24/7 Wall St. 2007 Break-Up Values: Dow Chemical $52.50 (Current Price $41.84)

Dow Chemical (DOW) – Price $41.84; Break-up Value $52.50

Investors know Dow to be a highly cyclical company, one that many use as a proxy for the basic materials sector as a whole.  Earnings may fluctuate wildly year to year as pricing levels in certain products fluctuate along with worldwide supply & demand.  One of the biggest goals of company management in recent years has been to reduce the inherent cyclicality by growing businesses that have more stable business results.  According to the CEO on the most recent conference call, cyclical business has been reduced to 47% of earnings, and “we are no longer a cyclical company”.  That’s a real hard sell considering that net income still swung 17% lower on a 5% rise in revenue for the year.  Still looks pretty cyclical to us, which is why the company trades for only 10x forward earnings. 

The two segments that have shown the most cyclicality, Basic Chemicals and Basic Plastics, are ultra-commoditized and admittedly being used by management to feed cash flows into other areas such as Agricultural Sciences, Performance Chemicals, and Performance Plastics.  That doesn’t seem to please all interested parties, as there have been recent rumors of private equity interest in acquiring parts of the company.  Operationally, Dow is very close to BASF (which trades for about 12.5x forward) and Rohm & Hass (13.5x forward), but the stock has the unattractive exposure to Union Carbide asbestos litigation, and they have also been recording massive charges to close down facilities deemed “unworthy” of capital expenditure. 

Dow has numerous joint ventures in place, which helps keep their tax rate low (well below 30% combined) and allows them to test different markets and potential business partners.  Their 50% stake in Dow/Corning is worth close to $4b alone, as stated in our previous break-up value of Corning.

Debt/Cap has come down nicely to 34% from 39% in 2005 and is a stated objective of management to push this number a bit lower.  Their paper is still at the bottom end of investment-grade, so it’s still a prudent source of capital.  Dow has also become much more aggressive with buying back stock, but they have to tread lightly in this area as cash flows can still fluctuate so much quarter to quarter. 

Unless private equity comes in with a slam dunk offer, the best bet for increased shareholder value is for Dow to continue paring off the commodity-based business segments, most notably Basic Chemicals, where they aren’t a true leader.  The hydrocarbons segment is mainly used to produce components for other Dow end products and is a “dummy” operating group, so we pretty much have to keep this one on the books.  In plastics, Dow is definitely the world leader in both sales and efficiency, so we’ll keep this as the backbone of the company. 

If we count the equity value of other joint ventures at 12x operating earnings to account for favorable tax treatment, their total value comes to just shy of $8b.  A sale of Basic Chemicals at a cheap 1.2x sales is worth $6.5b.  That leaves Dow with both plastics segments, Performance Chemicals, and the promising Agricultural Sciences segment.  The combined operating margins here would be slightly higher than peers, and should allow for slight multiple expansion to the tune of 12-13x current earnings over time.  For now, we’ll keep the current company multiple to account for the unknowns of restructuring costs and litigation concerns, giving the remaining Dow company a market cap of $32.7b, and providing a total break-up value of $52.50/share.

All told, investors will have to hope that management is serious when they talk of a less cyclical business, as it’s the only strategy that will allow the multiple to approach market-based levels of 15-18x earnings. 

Ryan Barnes

Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others.  Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.

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