Dow Chemical is one of five chemical stocks that I am short
against a long position in Eastman Chemical, a security that I believe is far
more attractive (I
explain my long case for Eastman in this article). In light of the Third
Point letter on Dow Chemical I want to explain why I view shares of Dow as
relatively unattractive.
Valuation
Dow Chemical trades at an expensive valuation compared to
its chemical sector peers. As seen in the charts below, Dow has one of the
lowest EBITDA margins in the chemical sector yet trades in the middle of the
group in terms of valuation.
This comparison is generous to Dow as it ignores Dow’s $9
billion unfunded pension liability. If one includes the pension deficit in
Dow’s enterprise value than EV/EBITDA is roughly 10 times. This adjustment puts
Dow squarely in the high end of valuation versus its chemical peers despite a
low quality mix of businesses. An
analysis based on P/E ratios would make Dow look even more expensive.
Turnaround
The Third Point letter points to “cost cutting and operating
optimizations that could amount to several billion dollars a year in annual
EBITDA”. Dow Chemical has announced multiple restructurings & layoffs over
the years leading to the lowest SG&A/sales ratio in the chemical sector.
Dow’s SG&A is only 5% of sales. This suggests limited room for margin
improvement through cost cutting. Where else will the cost cutting come from if
not from SG&A? Are they running their crackers inefficiently? Are they
selling commodities at below market prices?
The Third Point letter gives no details of what operating
optimizations could save billions so it is difficult for me to refute that
point. However, later in the letter Third Point complains about “poor segment
disclosure combined with Dow’s opaque and inconsistent transfer pricing”. This
is seemingly contradictory. If Dow’s disclosures are poor, than how can Third
Point be certain these optimizations are possible?
Spinoffs & Asset
Sales
Justifying a high price target for Dow Chemical involves
placing a premium multiple on every business line (while ignoring the pension
deficit). If one takes any diversified chemical company and puts rich multiples
on every segment than all of them will look cheap, with tremendous upside.
There is no reason to believe that Dow will achieve these rich multiples.
Proponents of Dow point to spin offs and asset sales.
It is unclear to me why spin offs will help Dow as their
blended businesses already trade at relatively high multiples. Axiall, which is
the comp for the business Dow is planning to spin off, trades at only six times
EBITDA. Dow owns numerous low margin, commodity businesses that deserve to
trade at low multiples. With Dow trading at roughly 10 times EBITDA (including pension)
that means that the rest of Dow trades at well over 10 times EBITDA. Secondly,
why would these spin-offs trade for best of breed multiples if they don’t
perform like best of breed businesses?
Significant asset sales seem like a pipe dream as well. Dow
and Dupont are the two largest US chemical companies. Both have activists and
both are looking to sell assets. If the two largest companies are sellers, who
will the buyers be? It is possible that Dow and Dupont will find buyers for
some businesses but any sales are unlikely to be significant to either company.
Summary
Dow Chemical appears to be among the most overvalued
chemical companies relative to its peers. Spinning off a business is not a
magic elixir that turns around a business. There are higher quality companies
with great managements available at cheaper multiples (see
Eastman Chemical). A fixer upper is not always a great deal and can often
be a money pit.
