DOW New Hghs Coming Sooner Than Later

The yr 2022 served as a swift reminder for traders and operators, particularly these in commodity-based companies, that the period of simple cash could also be exhausted. An air of uncertainty and actuality checks could also be settling throughout the market resulting from rising rates of interest and elevated commodity costs, which drive enter prices. Moreover, a slowing economic system is affecting client demand for myriad merchandise.

The third quarter of 2022, particularly the month of October, marked a turning level in the USA manufacturing PMI index studying. The widely-followed indicator crossed beneath 50%, signaling financial contraction (any studying above 50% indicators enlargement, whereas any studying beneath 50% signifies contraction). Continued contraction readings have pointed to an total slowdown within the U.S. economic system. Nevertheless, sticky inflation has stored enter prices for a lot of corporations elevated, negatively affecting margins.

Lackluster demand

Within the case of DOW (NYSE: DOW), the place the vast majority of revenues are derived from their packaging and specialty plastics phase, which additionally consists of their power and hydrocarbons operations, client demand took the largest hit in each contracting revenues and compressed gross margins. Inside the hydrocarbons operation, DOW produces a considerable quantity of ethylene, which is broadly utilized in building as a gasoline for welding and slicing steel. Ethylene will also be additional processed into polyethylene, the primary ingredient in building supplies resembling pipes, siding, and insulation.

One other important issue impacting the packaging and specialty plastics phase at DOW was the slowdown in world commerce and delivery, attributable to provide chain bottlenecks throughout a number of ports. This resulted in extreme reductions in orders for containers and specialty plastic wrapping. The phase’s gross sales quantity ended the 2022 yr with a 16% contraction from 2021, reflecting each elevated enter prices from uncooked supplies and the sharp decline in delivery.

The commercial intermediates and infrastructure phase is the second-largest at DOW, and closely will depend on building exercise and funding globally, with a give attention to prospects in the USA. In 2022, income from building supplies and chemical compounds declined by 20% as builders throughout North America and EMEA (Europe, Center East, Africa) decreased their order volumes resulting from rising capital prices and different challenges within the building trade.

The confluence of heating inflationary pressures and rising rates of interest in 2022 resulted in DOW experiencing its leanest gross margin fiscal yr previously six years (excluding 2020, which was closely impacted by lockdown results). As well as, crude oil costs remained persistently excessive, hovering largely above $90 per barrel all year long. As oil is the primary part in all the merchandise that DOW makes for its prospects, the corporate skilled important margin compression resulting from these components.

Time to chill off

Regardless of commodities having fun with a bull cycle of their respective industries, and DOW exhibiting the signs of such a cycle, there are some fascinating issues administration has achieved to be able to cut back the present – and almost certainly future – impacts from the character of the enterprise. 

Regardless of gross margins being at their lowest ranges since 2017, working margins at DOW got here in at their second-highest ranges (after the low enter price and low-cost capital cycle of 2021), suggesting that some working components are seeing clearer and extra optimized paths. By optimizing their core actions and implementing technological course of enhancements whereas shutting down underperforming belongings or factories, labor and repair prices are anticipated to ship roughly $1 billion USD in financial savings for 2023.

These effectivity features, achieved over the previous six years and are anticipated to proceed, will shorten the stock cycle, cut back the necessity for uncooked materials purchases, and end in shorter turnaround instances. These achievements are anticipated to translate into greater margins, elevated liquidity, and most significantly, free money movement.

Taking off with a silencer

Talking of free money movement, the corporate has returned a big quantity of it again to shareholders as of late. 2020, 2021 and 2022 returned 2.5%, 18.2% and 39.7%, respectively within the type of share buybacks. Despite the fact that payouts have gotten bigger and bigger, it appears like free money movement era and total dimension is greater than outpacing the speed of money returned to shareholders. 

This tells traders greater than something that administration believes the inventory to be undervalued in comparison with their very own administration – or base – valuation case. When looking on the asset base, internet of debt, traders can arrive at a internet asset worth (NAV) per share of $60.50 per share in 2022. With the inventory at present buying and selling across the low 50s, this represents an preliminary incentive and margin of security for traders seeking to acquire publicity to not solely a restoration in building but additionally a retreat within the worth of crude oil. 

Realizing that the inventory is in actual fact beneath internet asset worth, and buying and selling at a price-to-earnings ratio of solely 8.2x (comparatively low for a $35 billion USD market cap firm), and an analogous 6.6x price-to-free money movement ratio (once more, low), analysts have pointed to a consensus worth goal of slightly below $60 per share.

Noting that this worth goal ought to solely be the beginning of an affordable elementary worth stage for the corporate, and that these worth ratios are closely compressed for a large-cap inventory, some analysts are pushing a high-scenario towards $81 per share, translating to a extra cheap 12.9x worth to earnings ratio.