If a massive industrial maker of coatings, paints, solvents, lubricants, packaging, and specialty polymers doesn't get you excited, its story will. Even since its spinoff from DowDuPont in late March 2019, Dow (DOW +0.00%) shares have been all over the place -- as high as 24% above the spinoff price and as low as 17% below it. That's some serious movement for an industrial company of its size.
Since Dow reported second-quarter earnings on July 25, the company has found itself trending lower. That said, Dow is a free cash flow machine. The company acts as a supplier of high-volume commodity chemical products like valuable silicone and polyethylene. Almost all Dow's chemical products are tied to basic feedstocks, most notably crude oil.
The cyclical nature of Dow and its tethering to feedstocks and global trade makes the company vulnerable to the volatile commodity prices and trade tensions that have plagued the market of late. With earnings approaching on October 24, investors should reflect on Dow's prior quarter to gauge whether the company is on track for long-term shareholder value.
Source: Getty Images.
Dow is down on its luck
Dow had a difficult second quarter, mostly due to margin compression across almost all of its high-volume products. "Operating EBIT was $1.1 billion, down 35% versus pro forma results in the year-ago period. Margin compression in polyethylene, isocyanates, and siloxanes, as well as lower equity earnings, more than offset volume gains in packaging applications, contributions from new capacity on the U.S. Gulf Coast and savings from cost synergies and stranded cost removal," said Dow in its second-quarter financial highlights.
That makes things sound worse than they really are. Dow is taking hits from lower commodity prices but is improving what it can control: Operations. The company is cutting costs while expanding capacity in one of its largest export markets, the U.S. Gulf Coast. In total Dow delivered "more than $130 million of cost synergy savings and $45 million of stranded cost removal" during the second quarter.
Dow isn't the only industrial that's down on its luck. Most of the manufacturing and industrial sector has been strained for about two years now, as evident from a declining purchasing managers' index (PMI). PMI is a good indicator of the direction of economic trends in the manufacturing and service sectors. The index is a number from 0 to 100, with any number less than 50 signaling an economic contraction and any number above 50 signaling expansion. The U.S. manufacturing PMI fell below 50 in mid-2019 and the Eurozone manufacturing PMI, as reported by IHS Markit, has been below 50 since the beginning of 2019. Both indexes were around 60 in late 2017/early 2018.
While this metric doesn't directly relate to Dow, it has trickle-down consequences for a company that produces products that drive the American and European economies. On top of that, Dow has faced several analyst downgrades on fears of an economic slowdown.
Impeccable management
|
Metric |
Q2 2019 |
Q2 2018 |
|---|---|---|
|
Net sales |
$11 billion |
$12.9 billion |
|
Operating EBIT |
$1.1 billion |
$1.6 billion |
|
Operating EBIT margin |
9.6% |
12.8% |
|
Operating EBITDA |
$1.8 billion |
$2.4 billion |
|
Operating EPS |
$0.86 |
$1.41 |
|
Cash provided by continuing operations |
$960 million |
$760 million |
Data Source: Dow 2Q2019 Investor Presentation Deck
Dow management is painfully aware of margin compression and declining sales between the second quarter of 2018 and the second quarter of 2019. Fortunately, Dow's business is more streamlined than it was in the past. Aside from inheriting a few material sciences divisions from DowDuPont, Dow is focusing its attention on three core business segments: performance materials and coatings, industrial intermediates and infrastructure, and packaging and specialty plastics.
| Operating EBIT Margin |
Q2 2019 |
Q2 2018 |
|---|---|---|
|
Performance Materials & Coatings |
9.1% | 10.9% |
|
Industrial Intermediates & Infrastructure | 4.6% | 12.6% |
|
Packaging & Specialty Plastics | 14.8% |
15.1% |
Data Source: Dow 2Q2019 Investor Presentation Deck
When you break down each segment, it's clear that most of the margin pain comes from just one of Dow's segments. Margins compressed from 12.6% to 4.6% in the industrial intermediates and infrastructure segments but declined less than 2% in the performance materials and coatings division and only 0.3% in the packaging and specialty plastics division.
"In the quarter, we faced margin compression in our intermediate products in both our core business and equity earnings. However, we achieved demand growth in packaging applications, supported by new capacity on the U.S. Gulf Coast," said CEO Jim Fitterling.
There's no doubt that Dow's reliance on polyethylene, siloxanes, isocyanates, and monoethylene glycol (MEG) hammered the quarter. But commodity prices are out of Dow's control. With what can be controlled, Dow is doing what it can.
A compelling investment
Average analyst earnings-per-share estimates for Dow's next two quarters are $0.75 and $0.82, respectively, adding up to $3.54 in 2019 earnings. That would be a 2019 P/E ratio of 13.3, well below the market average. Dow's whopping 6% dividend, low P/E multiple, and responsible management provide a buy case for Dow. As long as Dow's management can continue to perform despite global headwinds and declining commodity prices, then Dow will prevail during short-term economic contractions. The key to any cyclical business like Dow's is management's ability to position itself for various economic environments. That's exactly what Dow is doing, making the stock a compelling long-term investment.
