Dow Chemical – Neither Fish nor Fowl
Dow Chemical’s second quarter demonstrated a problem that has concerned investors – both passive and active – for some time. In the face of apparently very strong US and European basic plastics margins, the company did not do that well. It will be interesting to see what the more pure play commodity polyethylene names do in the second quarter, as we suspect that they will show a better uplift than Dow. Dow’s integration upstream into what are labeled “performance” products or “solutions” means that more and more of the commodity base materials within Dow are consumed into next stage derivatives that do not display the same level of cyclical pricing. Polyethylene pricing may rise, but Dow’s advanced products have much more sticky pricing and do not move as much.
Dow is not displaying the cyclical swings that it used to, and as the chart shows, while returns on capital remain low and very close to the longer-term negative trend, the volatility is more muted.
However, Dow is not really a growth story either. Dow saw 3% volume growth in Q2 on a like for like basis (excluding business sold and its raw material business related sales/trading), which is not terrible given the state of the global economy, but it is also not a growth story. It is certainly not enough of a growth story to support the significant R&D investment and capital investments that Dow is making.
The activist initial ideas are likely correct – the company is really two companies – a large efficient commodity chemical company and a large innovation driven growth company. Dow may not appear to many to be a better company, or pair of companies on that basis, but it may be a much better stock.
- Both pieces need a better focus on costs – with the commodity piece shedding the overheads associated with trying to “up-sell” and focusing on lowest cost production and highest quality
- The growth piece needs to focus on an appropriate cost structure as well, and like DuPont needs to understand what it is getting for the R&D investment.
Right now the value investors are not getting their cyclical upside and the rest are not getting the growth. Tactically the company has a couple of options; start moving down the path suggested, or increase TSR by significantly increasing the cash return to investors – the company has been buying back stock but its dividend remains below where it was on a per share basis before the financial crisis.
Either move would likely be positive for the stock near-term, though we may be looking at relative outperformance versus the sector rather than absolute if the commodity based sell-off continues.