A Dow chemical plant in Torrance, Calif.
David McNew/Getty ImagesEverything is breaking right for chemical company Dow, but market analysts have failed to notice. This is one time when investors can get in ahead of Wall Street.
It’s not that Dow (ticker: DOW) hasn’t been producing gains. Its stock has risen 7% in 2021, easily topping the 1.5% rise of the S&P 500, and the company couldn’t ask for a better fundamental backdrop. The economy is improving, commodity chemical markets are tightening—it’s one area where the Texas weather disaster is actually benefiting somebody—and it’s spending less on new assets, freeing up more cash flow for investors.
Yet the stock remains unloved on Wall Street. The Midland, Mich.-based company was founded two centuries ago, but this version of Dow is only a few quarters old after spinning out of DowDuPont. That massive transaction gave investors Dow, DuPont de Nemours (DD), and agricultural-input seller Corteva (CTVA). These days, only about a quarter of the analysts covering Dow rate its shares Buy, well below the 57% average for stocks in the Dow Jones Industrial Average, of which it is a component. Despite their pessimism—and the stock’s recent gains—it’s a good time to buy Dow.
Visiting a chemical plant is, frankly, a bit of a letdown. There are miles of pipes. Everything is enclosed. Raw materials, which are usually derivatives of oil and natural gas, go in one end, and plastic products, such as polyethylene beads, come out the other end. There isn’t much to see. The whole process feels like a black box.
That’s the way chemical stocks can feel too. Chemical companies are, essentially, spread businesses. They sell products, such as plastic pellets, for pennies more than the cost of the raw materials used to make them. There are dozens of intermediate products that are bought and sold. There is more than one raw material too. Oil and gas prices aren’t always equivalent for chemical makers, and prices don’t always move in lockstep with one another—just ask residents of Texas about recent natural-gas pricing. The complexity makes commodity chemicals a bit of a “trust me” business.
And 2020 wasn’t a trust-me year. As the pandemic hammered the global economy, Dow stock was moribund. It rose a measly 1.4%, excluding dividends, trailing the S&P 500’s 16% gain. That return wasn’t reflective of the company’s performance, however. Dow generated a boatload of cash—roughly $5 billion—even as its shares tumbled to about $22 from north of $50.
“[We] are a cash-generating machine,” Dow Chief Financial Officer Howard Ungerleider recently told Barron’s. It’s a boast, but one the company can back up.
What isn’t complicated is the dividend. Dow stock yields about 4.7%, about three times the S&P 500’s 1.5%. What’s more, the dividend looks secure, thanks to all that cash. Dow spent roughly 40% of its 2020 free cash flow covering the dividend. Dow’s peers, including LyondellBasell Industries (LYB) and Eastman Chemical (EMN), needed roughly 60% of 2020 cash flow to cover their dividends. There is a bigger margin of safety with Dow than many other large, diversified commodity chemical makers. That isn’t reflected in the dividend yields, however. Many of Dow’s commodity peers yield between 2% and 4%, while the chemical components of the S&P 500 yield roughly 2.5%.
If Dow paid out 60% of its 2021 estimated free cash flow and traded at a 4% dividend yield, shares would be around $75, up 26% from Friday’s close of $59.31. That’s just one way to quantify the opportunity. Dow has cash, and the stock isn’t all that pricey. Shares are trading at a free-cash-flow yield of about 8% based on 2021 numbers, and the stock’s price/earnings ratio is about 17. The S&P trades for about 22 times estimated 2021 earnings. It’s not a bad setup for a stock that offers generous quarterly dividend payments.
Wall Street hasn’t caught on yet, but a few analysts are warming up to the company. BofA Securities analyst Steve Byrne, for one, upgraded Dow shares to Hold from Sell on Feb. 22, noting that product prices for the U.S. chemical industry continue to trend higher. His price target went to $64 from $53, though that isn’t exactly a ringing endorsement. He joins 15 other analysts who rate the stock Hold or an equivalent.
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The number of Buy-rated analysts is slowly increasing, however. They now number six, up from four in November. Fermium Research analyst Frank Mitsch, for instance, cites Dow’s “impressive” free cash flow, its “solid” management team, and a “favorable” backdrop for chemical companies as reasons to own Dow shares. “The stock should work,” he says.
In fact, some might say that the stock already is.
Write to Al Root at allen.root@dowjones.com
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