2023-10-25 11:52:03 ET
Summary
- Dow's Q3 earnings beat expectations with adjusted EPS of $0.48 and revenue of $10.7 billion.
- The company saw declines in volumes and prices across its business segments, but the automotive sector showed strength, while the rate of decline is set to improve.
- Dow generated $1.06 billion in free cash flow in Q3 and has the balance sheet strength to maintain its dividend, offering a 5.8% yield.
Shares of Dow ( DOW ) have traded slightly higher over the past year, despite what has been a sharp decline in its business as cost controls and working capital management have helped to preserve cash flow. In the company’s third quarter, it is clear that headwinds are there but lessening. So long as you do not expect a recession, results may be nearing (though not yet at) a trough, creating moderate upside potential in shares.
In the company’s third quarter , Dow earned $0.48 in adjusted EPS, beating consensus by $0.03. Revenue fell by 24% to $10.7 billion but still beat estimates by $300 million. Adjusted earnings were down from $0.75 last quarter and $1.11 last year given an environment of lower revenue and shrinking margins. Overall, the company saw volumes fall by 6% from last year while prices fell by 18%.
That degree of volume decline is akin to a moderate recession, and in some ways, industrial activity has been facing recessionary pressures. Many manufacturing surveys have pointed to contraction, and for many of Dow’s chemical products, China is a primary source of demand. Its construction industry has experienced a multiyear slump, exacerbated by the potential liquidation of Evergrande and Country Garden. I would note that some of Dow’s pricing is tied to energy, and natural gas prices are lower than last year, particularly in Europe, driving much of that price decline.
Lower feedstock prices were able to offset much of the 24% revenue decline but not all of it as company-wide margins fell 260bp to 5.8%, a nearly $300 million headwind (~$0.32/share) from last year. Much of this operating margin decline is due to lower volumes and less utilization, given that there is a large degree of fixed cost in chemical production. Dow has also undertaken a $1 billion savings program with 85% of its headcount reduction already complete.
Looking at segment results, declines across Dow’s business were pretty broad based. Packaging and plastics, Dow’s biggest segment, saw revenue fell 26% from last year to $5.4 billion. Prices were down 20% and volumes 7%. Margins also compressed 200bp to 8.7%, leading to a nearly 40% decline in operating income of $476 million. Europe was particularly weak whereas packaging demand rose in Asia and Latin America.
Industrial and infrastructure saw a 25% drop in sales to $3 billion with pricing down 17% and volumes falling 7%. While operating income was down nearly 90%, it did swing back to a positive $21 million from a $35 million loss last quarter. It was encouraging to see the cost cuts Dow has been undertaking helping to bring this business back above breakeven
Finally, its coatings unit was down 20%, with price down 17% and volume down 3%. Operating margins fell 300bps to 8.4% with profits down over 40% to $179 million. Coatings was the relative bright spot, relative being an important word, given that smaller volume decline. This unit primarily sells paints and products to the automotive sector. This has proven to be a sector able to buck the negative momentum. While auto demand tends to be quite cyclical, there were so many supply bottlenecks from 2020-2022, that automakers had been underproducing to demand, creating pent-up demand they are still feeling. In particular, European auto sales were strong, and even China saw improvement.
Management noted that demand from the auto sector has “held up well” despite the strikes here in the US. While management said sales could fall due to the strike in Q4, depending on how much more it lingers, this will ultimately be temporary and there would likely be some catch-up after the strike. The targeted nature of the strike may be reducing the impact on volumes even as it has lasted for longer. This theory is also supported by history. In 2019 when General Motors ( GM ) faced a strike, US auto production fell by 10% but by February was higher than it was pre-strike (though with COVID, that increase proved to be short-lived)
Ultimately, Dow cannot control the macroeconomic environment it faces, and this has clearly weighed on its business. However, it has controlled what it can quite well. Dow generated $1.06 billion of free cash flow in Q3. Now much of this has been management aggressively destocking inventory with a $600 million free cash flow benefit in Q3. In addition to supporting free cash flow, by working down inventory, Dow is helping to tighten chemical markets, which means when demand does recover, pricing power and margins should as well.
With its strong Q3 free cash flow generation, it has generated $1.9 billion this year, down from $4.1 billion last year. I would note that free cash flow is $1.5 billion year to date excluding working capital. Even with declines it faces, Dow is still a cash generative business. Ultimately, just as Dow was “over-earning” its cycle average when it was generating $4 billion in free cash flow in 2021/2022, it is now under-earning relative to its cycle average.
That is the nature of a cyclical business; importantly Dow has also created the balance sheet flexibility to support itself through the cycle. Dow has no major maturities until 2027, meaning it will not need to come to the market and issue debt at today’s high interest rates. Additionally while net debt of $10.9 billion is up $300 million this year due to shareholder returns, it is down $ 4.6 billion from 2019 when its series of corporate mergers and spin offs with DuPont were finalized. That leaves it comfortably within Dow’s 2-2.5x mid-cycle debt to EBITDA target.
This will allow Dow to maintain its dividend in this current operating environment, which offers a 5.8% dividend yield. Over time, management targets a dividend payout of 45% of operating cash flow and share repurchases up to 20%. There were $125 million in repurchases during the quarter, and the share count is down about 1.5% from last year. Over the next two quarters, I would expect limited buyback activity, similar to this quarter’s base, with its ~$490 million quarterly dividend the primary source of capital return.
In the fourth quarter, management is guiding to a 2-5% decline in sales, partially driven by seasonal factors. This is a sequential improvement from the 6% decline registered from Q2 to Q3. So while macro conditions continue to be a headwind, they are deteriorating at a slower pace. I am also encouraged that there will be growth from its packaging and specialty products unit, with pricing growing more supportive with the strength from Asia and Latin America noted above showing some further momentum.
Overall as you can see below, Dow is still painting a cautious picture on the global environment. While it has highlighted strength in India and Mexico, few areas are “green,” and they are exclusively coming from the auto sector. Europe also stands out at as the weakest area as relatively high energy prices there do continue to weigh on consumer sentiment.
Now as noted above, I believe Dow may be nearing a trough, but is not quite at it. However, aside from infrastructure, Dow largely sees stabilization. Now, management sees signs US construction is picking up, for instance there are more permits for infrastructure and pipelines, but that residential is soft. China is more uncertain. I actually think the market may be too negative on infrastructure activity, especially in the US. While residential activity has fallen, nonresidential activity has picked up as various government spending plans, like the bipartisan infrastructure bill and CHIPS Act, have ramped. As this spending ramps up, Dow may begin to see some stabilization.
I believe you want to own a cyclical stock like Dow as the cycle is turning and things are nearing as bad as they get. Now, if you expect a global recession, declines may continue well into next year, and you probably should avoid most cyclical stocks, Dow included. However, with its packaging & plastics unit poised to flip back into growth next quarter, autos holding up well, and infrastructure spending still ramping in the US, we are seeing the rate of decline in Dow’s business slow and next quarter or Q1 2024 may be a bottom, particularly given its aggressive inventory destocking.
Just by recovering half of its lost volume and recapturing half of its lost margins, Dow would have about $3.20 in earnings power, giving shares a 15x multiple. I believe this is a plausible outlook for 2024, and at that level of earnings, Dow should be comfortably generating $2.75 billion in free cash flow, absent any working capital changes, providing capacity for about $700 million in buybacks on top of its dividend.
At its current price, shares have about an 8.1% forward free cash flow yield. I view that as an attractive entry point. For now, investors collect a healthy 5.6% dividend, and over the next year, I believe shares can migrate towards $55 or a 14x free cash flow as market grow confident in Dow as an earnings recovery story.
For further details see:
Dow's Business May Be Nearing A Bottom