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 choices.
Tracing its roots to 1897, Dow has a market 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
As Gordon 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 in revenue last year -- 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 the Federal 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.
Meanwhile, as U.S. farming comes off of one of the worst droughts in decades, data from the Department of Agriculture show that net farm income increased just 4% last year, to $122 billion.
Clearly, there's room for upside, and Dow is poised to surf that wave 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 always now.
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 annual sales 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, and analysts 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 the top line. And with a combined average growth rate of nearly 15%, expect that to contribute significantly to the bottom line as well.
Under the leadership of CEO Andrew Liveris, Dow set its focus on identifying strategic options, primarily in the form of divestitures that will generate cash 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 in free 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. That cash flow, plus cash from divestitures, could reduce Dow's long-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 the commodity 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.
Another red flag comes from the fact that 64% of the company's sales last year came from outside of North America; Liveris recently made some bearish comments on data from China. In addition, the idea of increasing cash through the sale 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 annual dividend of $1.28, which equates to an attractive yield of nearly 4%. Based on the company's exposure to high-growth areas, excellent free cash flow, and shareholder value action plan, a 12-month price target of $42 would be reasonable. Adding the dividend would push the total return potential to near 24%.