Dow Chemical's Risky Gambit

THE REPURCHASE

Dow Chemical announced that they will repurchase $4.5 billion worth of stock over the course of 2014 amounting to roughly 8% of the float of the stock at the current price. The vast majority of this repurchase will be done with borrowings as there will likely be very little cash left over after capital expenditures and dividends. Share repurchases of this size are generally very bullish for the near term performance of a stock but there is more than meets the eye to this repurchase.

THE CONVERTIBLE PREFERRED SHARES

In 2009 Dow issued a total of $4 billion in convertible preferred shares to Berkshire Hathaway and Saudi Aramco (SA) in order to complete their acquisition of Rohm & Haas. These shares pay a preferred dividend of 8.5% and have a strike price of $41.32. It is unlikely that Berkshire or SA will opt to convert these shares because of the hefty dividend and the value of the call options. However, this large dividend is burdensome to Dow and Dow can force conversion if the common stock price exceeds $53.72 per share for any 20 trading days in a consecutive 30-day window. I believe this share repurchase is essentially a risky gambit to force conversion of these preferred shares. If this plan is successful then there will actually be more shares outstanding following the plan than before the repurchase.

THE RISKS

On the surface this plan appears to be sound as it removes burdensome preferred shares paying an 8.5% dividend and replaces it with cheaper debt. The risk is that the plan fails (ie. Dow can’t force conversion) and that Dow enters the next down cycle with an additional $4.5 billion in debt, the burdensome 8.5% preferred and an enormous pension gap that would likely balloon further. It seems that Dow has the debt coverage ratio to take on the additional debt but that ignores the gaping pension hole and the likelihood that EBITDA would contract dramatically in a cyclical downturn. I am not predicting a cyclical downturn but noting the risks if it does occur.

THE OUTLOOK

My experience with share repurchase of this size is that they are positive for near term performance even if they are not in the best long term interest of the company. However, once the stock price approaches $53.72 Dow becomes a compelling short. In addition to the very rich valuation there would likely be enormous selling pressure at that price. At that price Berkshire and SA would need to start selling down shares unless they want to be owners of Dow Chemical stock. If Berkshire & SA sold down their stake it would amount to over $5 billion, greater than the amount of the Dow repurchase. It is also possible that funds aware of this situation would sell ahead of that price.

MY PLAN


Dow Chemical is one of five chemical stocks I am short against Eastman Chemical, a stock I believe is far more attractive. As a result of the share repurchase announcement I covered a portion of my Dow short despite the fact that I believe shares are overvalued. I don’t want to stand in front of an 8% repurchase as there is no money in being a martyr and I want to be in a position to short with reckless abandon if the shares approach $53.72.

Dow Chemical Is No Bargain

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.

Four Investment Ideas With Upcoming Catalysts : Part 2

In this two part post I outline four value investments that I own with catalysts in the first quarter of 2014.  In part 1 of this post I reviewed Air Products and Chemicals (APD) and Annaly Capital Management (NLY). Here are my final two picks:


Eastman Chemical (EMN)
Catalyst: Aggressive share repurchase plan starting in Q1 2014

I laid out a detailed case for owning Eastman Chemical in late October. In summary, over the past decade Eastman has transformed itself from a maker of commodity chemicals into a specialty chemical maker with among the highest margins in the group. Specialty chemical makers tend to trade for a large premium to their commodity peers yet Eastman is among the cheapest stocks in its sector. Eastman has one of the highest free cash flow yields, lowest P/Es and lowest EV/EBITDA ratios in the chemical sector.

Eastman has spent the past few quarters paying down debt that resulted from an acquisition and will be done paying it down by the end of 2013. I believe that starting in the first quarter of 2014 Eastman will direct free cash flow towards shareholders in the form of an aggressive share repurchase.

Eastman management has stated numerous times that they will use their balance sheet and ample free cash flow to reach their earnings goal of $7 in 2014 and $8 in 2015. They have also said that acquisition targets are too expensive now, which points towards share repurchases to increase earnings. Management also mentioned in passing on a recent webcast that share repurchases have a larger effect on EPS when done earlier in the year. This leads me to believe that Eastman will start repurchasing shares aggressively in the first quarter of 2014, getting the ball rolling on a re-rating of the stock. I am long EMN short ALB CE DD DOW FMC

Muni Bond Closed End Funds
Catalyst: End of tax loss selling

Municipal bond closed end funds (muni CEFs) are down as much as 30% from their highs in some cases. Fed tapering and headlines from Puerto Rico and Detroit have brutalized the municipal bond market and muni CEFs even more so. This leaves many muni CEFs trading at high single digit discounts to NAV and yielding nearly 7%, which is the taxable equivalent of over 10%.

I believe that scary headlines like those in Puerto Rico and Detroit are outliers. For the most part municipal finances have improved over the past year as tax receipts have grown along with the economy. One could even argue that municipal bonds value versus treasuries should be higher than ever as tax rates are higher so the tax advantage has grown. Municipal bonds offer the best after tax, risk adjusted return of any asset class. Once tax loss selling ends the market should begin to recognize this. I am long NRK VMO VKQ PMO NAN

Four Investment Ideas With Upcoming Catalysts : Part 1

Earlier in the week I outlined the difficult environment facing value investors. Finding new investments meeting a value criteria has not been easy after a nearly tripling of markets in less than five years. A couple of months ago my cash pile was growing as many of my investments reached their target and I could not find new investments to replace them. Much to my own surprise I have recently been able to put money to work and am excited about my portfolio. Four of my investments, which I will outline, have catalysts coming up in the first quarter of 2014.

Two of the investment ideas came along as a result of tax loss selling. Tax rates have gone up this year and many market participants have large gains. Those looking to offset gains with losses have very few choices this year, so a small group of losing stocks have bore the brunt of this selling. Tax loss selling is similar to forced selling in that sellers are not basing their sell decision on the merits of the stock. The good news is that there are less than four trading days left in the year and tax loss selling will soon be over. The other two ideas are are long/short ideas with company specific catalysts. Without further ado here are my four investment ideas:

Air Products and Chemicals (APD)
Catalyst: Announcement of new CEO

Bill Ackman took an activist position in Air Products and Chemicals earlier this summer. He was quickly able to gain board seats and remove the CEO. Normally, this would cause the stock to fly but due to the adverse publicity Bill Ackman has received from Herbalife and J.C. Penney the stock has barely outperformed its peers. Bill Ackman has had many successful activist campaigns and a small handful of failures. Air Products and Chemicals has a lot more in common with his successful campaigns.

Air Products has strong, recurring free cash flow that is being masked by a capex binge. Only $300-$350 million of Air Product's $1.52 billion a year in capex is maintenance capex, while the rest is expansion. New plants take three years before they are built and operating at the capacity needed to create strong cash flow. The benefits of the capex binge of the past few years has not been realized but will be realized over the next few years, resulting in higher cash flow. The new CEO is likely to reduce capex spending on new projects and direct more of free cash flow to investors.

Air Products has the lowest margins in its industry. It largest competitor, Praxair, has margins nearly 50% higher. There is a lot of room for cost cutting and increased sales productivity to improve margins. With modest margin improvement and the realization of the benefits of their capex binge, Air Products could see over $14 in free cash flow per share annually some time in the next few years.

Many people I have discussed Air Products with have been scratching their heads as to why Bill Ackman has chosen the company. Bill Ackman has still not laid out a detailed case for this purchase,as he is likely waiting for the new CEO to be announced. A new CEO has not been chosen yet but is likely to be chosen in the first quarter of 2014. The appointment of the new CEO is likely to act as a catalyst for the stock as the new CEO lays out his strategy and Bill Ackman lays out his investing case. I am long APD / short PX ARG

Annaly Capital Management (NLY)
Catalyst: End of tax loss selling

I recently laid out a detailed case for owning Annaly Capital Management. In summary, Annaly trades for an unwarranted 20% discount to book value. Annaly has lowered leverage, hedged and diversified into commercial mortgage backed securities. Annaly is positioned well to withstand  future interest rate increases with minimal damage to book value. I believe the reason for this deep discount is primarily end of the year tax loss selling and the fear of the effects tapering will have on Annaly's book value. Tax loss selling will soon end and as time passes the market will eventually become more comfortable with the effect tapering has on Annaly's book value. I am long Annaly.

Click here for part 2

The Current Value Investing Environment

I don't believe I am making a bold statement when I say that the US stock market is not cheap. Even if one takes earnings at face value and uses the bulls optimistic estimates for 2014, multiples are 10%-20% higher than average. If it turns out that artificially low rates have been boosting earnings and that five years into an expansion we may be close to peak earnings than the stock market is expensive.

For value investors whose primary goal is avoiding the loss of capital, the current market environment hardly provides a margin of safety. Of course, the overall market matters less if one is able to find individual securities with a margin of safety. Even in the year 2000, during the biggest stock market bubble in US history, there were bargains as many small cap & "Old Economy" stocks were being discarded in favor of "New Economy" stocks and blue chips. 

Finding bargains in the current market might be even harder than in the year 2000 as small caps trade at record valuations and dispersion in the S&P 500 is at an all time low. The lowest dispersion ever means that the difference between the most and least expensive stocks is smaller than ever. In some sense value investing has become a victim of its own success as "cheaper" stocks have been bid up. The cheapest part of the market, where value investors tend to fish, is as expensive as it has ever been.

What is a value investor to do in such an environment? This makes it much more difficult for a value investor but not impossible. I believe the most important thing is not to force investments or lower ones standards in any environment. If that means holding more cash so be it. 

(As an aside I am actually quite optimistic about my portfolio for the new year, although my positions are largely not traditional value investments (ie. long common stocks). I plan to write about why I'm optimistic about my portfolio some time in the next week.)

If there is anything that I have learned having lived through two bubbles its that expensive can become more expensive. I have also learned that few who say "I will dance until the music stops" find a chair when the music ultimately comes to an abrupt halt. Unless one believes that we are in a new paradigm where cycles have been eradicated than there will be better opportunities some time in the future for value investors. Will you have cash to invest when that happens?

Annaly For The New Year

SUMMARY

Annaly Capital Management trades at nearly a 20% discount to its book value, which is comprised of highly liquid securities. Annaly has recently delevered and hedged, which should limit further losses. The stock is currently priced for a disaster and anything short of that should lead to attractive gains. An end to tax loss selling season or putting the taper behind us could be the catalyst for gains.

BUSINESS

Annaly Capital Management is a mortgage REIT that primarily owns a levered portfolio of agency securities. Through Annaly’s acquisition of its subsidiary, Crexus, Annaly has diversified modestly into CMBS as well. Annaly now deploys 11% of its capital in the CMBS market. Additionally, Annaly owns a small asset management business.

Annaly has been in the agency RMBS business for over 15 years. The way the business works is that Annaly owns a levered portfolio of agency securities. Annaly makes money through two spreads, the spread between longer rates and shorter rates and the spread between agency securities and treasuries. This is a very simplified explanation of the business. Annaly has to choose what securities to own, how much leverage to employ, how to fund the portfolio and how to hedge based on the current environment.

WHAT HAPPENED

For nearly 15 years Annaly had been in a great business with some minor bumps along the way. Over this period Annaly was able to offer a dividend that averaged in the double digits plus capital appreciation. When QE came along it compressed both the spreads that Annaly was profiting off of. QE succeeded in lowering interest rates and the spread between agency securities and treasuries collapsed.

Instead of backing off the trade as the spreads became narrower many agency mortgage REITs increased or maintained leverage in order to sustain returns. When the Fed announced a possible taper in May this caused rates to go higher & spreads to widen. This led to losses across these leveraged portfolios. Most agency mREITs have locked in these losses and delevered their portfolios since.

PRESENT

Annaly’s book value has fallen from $15.85 at the beginning of the year to $12.70 at the end of the most recent quarter. This is partially due to the large dividend they continued to pay out despite losses but mostly due to the increase in rates and spreads. In reaction to these large losses Annaly has delevered and hedged more aggressively. At the end of the latest reported quarter Annaly was levered 5.4 times, which is at the very low end historically. Annaly is 74% hedged, which is at the very high end historically. It is estimated that Annaly would lose 4.4% if yields were to go up by 100bps.

Annaly has historically traded at approximately a 10% premium to book value. After this past years missteps it currently trades at a roughly 19% discount to its book value. The most common response I get when pitching Annaly is that rates are likely to go higher and spreads are likely to widen as the Fed tapers. However, even if rates went up by 125 basis points and spreads widened its unlikely that book value would fall much more than 10%. If that were to occur the Annaly would still trade at a 10% discount to book and the spread would come back into the trade that they do, making it attractive again. All the while one is likely to be paid a 10% dividend to wait (currently the dividend is 14% but likely to go lower). In November four different insiders purchased shares in Annaly at prices higher than current levels.

CATALYST


It is likely that much of the recent selling has been tax loss selling as Annaly is down more than 45% from its highs. Tax loss selling ends at the end of December and these sellers will no longer be present in January, paving the way for a higher share price.  It seems that every time somebody mentions the word taper that Annaly gets hit. Getting the big, bad event behind us will likely be a positive as Annaly is hedged for higher rates and the fear of the taper is likely worse than the taper itself. 

Eastman Chemical : Specialty Chemical For A Commodity Price

In a little over a decade Eastman Chemical  has transformed itself from a producer of commodity chemicals into a producer of specialty chemicals. Despite Eastman's transformation the stock still trades at the valuation of a commodity chemical company. After paying down debt in 2013 Eastman will be able to use its strong free cash flow in 2014 for repurchases or accretive acquisitions that should lead to a rerating of the stock.

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