performed during the last recession. However, we do see the company’s product lines as holding up fairly well during recessions, as its products are used in a wide variety of consumer staple sort of applications.
In addition, a recession may actually make the company’s input costs materially lower, which would help bolster margins at the time it would be needed the most.
While we don’t rate Dow as a defensive stock, the risk of recession is less for chemical makers than many other types of businesses. We think investors will find the next recession to be a buying opportunity in Dow.
While Dow’s results in Q1 were quite weak, we see them as a temporary bump in the road. We like the company’s focus on consumer-driven growth and the global nature of its revenue should help lessen the impact of economic downturns in any one part of the world. Pricing, according to management, should be stabilizing, and with that, revenue and margins should rebound.
The company’s goal of being a class leader in capital returns is already well underway, as the stock yields nearly 6% and management is committed to buying back almost 9% of the float. We think the market is assuming a lot of negative news in the coming quarters and thus, upside surprise should be of higher likelihood than downside.
Given the reasonable valuation, what we view as improving growth prospects, and the huge yield, we rate Dow a buy. Patient investors will receive the 5.8% yield while they wait for better growth and a higher valuation, and we see Dow as providing shareholders with double-digit annual returns in the coming years.