Dow Chemical: A Company in Transition
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Dow Chemical (NYSE: DOW) is a company in transition.
Over the last several years, Dow has cited a strategic shift in its operating strategy. As early as 2008, the company has stated in their annual report a new policy of transforming themselves into an earnings growth company. This is to be accomplished by moving away from products that take advantage of high volume and low margins, or basic plastics and chemicals, and putting a greater emphasis on products that generate higher margins, higher cash flow, and better poise the company for earnings growth. Increasing market share in performance plastics and specialized materials is the way in which Dow plans to make this transformation possible.
Dow even changed the way it classifies its operating segments in the third quarter of 2011, further emphasizing this shift in product mix. Numerous acquisitions and disposals of product lines and subsidiaries further verify this shift.
By the standard of the most basic financial metrics, 2011 was a great year for Dow. Dow’s financials were beyond impressive. The company posted record revenues, just shy of $60 billion, which was a double-digit gain from 2010. EPS grew at a double-digit rate. And the company generated almost $4 billion in cash flow from operating activities. In the second quarter of last year the company increased its quarterly dividend by $0.10, to $0.25. A dividend yield of nearly 4 percent is very attractive given the current state of affairs in our economy. YTD its stock has gained $3.39. Dow’s stock was trading in the $45 dollar range during May 2007, just before the financial crisis, and then it proceeded to fall to a five-year low. After the market rebounded in 2009 the stock has been practically sideways ever since. Considering the stock’s recent success, it is easy to conclude that Dow‘s stock price is finally poised for a rebound and a return to its old self.
But when analyzing Dow’s financials and related stock price, the company should be judged in the prism of its long term strategy, transforming itself to deliver sustainable growth for shareholders. With this in mind the results are mixed. Two main aspects of its recent financial success are a cause for concern. First, the increased dividend is counter to the overall strategy of the company. Secondly, 2011’s revenue growth looks hardly sustainable.
At least some form of minimal skepticism should be taken when a growth company increases its dividend. This is especially true for Dow. The company is still in the early stages of its bid to become a growth company. Traditionally, growth companies return little money to shareholders. They use these would-be dividends to invest in new projects, generating growth internally. An increase in the dividend by a growth company, paying-out money to shareholders instead of reinvesting, could be a sign they are short of available investment opportunities. Fewer investment opportunities will harm a company’s potential to generate future earnings growth.
For a company like Dow, spending on R&D can be an easy way to analyze the amount of money a company is spending to generate internal growth. A warning sign for Dow can be seen when analyzing these numbers. Although R&D expenditures have increased from 2007 to 2011, an increase from $1.305 billion to $1.646 billion, spending was essentially flat from 2010 to 2011. R&D costs were $1.66 billion in 2010. If this trend continues the effectiveness of Dow to implement its long-term strategy should come into question and its stock price should suffer.
The record revenues Dow earned in 2011 can be misleading for two reasons, especially when considering the company’s long-term goals. First, revenues increased while sales volumes declined. Secondly, recent rises in input costs have lead to a substantial rise in prices for Dow’s products.
Puzzlingly, the 12% increase in revenues last year was accompanied by a 1% decrease in sales volume. Excluding divestitures, volume was up 4%. Even more puzzling was that this is almost identical to 2010. In that year, revenues increased 20% with only a modest 2% increase in volume. Again, excluding divestitures, the volume increase was a more attractive 12% when compared with 2009. Granted, divestitures are normal for a company in transition. But the 2012 outlook for Dow’s performance materials and performance plastics, two operating segments that combine for 51% of revenues, are uncertain. Dow cites only a moderate increase in demand for its performance materials segment this year. Citing a variety of factors, the 2012 demand outlook for performance plastics is mixed. Sales volume decreased for both of these segments in 2011. Until Dow can create sustainable volume growth, its goal of delivering sustained long-term growth to shareholders will become more difficult.
Another troubling aspect of the 2011 revenue numbers was the fact that they were partly driven by a significant increase in input costs. The company cited increased costs for feedstock, energy, and other raw materials. This attributed to the 14% increase in prices. In all but two of Dow’s six operating segments prices rose by double-digits. This double-digit price increase included both the performance materials and performance plastics operating segments, the company’s two largest segments by revenues.
The performance of Dow’s stock price should reflect its ability to successfully transform itself and deliver sustained earnings growth. If R&D expenditures become a trend, by continuing to remain flat, the company’s recent increase in its dividend should be a cause for concern. This would only confirm that the company is facing limited opportunities to invest in projects that will ultimately lead to future growth. Also, if revenue increases continue to be accompanied by modest increases in sales volume and double-digit price increases, revenue growth will be increasingly difficult to sustain. The prospect of limited investment opportunities and unsustainable growth in revenues are not characteristics of a company poised for sustained growth. If these two trends continue, Dow’s ability to transition will become exceedingly more difficult and that should negatively affect its stock price.
DavidLazarek has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.