More on Dow Chemical

9 Oct

(continued from previous post)

The 4% dividend yield is a nice pad to total return. Over at least the past 17 years, the company hasn’t cut or reduced its dividend, which has grown at an annual rate of a little over 3%. The company is watching costs, having shut down more than 50 manufacturing facilities across the globe over the last three years amidst record profitability. And they’re using cash to pay down debt and buy back shares. Yet this has happened before, most recently from about 1994 through 1998, and from there debt levels and share count grew again.

We know the third quarter is likely to be a little rough, as the company will be taking about $600 million in charges for severance and asset writedowns as a result of plant closings. Look for earnings to be boosted in future periods, as this writedown will hit earnings in the third quarter of this year and not affect them in future periods. Don’t be fooled, though, as actual severance and plant shutdown costs will continue to impact the company’s cash flows into the future.

Let’s look at another metric, the current forward price-to-sales (P/S) ratio, which is around 0.75. This is near the lows of the past 10 years and most similar to the lowest forward multiples experienced in 1995-96 for the expansion years of 1996-97. Coincidentally (or not), the period most similar to now in level of margins and ROE was 95-96. The average forward P/S multiple during those years was under 0.90 (since 1995 Dow’s average P/S ratio is 1.00) , while Dow’s P/E ratio averaged 9.5, which looks strikingly similar to now. What does all this mean?

Purchased at the low prices of 1995-96, Dow would have returned about 8.6% annually to date (including the 10-yr average dividend yield of 2.6%). The S&P 500’s total return over that period is around 10% annually.

Historically, it has been more profitable to buy cyclical companies when P/Es are high and profits are bottoming. In this case, Dow has a low P/E ratio and its profits are (probably) at or near a peak.

If you think the stock has upside between now and January but don’t want to invest the cash, write a Jan 40 put and buy a Jan 40 call. Based on current prices, you’ll effectively own the stock at a little over $39 (slightly over market) but without any cash outlay. Be aware that you’ll need to have the cash to cover the trade in the event the stock is put to you come January.


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