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Dow Inc. (DOW) was recently spun-off from DuPont (DD) in 2019. The combined industrial/chemical product companies merged in 2017 before the official breakup, including a third wheel split, the Corteva (CTVA) agribusiness. Dow and DuPont each held complementary/competing businesses that first merged together areas of similar focus, then broke apart based on those differences. The question remains: will the divorced group perform better dating on their own and searching for deeper meaning and profits while single?
My quick answer is yes. All three of the former DuPont family will have stronger futures as individually-focused enterprises. Each can now determine a growth path, which catalysts to invest in heavily, and what cost structure best fits shareholder returns long term. Dow manufactures a wide range of chemicals worldwide from ethylene and propylene to polyethylene, ethylene oxides, propylene oxide, propylene glycol and polyether polyols. Aromatic isocyanates and polyurethane systems, coatings, adhesives, sealants, elastomers, and composites are part of the equation. It also provides caustic soda, ethylene dichloride and vinyl chloride monomers, plus cellulose ethers, latex powders and acrylic emulsions. Architectural and industrial paints/coatings, plus industrial coatings for wood, metal packaging, traffic markings, thermal paper, and leather are part of the portfolio. Performance monomers and silicones round out just some of its offerings.
All told, Dow is the base supplier for a vast list of goods and products we use every day. If you look up from computer or smartphone right now, you can probably find ten or more items in your surroundings that have some sort of Dow ingredient. Below is an idea of the breadth of end markets served by Dow Incorporated. With 36,000 employees and 109 plants in 31 countries, Dow is an integral part of our interconnected global economy.
Image Source: Company Website
For Dow in particular, a lower U.S. Dollar during 2020-21 will create oversized benefits, on top of an improving global economy recovering from the coronavirus shutdown the next 12-18 months. With just 30% of sales in 2019-20 coming from the U.S., Dow is well positioned to see an unusual spike in sales and income reported in U.S. dollars. In past articles during 2020, I have talked about the powerful accounting bump in value for overseas sales and assets a big dollar tumble will create. My view of a declining U.S. currency exchange rate has been playing out all summer. Below is a table of sales by region in 2019-20.
Image Source: Page 20, June Quarter 10-Q
In addition, it is quite possible we are reaching for an inflection point where global growth begins to outstrip American gains, because of our out-of-control debt accumulation for decades. If this holds true, owning industrial growth assets OUTSIDE of the U.S. may prove a winning investment proposition going forward. Hands down, Dow fits the definition for super-sized foreign asset growth (70% of current revenue) in a smarter fashion than the average S&P 500 company, which generates 45% of sales away from U.S. borders.
COVID-19 Challenges Fading
Plenty of positive news was gleaned from the latest Q2 earnings release. The company is aggressively lowering costs (cutting expenditures and laying off 6% of the workforce), plus sales have rebounded strongly in June-July. The company is optimistic its main markets serviced are about to see well above GDP trend growth into 2021-22. Below are some slides from the earnings presentation.
Image Source: Company Q2 Presentation
Free Cash Flow Giant
Dow is a top investment pick because of low costs, excellent diversification of sales, and still super-strong free cash flow generation, even during the coronavirus pandemic. It’s hard to make exact comparisons to peers and competitors, as Dow is a leader in most of its markets, but the company looks quite inexpensive using the limited trading data for the new outfit since April of last year. With many of its fixed assets developed and constructed over the decades, the spun-off operation has little need for heavy capital investment, at least initially. Out of $57 billion in accounting construction costs for plant & equipment, $35 billion has already been depreciated. The result for early shareholders is a high level of free cash flow during 2020, even during a recession. $6.5 billion in operating cash flow and just over $4 billion in free cash flow has been generated the trailing 12 months through June. The upside of Dow’s balance sheet setup is rising inflation in the U.S. and a devalued dollar currency overseas will mostly flow to the bottom line, increasing cash flow and income at above normal rates.
Below you can see the discount Wall Street is putting on the valuation of the old, now new business offering from Dow. Compared to DuPont, Corteva, 3M (MMM), LyondellBasell (LYB), International Flavors (IFF), Eastman Chemical (EMN) and Huntsman (HUN), Dow is priced at a large discount on price to trailing free cash flow and regular accounting cash flow.
Free cash flow and operating cash flow returns on assets employed are also nicely above industry norms. Below you can review these data points.
Inventory turnover is quite robust, meaning the company is able to sell what it produces quickly. Cash flow is at an optimal rate when little inventory is carried.
Balance Sheet and Other Valuation Ideas
High cash flow rates are taking place without an inordinate amount of debt and financial leverage. $6.5 billion in operating cash flow the past year compares favorably with a net long-term liability total of $30 billion at the end of June ($16 billion in cash and current assets vs. $46 billion in total liabilities). Constant cash flow generation would take a theoretical 4.5x years to pay off all net liabilities, not much different than 4x ratio for the peer group discussed in this article. Against an S&P 500 equivalent number around 5.5x years, Dow Inc. easily passes my favorite apples to apples formula comparison for balance sheet safety and flexibility.
Using other traditional measures of financial ratio analysis, Dow also looks to be inexpensive versus equity investment alternatives in the chemical industry. On price to book value and sales, Dow is in a fair to undervalued range vs. peers and competitors.
Wall Street analysts are projecting an operating profit during the difficult recession year of 2020, followed by a sharp earnings rebound starting in 2021. Below is a graph of the EPS consensus estimate situation for coming years. The 20x ratio on 2021 EPS estimates and 16x multiple for 2022 are below the current S&P 500 average estimates of 25x and 22x, using equivalent respective time periods. Plus, my research suggests sales and earnings growth are completely “understated” given a sharp drop in the U.S. Dollar. I am using estimates of $3.00 EPS for 2021 and $4.00 for 2022 in my modeling, far above Wall Street expectations.
Leading Dividend Yield
Perhaps the strongest bullish argument for ownership is the company’s insistence on paying an industry leading dividend payout, as cash flow is strong and liquidity already exists on the balance sheet. Falling from close to 7% for a cash distribution yield annually a few weeks ago on a $40 share price, today’s 6.2% is still sky-high for the industry and 4x the S&P 500 rate of 1.7% today. Against the short to intermediate duration Treasury yield curve under 1%, Dow’s 6.2% upfront yield is quite extraordinary for income investors to consider.
While the $2 billion payout represents more than 100% of estimated 2020 earnings, it stands at 50% of $4 billion in free cash flow and 30% of $6.5 billion in operating cash flow over the last four quarters. The good news is a quick rebound in the global economy would usher in much greater profitability during 2021-22, allowing Dow to maintain or even increase distributions to shareholders.
Technical Trading Momentum Upswing
I have mentioned numerous ways to play the lower Dollar in 2020, as out-of-control money printing to fight the coronavirus erodes the purchasing power and confidence in our currency by foreigners. Wall Street traders and investment companies are taking notice of the devaluation beginning in the middle of 2020 by shooting precious metals investments through the roof first. My last article gave a review of my still bullish gold/silver/platinum feelings. And, evidence of changing investor attitudes are showing up in regular stocks with extensive overseas sales and assets. I talked about this extra kicker for returns by Abbott Labs (ABT) in July here, as an example. Dow Inc. is witnessing many of the same investor buying patterns as Abbott, although they are in completely different business fields.
Dow’s technical picture scores very highly of late using my favorite momentum indicators. How strong is the foundation of buying underneath the stock in July-August? I have it ranked at #9 in my S&P 100, largest blue-chip index creation for short-term buying interest, as of Friday’s close. The 2020 advance leaders of Apple (AAPL), Amazon (AMZN) and Alphabet (GOOG) (NASDAQ:GOOGL) are ranked slightly higher for comparison shopping.
Below you can see steady accumulation has not translated into a price explosion to the upside yet vs. late 2019. However, the stock quote has doubled its March low trade around $22. This past week it appears Dow is preparing to break out above the June high watermark around $46, after several months of price consolidation. Staying above the simple 50-day and 200-day moving averages will be something to watch going into the fall months. The “golden cross” of the 50-day jumping over the 200-day is about to happen also.
On the 1-year chart above, I have drawn the Average Directional Index (ADX), a medium-term momentum indicator. The July-August period, circled in green, is highlighting a lack of clear price direction currently. A flatline of this duration usually precedes a major turn higher or lower. If you have confidence in the economic recovery and the stock market’s future price trend (which I am personally wavering on), Dow’s next immediate price trend may very well be bullish.
The Negative Volume Index (NVI) has risen nicely the past 12 months, despite volatile price moves to the downside earlier in 2020. The steady uptrend in the NVI, marked with a red arrow, tells us buying interest has existed on lower volume, less newsworthy days. My read of the situation is the recession and fears of a prolonged cyclical drop in the chemical sector have not been widely held by investors. The exaggerated sell-off was something of a kneejerk reaction to the coronavirus shutdown, following the market lower in an arbitrage manner. The sell-off was essentially not a company specific event, but a general macro stock market dump.
Lastly, On Balance Volume (OBV) numbers have been relatively bullish all year, marked with the blue arrow. High volume buying happened in March and April, mixed between the dramatic sell days. OBV over 1-year, 6-month, 3-month and 1-month periods is positive. In combination, the technical indicators pictured (and many more which are not) for Dow Inc. are in a bullish to uber-bullish position right now.
Strong cash flows, the increasing odds a lower Dollar will pump overseas results, an economic upturn in coming months, decent valuations, a super dividend yield and serious technical buying activity all argue for an upturn in Dow from $44 a share in August.
The primary risk to the bullish outlook is an extended recession or a double-dip in global economic activity from the potential (if not probable) rise in coronavirus issues this fall and winter. And, changing views of the COVID-19 pandemic may be the final decider on the immediate price direction in Dow shares. I have owned shares off and on the last several weeks, as my personal views remain in flux. I am thinking U.S. and worldwide infection cases and deaths will almost surely rise the next 3-6 months. How much economic damage occurs in a large second wave is more debatable. Nevertheless, if you believe the virus problem is peaking now, Dow’s upside is very substantial going forward.
Asbestos and silicon lawsuits and damages are another knock against Dow’s business holdings. Yet, these operating costs appear more manageable vs. a decade ago, with losses and payments having a longer accounting history. Company projections and write-offs for such are down to the $1-2 billion range yearly, as courts generally follow past examples of verdict award ranges, something akin to worker’s compensation mandates from a legal perspective.
Weighing all the pros and cons, my specific trading plan for Dow revolves around its performance in coming months against the S&P 500. The stock has a variety of characteristics pointing to market “outperformance” the next 12-18 months. As long as the price holds up better than the general market, especially during a downturn into the November election, I will rate it a buy and attempt to purchase shares on mild weakness. My working thesis is a 10-15% drawdown from a second wave coronavirus situation will open extra upside during 2021, on the inevitable economic rebound.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is suggested before making any trade.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DOW over the next 72 hours. 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.
Additional disclosure: This writing is for informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. This article is not an investment research report, but an opinion written at a point in time. The author’s opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. Any and all opinions, estimates, and conclusions are based on the author’s best judgment at the time of publication, and are subject to change without notice. Past performance is no guarantee of future returns.