At $35, Dow Chemicals (NYSE:DOW) shares trade on a trailing price to earnings ratio of 16.68. This is far higher than competitor companies, BASF (BASFY.PK) and Du Pont (NYSE:DD) at 9.89 and 13.98 respectively. With a forward price to earnings ratio of 10.12, earnings are expected to rise strongly through 2012.
This growth in earnings will be helped by certain items dropping out of its results. In the fourth quarter of 2011, earnings retracted by nearly 90%, even though sales were up by 2% on the same period a year earlier. This poor earnings result was impacted by an increased tax charge in Brazil, which was equivalent to $0.23 per share, on the recognition of a valuation charge.
The driver of growth through the quarter was its emerging markets sector, which now accounts for 35% of total group sales. Sales in China starred, improving by 12%, but for the emerging markets in total sales improved by 7%. Meanwhile, sales in the United States declined by 2%, and in Europe by 5%.
On a positive note, the company increased its prices by an average of 5% across all its businesses and in all geographies. This offset rising costs of its raw materials.
The company’s operating rate fell by 9% to 72% as weak demand in Europe hit and it started de-stocking. At the time of the results, company management said that it expected economic recovery to resume in Europe in the second half of 2012.
I am bearish of Dow shares, for the following reasons:
· Whilst the one off charge from Brazil relating to the tax charge will fall out in the year to come, it has highlighted the regulatory difficulties in dealing in emerging markets. With this sector now constituting 35% of its business, future deals will have to be examined more closely to avoid a repeat of such retrospective actions. This will place higher costs on doing business in these countries.
· Dow had a tough time in Europe last year, but expects the economy to pick up in the second half of 2012. Since Dow’s results announcement, the European Union has said it expects the Eurozone to be in mild recession through 2012, with Europe as a whole no better than flat. European PMI numbers out last week indicated a marked and more severe slowdown taking place than this.
· Costs of its raw materials are increasing: with the price of oil rising due to tensions in the Middle East, such costs are unlikely to reverse. Meanwhile as Dow attempts to raise its prices, it becomes less competitive in its markets. This raising of prices could be a reason for its poor performance in the United States in the fourth quarter, where sales were down by 2% despite gdp growth at an annualized 2.8 %.
· Finally, a main driver of its business last year, China, is facing a slowing rate of growth. From expectations for growth this year of over 10%, the Chinese government has cut its growth forecast to 8%. This is certain to impact Dow’s performance there.
Overall, I see more risks to the business than opportunities. The 2.9% dividend yield at current levels, with the dividend pay out rate of nearly 50%, is not high enough to tempt me to buy for income. Du Pont yields 3.2% at current levels, trades on a lower price to earnings ratio, and a forward price to earnings ratio in line with Dow. To come into line with Du Pont, on a yield basis, Dow shares would have to drop by some 10%. Unfortunately, I expect the shares to fare worse than this.
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