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)
We discuss a broad range of issues that are often investment-related, but not always so. We call it a 'thought blog'. Sagacious: Having or showing keen discernment, sound judgment, and farsightedness.
A Contrarian Thought for (another) Record DJIA High
"Follow the course opposite to custom and you will almost always do well."
- Jean Jacques Rousseau
- Jean Jacques Rousseau
A New High - Now Let's Move On
As oil falls below a key psychological level of $60/barrel, the Dow Jones Industrial Average hits a new intraday high! If you've read previous posts, this is not something that gets me too excited, since at these levels on the Dow, the S&P 500 is still 12% below its all-time high. Let’s do a brief analysis of just how the prices of the stocks in the average can affect the DJIA’s overall returns.
General Motors (GM) is the average’s top performer year-to-date, up 74% and responsible for about 1.7% of the DJIA’s YTD performance. Looking deeper at the Dow’s YTD performance, we can see how the price-weighted average calculation method can affect its returns. Merck (MRK), now a $42 stock, is the second highest contributor after GM – up over 32% year-to-date and responsible for about 0.9% of the DJIA returns. The third largest contributor, Boeing (BA), an $82 stock, is up only about 17%, yet has contributed the same amount as MRK (about 0.9%) to the Dow’s returns. Despite Merck's returns exceeding those of Boeing by almost double, the effect on the DJIA is the same.
Note that the index in no way tries to overweight undervalued stocks or underweight the overvalued stocks. I don't know many money managers who determine a stock's weighting in a portfolio based solely on price.
General Motors (GM) is the average’s top performer year-to-date, up 74% and responsible for about 1.7% of the DJIA’s YTD performance. Looking deeper at the Dow’s YTD performance, we can see how the price-weighted average calculation method can affect its returns. Merck (MRK), now a $42 stock, is the second highest contributor after GM – up over 32% year-to-date and responsible for about 0.9% of the DJIA returns. The third largest contributor, Boeing (BA), an $82 stock, is up only about 17%, yet has contributed the same amount as MRK (about 0.9%) to the Dow’s returns. Despite Merck's returns exceeding those of Boeing by almost double, the effect on the DJIA is the same.
Note that the index in no way tries to overweight undervalued stocks or underweight the overvalued stocks. I don't know many money managers who determine a stock's weighting in a portfolio based solely on price.
Private Equity's Newest Bet
Harrah’s Entertainment (HET) shares got a big boost today, up about 14%, having received an $81/share buyout proposal from two private-equity firms. That price values Harrah’s at 20 times forward earnings and about 10 times operating cash flow. At market close, the shares were still trading about 7% under the deal price. Does the market not think this deal will consummate?
It’s a cash deal, which means that the newly private firm will be saddled with large amounts of new debt (Harrah’s market cap at the deal price is $15 billion) while assuming over $10 billion of existing debt. Interest expense currently totals around 25% of EBITDA. My primary worry in the near-term is that adding significantly to its debt load would limit its flexibility during a downturn.
True, at this point Harrah’s generates a healthy amount of operating cash flow that could service additional debt, but in recent years that cash flow has been used to fund considerable capital expenditures. Could more debt meaningfully restrict their ability, for instance, to develop their properties on the Vegas Strip to better compete with MGM’s upcoming City Center?
Typically, these private equity deals work out the best when a firm can slash costs, wringing out extra cash to pay down the new debt. Yet this could be detrimental to Harrah's, where capital spending is vital not only to maintain its growth track, but also to keep its casinos relevant and its competitive position in place.
It’ll be interesting to watch. With insiders owning over 4% of the shares, shareholders can bet the board has their interests in mind. Feel like a gamble? Go long Harrah’s shares and bet the deal goes through.
It’s a cash deal, which means that the newly private firm will be saddled with large amounts of new debt (Harrah’s market cap at the deal price is $15 billion) while assuming over $10 billion of existing debt. Interest expense currently totals around 25% of EBITDA. My primary worry in the near-term is that adding significantly to its debt load would limit its flexibility during a downturn.
True, at this point Harrah’s generates a healthy amount of operating cash flow that could service additional debt, but in recent years that cash flow has been used to fund considerable capital expenditures. Could more debt meaningfully restrict their ability, for instance, to develop their properties on the Vegas Strip to better compete with MGM’s upcoming City Center?
Typically, these private equity deals work out the best when a firm can slash costs, wringing out extra cash to pay down the new debt. Yet this could be detrimental to Harrah's, where capital spending is vital not only to maintain its growth track, but also to keep its casinos relevant and its competitive position in place.
It’ll be interesting to watch. With insiders owning over 4% of the shares, shareholders can bet the board has their interests in mind. Feel like a gamble? Go long Harrah’s shares and bet the deal goes through.
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