A Look at Dow Chemical

Is Dow Chemical undervalued at $38 and change? At 9.5 times forward earnings, about 0.75 times sales, and a 4% dividend yield, on the surface it looks like a value.

This is a cyclical company that lacks an economic moat. In other words, it is largely not in control of its own destiny. It has high returns during economic expansion (when demand exceeds supply) and experiences poor returns during contractions (when demand weakens, or supply brought on during expansions exceeds demand). Roughly 50% of revenues come from specialty chemicals and plastics. These businesses are less cyclical than other, basic chemical lines but all segments remain sensitive to the economic cycle.

Especially in its North American operations, the company has little control over its resource costs and is only able to pass cost increases along to customers when demand is high. Thus, when economic activity slows and costs in increase the company’s margins get squeezed. Of course, this works both ways. Both oil and gas, which comprised almost half of Dow’s total costs in 2005, are down dramatically in price as of late. This is likely to lead to some margin gains and maybe even to an upside earnings surprise in Q4, perhaps even in Q3. But these gains may be fleeting.

Operating and net margins appear to be at cyclical highs (18.5% and 9.5%, respectively, versus a 14% and 5.2% 7 year average), as does return on equity (ROE), at about 26% currently, versus a seven-year average of 15%. The current numbers are direct evidence of pricing power during a period of high demand. Looking back as recently as 2001 and 2002 (recessionary conditions), Dow’s operating margins were near 10% and net margins were negative.

The market doesn't capitalize peak earnings, so let’s use the above numbers to “normalize” Dow’s earnings over an economic cycle. That is, average out the swings in profitability that result from the cyclical nature of the business. Using the 7-year average ROE of 15% times the current (2Q 2006) book value of $17.52, I get a “normal” net income number of $2.63. Using the normalized net profit margin based on projected 2006 sales we arrive at about the same number. At today's price, this puts Dow at nearly 15 times normalized forward earnings. This happens to be right around Dow’s average P/E since 1990.

(look for more on Dow in coming days)