No Organic Growth for Chemical Giants

Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A federal jury in the U.S has ordered Dow Chemical (NYSE: DOW) to pay $400 million in fines over price fixing of urethane. Several companies were named in the $1 billion class action law suit filed by urethane buyers, but Dow was the only one that had not settled. Other defendants in the case included Bayer AG, Huntsman Corp’s (NYSE: HUN) Huntsman International and BASF SE. Dow will try to have the lawsuit dismissed in a post-trial motion. However, if the verdict is sustained by the judge, then the $400 million could potentially become $1.2 billion under federal anti-trust statutes.

This wasn’t the only disappointing news coming this year from Dow. The company also reported earnings that fell short of the market’s expectations due to slow activity in China and Europe as the demand for polyurethane and chlorine remained soft. Quarterly losses blew out from $20 million in 2011 to $716 million. Excluding one-off items and restructuring charges, this translated to earnings of $0.33 per share. Sales volume was flat, its average selling prices fell by 1% and overall sales fell by 1.3% to $13.9 billion. The company is the world’s leading supplier of chlorine; the closure of chlorine plants and suspension of production activity due to repair work hurt volumes delivered.

The U.S market is enjoying falling input costs, particularly natural gas, which has prompted Dow to invest $4 billion in the market to develop additional capacity. However, “significant deterioration” in China and the 5% plunge in sales volume to Western Europe was enough to offset all the positives coming out of the U.S. The company has also revealed that the global chemical industry has not witnessed any volume growth in the last six quarters while Dow’s own volume increased by just 1% in 2012. The future is not going to be easy, and an increase in earnings in the future will come from operational efficiencies, not organic sales growth.

Dow is having to rely on cost cutting, technological improvements in agriculture and lower raw material costs to create earnings growth. This is long overdue in my opinion, as the company has been resting on its cash cows for far too long. If you are not going to be inventive because of economic uncertainty then you should at least become lean. Earlier in October, Dow announced that it would slash 5% of its workforce, shut down 20 plants and write off the value of its lithium-ion battery operations. The business unit incurred a charge of $990 million in its last quarter over this.

Meanwhile, DuPont (NYSE: DD) has also disappointed its shareholders by reporting net income of just $111 million, a massive 70.24% drop from $373 million reported a year earlier despite flat sales of $7.3 billion. The decline was attributed to both the dysfunctional solar energy vertical and industrial vertical. Agricultural products performed well with pre-tax operating income rising by 18% to $1.5 billion as both volume and prices increased rose by 11% and 7% respectively. This sector will remain a key growth area for DuPont in the future. The need for improvements in agricultural chemicals will be a key driver to food security in rapidly expanding emerging markets. 

DuPont is the market leader in Titanium Dioxide (TiO2). TiO2 is suffering from both weak demand and falling prices. A tertiary casualty of the world’s various property bubbles, TiO2 has suffered from overcapacity in the need for white pigments. As the demand profile improves and DuPont can bring its new production techniques online, TiO2 could be a real bright spot for the company. DuPont believes this and is investing $500 million to revamp its Titanium Dioxide facilities.  

Both Dow Chemicals and DuPont have a share buyback in their pipelines. Share buybacks are simply another stop gap plan to divest excess cash that companies are afraid to invest in the current debt deflationary environment.  Dow’s board has recently approved a share buyback program of up to $1.5 billion. The company is also looking at a cash injection from a $2.16 billion payout by Kuwait based Petrochemical Industries Co. as part of the settlement for backing out of buying one of Dow’s business units in 2008.

Meanwhile, DuPont has now completed the sale of its performance coating business for $4.9 billion cash to The Carlyle Group (NASDAQ: CG). Performance coatings are capital and research intensive products, and this move is a clear signal that DuPont is uninterested in bearing the risk right now. DuPont had earlier said that it would repurchase $1 billion of its common stock in 2013 if it completes the aforementioned sale. DuPont will use the remaining amount (roughly $3 billion after tax) for “future … growth opportunities.” 

Since we are still a long way away from being in a capital expanding environment, companies like Dow and DuPont need to be looked at as bonds rather than as growth engines. In that case, DuPont’s lower multiple and far higher RoE make it a better choice for the income-interested investor.  Growth investors need to look elsewhere.

<table> <tbody> <tr> <td> <p><strong><em> </em></strong></p> </td> <td> <p><strong>DD</strong></p> </td> <td> <p><strong>DOW</strong></p> </td> </tr> <tr> <td> <p><em>Stock 6M</em></p> </td> <td> <p>-5.60%</p> </td> <td> <p>6.00%</p> </td> </tr> <tr> <td> <p><em>P/E</em></p> </td> <td> <p>16.13</p> </td> <td> <p>45.09</p> </td> </tr> <tr> <td> <p><em>EPS</em></p> </td> <td> <p>2.95</p> </td> <td> <p>0.7</p> </td> </tr> <tr> <td> <p><em>Yield</em></p> </td> <td> <p>3.60%</p> </td> <td> <p>4.10%</p> </td> </tr> <tr> <td> <p><em>ROA</em></p> </td> <td> <p>5.75%</p> </td> <td> <p>3.66%</p> </td> </tr> <tr> <td> <p><em>ROE</em></p> </td> <td> <p>25.91%</p> </td> <td> <p>4.84%</p> </td> </tr> </tbody> </table>


PeterPham8 has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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