Saturday, January 20, 2007

DOW CHEMICAL (DOW) - Why Don't You Own This?

The most fundamental tenet of value investing is buying a good company that is currently out of favor with a depressed stock price and waiting for its true value to be realized. This summer when I started looking at (and buying) DOW I just could not understand what the problem was? Why is it so cheap? What was I missing? Turns out nothing, it was everybody else who was (and still is) missing the boat here. I now wish I had done more than just dip my toes in the water then. Lesson: if you do the research, learn to trust yourself (I have bough much more since then). This summer it was disgustingly undervalued, after a 20% run since then it is only alarmingly undervalued with plenty of room to go. You can buy DOW now for the same share price you could have bought it for in 2004 despite eps more than tripling since then. Let's discuss DOW:

Before we discuss DOW on it own merits, let just compare where it is now to its peers and see if it seems "cheap".

DOW ----------10 --------------3.7%
BASF ----------12-------------- 2.1%
DD ------------19--------------- 3.0%
BAY -----------24 ---------------1.7%
HUN ----------31 --------------2.9%
EMN ----------13 ---------------2.9%

It would appear on just a simple pe level DOW is at least 20% cheaper than its closest peer (BASF) and has a dividend yield that is 23% higher than its next most generous peer (DD). The skeptics would say that the pe is low because earnings are expected to fall and the price is anticipating that. Makes sense except when you consider no analyst nor the company itself predict a decline in 2007 eps over 2006. All expect an increase. So now we have a conundrum. Why then is DOW so cheap? It must be the financials, so lets look at them:

Let's take some 5 years averages and then look at 2006 and see how we measure up:

---------------------5 Year Avg. -----------Current
Net Margin -----------3.8% -----------------9.7%
LTD to Cap -----------49% -----------------37%
Return on Equity ------14% ----------------32%
Dividend Payout ------58% -----------------29%
Cash Flow Per Share --$3.76-------------- -$6.77

Ok, so it is not that because on those metrics, the financial engines at DOW are running full speed. So if its not the current situation at DOW then it must be something in its future prospects that we do not know. Something management is not telling us. Lets look at managements actions and see what they ARE telling us since we all know actions speak louder than words.

In July 2005 the company announced its first buyback since 1999. It said it would buy back 25 million shares before the end of 2007. DOW was so cheap in 2006 they purchased 16.8 million of the 25 million allowed (700,000 shares were purchased in 2005). In October 2006 they announced that they were adding another $2 billion to the buyback for roughly 5 million more shares. Is that all?? Of course not. In July when the stock tanked to $34 a share management stepped in with $3.5 million dollars of their own money and scooped up shares. So I guess management thinks that the future is bright, either that or you have to believe they enjoy watching their money evaporate. Doubtful.

Now we hear that private equity may be interested in DOW. Who can blame them? What do the private guys look for? They want companies that can be bought that are currently priced below their true value, even after the premium they would have to pay for DOW to shareholders. Then they can them either sell off pieces or hold it for a few years and let its value be recognized and then spin it off for a handsome profit.

Let's take a step back now and look at what we have. We have a company trading at a discount to it's peers, whose financial condition is the best it has been in decades, who is buying back billions of dollars of its stock, who has management spending millions of its own dollars to buy the stock, who has private equity rumored to want the whole company.

Do I really need to go any further? Next week place your buy orders for DOW please. Priced where it is, you can still get a bargin but with the private equity guy sniffing around the chance will not last long.


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