DOW - Why I Believe 5%-Yielding Dow Inc. Is 25% Undervalued

2024-01-01 02:44:01 ET

Summary

• I am putting an emphasis on value investments in 2024 due to lofty stock market valuation and the potential for subdued total returns.
• This includes looking for higher-income opportunities and focusing on dividends for a bigger part of total return in the next 10 years.
• Dow Inc. is a cyclical stock with a dividend exceeding 5%, but dividend growth is unlikely in the current economic environment.

Introduction

In 2024, I am putting a bigger emphasis on value investments. I'm doing that because of the lofty stock market valuation, which increases the likelihood of subdued longer-term total returns, making stock picking more important.

I discussed that in my 2024 Outlook , written on December 5, which is where I got the quote below:

I like beaten-down cyclical stocks. This includes railroads, machinery companies, and certain consumer stocks with proven track records, which I'm buying on weakness. This is based on the aforementioned phenomenon where cyclical stocks price in a recession well before it happens. I'm not going all in, but I'm gradually buying these stocks when the valuation offers a significant margin of safety.

I'm also looking for higher-income opportunities:

While I'm not a high-yield investor (I prefer dividend growth over dividend yield), I'm increasingly looking for income plays, as I believe that a much bigger part of the total return of the next 10 years will come from dividends.

As we can see in the chart below, in periods of prolonged elevated inflation, a bigger part of the total return tends to come from dividends.

That's where Dow Inc. ( DOW ) comes in, which is a cyclical stock with a dividend exceeding 5%.

My most recent article on the stock was written on July 9, titled " Dow's Juicy 5% Yield Would Be A No-Brainer If It Weren't For The Economy ."

In this article, I'm going to elaborate on this, dive into its dividend, and explain how I would handle this income stock based on current headwinds and tailwinds.

So, let's get to it!

The Attractiveness Of Dow's Dividend

There are 5% yields that are attractive and 5% yields that are unattractive.

It all depends on the bigger picture.

Dow currently pays $0.70 per share per quarter. This translates to a yield of 5.1%.

• This dividend is protected by $2.7 billion in 2023E free cash flow, which translates to an FCF yield of 7.0% and a cash payout ratio of 73%.
• Using its earnings payout ratio, we're dealing with an 88% payout ratio using 2024E EPS. That number is expected to decline to 62% using 2025 numbers.
• The company has a 2023E net leverage ratio of 2.2x, which is extremely healthy and a sign that DOW does not need to prioritize debtholders over shareholders.

However, since the company spun off from DowDuPont in 2019, it has never hiked its dividend.

That's why its dividend history is a horizontal line.

The good news is that DOW is increasingly well-positioned to boost shareholder returns.

During its third-quarter earnings call, the company highlighted a cash flow conversion of 129%, proving its ability to convert earnings into operational cash.

The balance sheet was described as the healthiest in four decades, supported by strong investment-grade credit ratings (BBB+) with no significant long-term debt maturities until 2027.

Unfortunately, dividend growth is unlikely to happen in this economic environment.

The Challenging Environment

The leading economic ISM Manufacturing Index has been in contraction (below 50) every single month in 2023. It is currently close to a multi-year low, which indicates very weak demand in the manufacturing sector. This also impacts the chemical industry and most companies with cyclical business profiles.

As a result, Dow's financial performance in the third quarter reflected this challenging global economic environment.

Net sales for the quarter were $10.7 billion, marking a 24% decline year-over-year.

This decrease was attributed to slower global macroeconomic activity, resulting in lower volumes and local prices across all operating segments and regions.

Operating EBIT for the quarter was $626 million, down significantly from $1.2 billion in the previous year, primarily due to lower prices and demand in key segments.

Despite the headwinds, the company implemented targeted actions to achieve $1 billion in cost savings in 2023, contributing to a sequential improvement in operating cash flow of over $300 million.

What's interesting is that during its press conference, the company also acknowledged the 13th consecutive monthly decline (it's currently worse) in global manufacturing PMI.

Weak demand in Europe, a slower-than-expected recovery in China, and ongoing challenges in various regions were highlighted.

We can see these findings in the chart below.

Dow also provided insights into its outlook for the fourth quarter.

The company anticipated continued challenging macroeconomic dynamics, including sluggish industrial activity and weak demand in certain areas.

Despite these challenges, Dow expressed confidence in its ability to navigate through the economic headwinds, which were reiterated at the Citi Basic Materials Conference.

Dow Is Poised For Long-Term Growth

Instead of just waiting for cyclical headwinds to turn into tailwinds, Dow is investing in future growth.

For example, during the Citi conference, the company announced the final investment decision for the Path2Zero project in Fort Saskatchewan, Alberta, where it is Leveraging learnings from the successful Texas-9 cracker.

This project is anticipated to drive underlying earnings growth of more than $1 billion per year.

Advantages include lower cash costs, 20-year feedstock contracts, and partnerships with industry leaders like Linde, Fluor, Wolf Midstream, and Ravago.

The Alberta Path2Zero project involves two phases, with a total CapEx spend of $6.5 billion. Dow anticipates receiving over $1.5 billion in governmental support, and the majority of incentives align closely with the project's CapEx deployment.

Furthermore, with regard to the aforementioned cost savings, Dow maintains a disciplined approach to financial and operational matters.

The company is on track to deliver $1 billion in cost savings in 2023, enhancing financial flexibility by reducing net debt and pension liabilities by over $10 billion.

This strategic approach has positioned Dow well to navigate near-term macro challenges and continue driving shareholder value.

Adding to that, in the polyethylene market, Dow is well-positioned for growth.

Despite some price pressure due to falling oil prices, the company sees strong volume movement.

Export strength has been a consistent positive, with consecutive monthly records in the export of polyethylene products from the U.S.

Furthermore, high demand for wire and cable products, silicone in chip manufacturing, and infrastructure-related products contribute to a diversified revenue stream.

While housing and home construction have been challenging, the company believes that potential green shoots in the housing sector offer opportunities for growth, especially if interest rates decline. I agree with that.

It also needs to be said that despite current headwinds, DOW has made tremendous progress since its spin-off.

• Free cash flow has more than doubled.
• The cash conversion rate is now close to 100%.
• The free cash flow yield is close to 10% (this also indicates dividend safety).
• Net debt has been reduced by almost $6 billion.
• Pension liabilities are now below $3 billion.
• The company has reduced the number of outstanding shares.

So, what about its valuation?

Valuation

Dow isn't the only one upbeat about its future.

As we can see in the chart below, analysts expect EPS growth to exceed 40% in both 2024 and 2025 after a potential 64% decline in 2023.

Furthermore:

• DOW shares are currently trading at a blended P/E ratio of 24.5x.
• The normalized valuation is 15.8x, which, I believe, is a valuation that fits the company's growth profile quite well.
• A 15.8x multiple (lower than its current blended valuation) could result in a fair price target of $70 by incorporating the expected EPS recovery. This would imply roughly 25% growth from its current price.

Currently, the stock has a $55 fair price target, which is where it is currently trading.

The last time the stock got targets close to $70 was in early 2023 when analysts weren't aware of the decline in global economic growth.

Hence, I expect DOW shares to make a move to $70 the moment economic growth expectations bottom.

For now, I expect the stock to remain in a volatile sideways trend.

If I were in the market for DOW shares, I would buy a small position and add gradually over time. If the stock declines further, investors get to average down. If the stock suddenly takes off, investors have a foot in the door and a 5% yield.

My Bullish target reflects the company's longer-term potential.

Takeaway

In my investment strategy for 2024, I'm focusing on value investments due to the elevated stock market valuation.

Beaten-down cyclical stocks like DOW, with a 5% dividend yield, catch my attention.

While its challenging environment, marked by a global economic slowdown, impacts short-term performance, Dow's resilience is evident.

The company's strategic initiatives, cost savings, and investments in projects like Path2Zero position it for long-term growth.

Despite near-term uncertainties, Dow's financial health, impressive free cash flow, and growth prospects make it an intriguing long-term opportunity.

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