On its face, Dow (NYSE:DOW) looks like a screaming buy. The petrochemical giant plays a largely irreplaceable role in the global supply chain, but DOW stock hardly seems to reflect that reality. DOW trades at nearly 9x 2020 EPS estimates while providing a 5.7% dividend yield. That is among the highest in the market.
But as is the case in investing, it’s not quite that simple. There are significant risks here. Short-term, trade war worries could slow macro growth and the demand for Dow products. The company itself believes tariffs will have as much as a $100 million impact on EBITDA this year. Looking out further, a cyclical slowdown represents yet another risk.
Dow remains a classic cyclical stock. The big fear is that Dow Inc stock looks cheap because its earnings are nearing a peak. The valuation isn’t a sign of the market not paying attention and leaving DOW cheap. Rather, investors are pricing in a likely decline in future earnings.
DOW stock looks attractive here despite the risks.
The Risks to DOW Stock
The risks to DOW stock can be seen clearly in the first quarter report. Dow Inc was still a part of DowDuPont at the time, but the company released pro forma results for the quarter in early May. They weren’t pretty.
Revenue fell 10% year-over-year. Notably, volume rose 1% — which is a key point to understand here. Dow’s products faced major pricing volatility that went against the company significantly in the first quarter. That wasn’t necessarily a surprise: DowDuPont had guided for a weak quarter in late January. DowDuPont stock also fell over 9% after that guidance was released — and Dow Inc modestly under-performed the outlook, which had projected a “high-single-digit” decline in revenue.
The big driver, according to Dow’s Q1 presentation, was a substantial compression in polyethylene margin. Essentially, Dow’s prices came down, which in turn had an amplified effect on margins. Dow’s Adjusted EBITDA fell 24% and adjusted operating income declined by one-third.
The worry is that polyethylene margin weakness isn’t a one-quarter problem. New supply has come online, with Exxon Mobil (NYSE:XOM) and LyondellBasell (NYSE:LYB) adding even more this year. Lower natural gas and oil prices present another potential headwind.
Dow saw similar margin issues in other markets, including isocyanates and siloaxanes. Currency had a negative effect as well. All of these factors go to the same broad risk: Dow’s pricing power is coming down, and potentially staying down. This suggests earnings will continue to decline — meaning DOW stock is not anywhere close to as cheap as it looks.
The Case for Dow Inc Stock
Those risks can’t be ignored, but on its face, Dow doesn’t seem similar to stocks like Caterpillar (NYSE:CAT) or Deere (NYSE:DE), whose sales and profits swing wildly with economic conditions. But at least as far as earnings go, it can be as volatile — which generally leads to a discount from investors.
A better (if seemingly odd) comparison might be memory chip manufacturer Micron Technology (NASDAQ:MU). Micron’s end demand isn’t that volatile. But pricing swings are enormous, driven — as in the case of polyethylene — in part by capacity additions among industry producers.
Dow’s earnings aren’t nearly as volatile as those of MU, but the broader point holds. Using four-quarter earnings to value either stock is going to make both look cheap. It’s important to understand where those earnings sit in relation to the cycle to truly understand fair value.
It’s that understanding that actually makes DOW stock look reasonably attractive. Earnings might be near a peak, but there are growth opportunities on the way. Before the spin the company highlighted some $800 million in cost savings between synergies and the removal of so-called “stranded costs.” Dow has its own capacity coming online over the next few years. Capital expenditures should moderate going forward, freeing up more cash for dividend growth and buybacks.
The point is that margin pressure is a real risk. But Dow has more than a few levers to pull to offset that pressure. At 9x earnings and with a yield nearing 6%, Dow Inc doesn’t need to do much more.
DOW Stock: An Aggressive Play
I wrote earlier this month that Dow Inc stock was one of the 5 worst Dow Jones Index components so far this year. That’s a bit of a stretch, but it was a way to highlight the disappointment that has accompanied the DowDuPont breakup. More than a few savvy value investors saw the breakup as creating $80 or more per share in value. The figure at the moment, based on current trading prices for DuPont (NYSE:DD) and Corteva (NYSE:CTVA), is under $50.
Short-term worries have led to those lower-than-expected returns and cannot be ignored. Dow is going to struggle if global macro growth slows. But the broader thesis of those value investors buying DWDP stock last year still holds. And it’s DOW stock that drove most of that upside.
That potential is why I also called DOW stock one of the best Dow Jones components for the rest of the year. It does make some sense why DOW shares are struggling at the moment, but there are enough reasons to believe that will change at some point.
As of this writing, Vince Martin has no positions in any securities mentioned.