Typically,investing is about making choices: growth versus
value, long versus short, domestic versus international, or
cyclical versus staple. Rarely do we get the best of both
Fortunately, the stars have aligned for onestock . Investors can
play defense with an old-line company whose products are a
necessity in two growth industries andwill be for years to come.
I'm talking about a perennial Americanblue chip ,
Dow Chemical (
Tracing its roots to 1897, Dow has amarket cap of more than $40
billion and is the nation's largest chemical manufacturer, making
everything from dry-cleaning solvent to agricultural products.
The company's stock has been stagnant for nearly a decade. But
that's about to change, thanks to Dow's exposure to two rapidly
growing yet starkly different industries: electronic materials
and agricultural sciences. Dow is also doing well in controlling
internal costs and generating shareholder value.
Better Living Through Chemistry
AsGordon Gekko might have said: "Chemicals are good. Chemicals
work." This is especially true when it comes to agriculture.
While Dow's agriculture business contributed $6.3 billion of the
company's $56.7 billion inrevenue lastyear -- roughly 12% of the
total -- that particular business line is projected to grow at a
10% clip through 2015. That's not bad.
However, an August 2012 survey by theFederal Reserve Bank of
Chicago found that farmland prices in Iowa, Illinois, Indiana,
Wisconsin and Michigan increased 15% from the previous year. A
concurrent study from the Kansas City Fed showed a 26% increase
in prices for the same period in the Great Plains.
Let's say U.S.GDP growth inches up at an annual rate between 2.5%
to 3%. That wouldmean the growth of farmland as anasset class is
nearly 10 times the rate of GDP growth.
Meanwhile, as U.S. farming comes off of one of the worst droughts
in decades, data from the Department of Agriculture show that net
farmincome increased just 4% last year, to $122 billion.
Clearly, there's room forupside , and Dow is poised to surf
thatwave with pesticides, herbicides, seed technology and other
agriculture-related chemical products.
"Plastics, Benjamin. Plastics."
Maybe the screenwriters of the 1960s film "The Graduate" were
thinking of the main character's prospects of getting a job
during the American postwar industrial boom, where the future is
That bit of dialogue proved prophetic. Dow Chemical may have even
been the inspiration. Plastic is found in nearly everything, and
there's a strong chance Dow had something to do with that.
The performance plastics business contributes nearly 25% of Dow's
annualsales and is projected to grow at an impressive 14% rate
over the next two years. But the more impressive number lies
within its electronic and functional materials business. The
segment contributed $4.4 billion to Dow's revenue last year, just
under 8% of the company's total, andanalysts project 17.5% growth
over the next two years.
The electronics division produces raw materials for use in
circuit boards and device manufacturing thanks to the tablet and
smartphone revolution. Combined, the agriculture and electronics
businesses should contribute 21% to thetop line . And with a
combined average growth rate of nearly 15%, expect that to
contribute significantly to thebottom line as well.
Under the leadership ofCEO Andrew Liveris, Dow set its focus on
identifying strategic options, primarily in the form of
divestitures that will generatecash and unlock shareholder value.
Over the next 18 months, the goal is to generate nearly $1.5
billion in pre-tax cash from sales of what Dow considers non-core
assets. The company is also expected to generate $1.6 billion
infree cash flow after paying out $1.5 billion in dividends. That
would be a 6% increase from free cash flow of $1.5 billion in
2012. Thatcash flow , plus cash from divestitures, could reduce
Dow'slong-term debt by an estimated 20% this year.
Despite a challenging environment, Dow has increased free cash
flow at an annual rate of 10.4%. Not bad for a gigantic company
that is highly susceptible to cyclicality.
Risks to Consider:
Dow is susceptible to the cyclical nature of thecommodity
chemical business, which represents 40% of the business mix,
while 60% comes from less cyclical specialty and consumer staple
products. This does give the stock a defensive bias.
Anotherred flag comes from the fact that 64% of the company's
sales last year came from outside of North America; Liveris
recently made somebearish comments on data from China. In
addition, the idea of increasing cash through thesale of non-core
assets sounds to me like a rainy-day plan.
Action to take -->
Dow currently trades in the mid-30s with a forward
price-to-earnings (P/E ) ratio of 14.7. The company also pays a
generous annualdividend of $1.28, which equates to an
attractiveyield of nearly 4%. Based on the company's exposure to
high-growth areas, excellent free cash flow, and shareholder
value action plan, a 12-monthprice target of $42 would be
reasonable. Adding the dividend would push the total return
potential to near 24%.
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