Chemicals are Cyclical: Now is the Time to Look

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

Last week I highlighted three stocks that Dodge & Cox Stock Fund (DODGX) held in its portfolio. Dow Chemical (NYSE: DOW) was a cyclical name that made my list (read the article to find out the other two names), and it might be a good option for those with a positive outlook for the global economy. It might also be worth a look for those with a less positive view that are willing to ride out the current rough spot, collecting an above market dividend, while waiting for better times to come.

Not That Dow, The Other Dow

Dow Chemical is one of the largest chemicals companies in the world. Founded over a hundred years ago, today its operations span 36 countries where it makes over 5,000 products sold into more than 160 countries. It breaks its business down to six areas, advanced materials, agricultural sciences, performance materials, performance plastics, feedstocks, and energy. It earns materially more money from foreign markets than it does domestically.

A Little SWOT Never Hurt Anyone

I found both the company's restructuring efforts and its dividend yield very interesting. However, from a high level, I'm not fond of the cyclical nature of its business. Seeing the pros and cons is easier for me after I create a strengths, weaknesses, opportunities, and threats analysis (SWOT). They aren't hard to do, requiring just a little time to critically consider each component of the SWOT. Strengths and weakness are internal factors, while opportunities and threats are external. Here's what I came up with:

Strengths (Internal)

  • Large and diverse business spanning industry segments and the globe.
  • Good name with over 100 years of operational experience under its belt.
  • Increasing focus on higher margin specialty chemicals.
  • Large foreign exposure.
  • Increasing control of feedstock prices.

Weaknesses (Internal)

  • Large amount of debt taken on to fund recent mergers.
  • Large foreign exposure.
  • Chemicals business is often the focus of legal and regulatory actions and DOW is a big target (often deservedly so).

Opportunities (External)

  • Growth of emerging markets.
  • Increasing demand for agricultural products.
  • Low natural gas prices in the United States.

Threats (External)

  • Increasing capacity in key markets could lead to oversupply issues.
  • Volatile and unpredictable prices for key inputs (natural gas and oil, for example).
  • Volatile prices for many of the company's products.
  • Cyclical end markets.
  • Economic cycle can have an outsized impact on the top and bottom line.

Some Thoughts

Dow Chemical has been around for well over 100 years and has seen its share of good and bad times. So while it is in a cyclical business, it's well versed in how to survive. In fact, recent acquisition and divestiture actively has been used to shift the company's focus more toward specialty chemicals. That's an intelligent shift, since these products tend to have higher margins and more stable demand. An effort to lock in low cost feedstocks is another positive. 

However, a material debt load, taken on to fund recent mergers (specifically the Rohm & Hass purchase), makes the company's financial position more precarious than it has been in recent times, but it is unlikely that the company is going to go out of business anytime soon. That said, the merger did result in a dividend cut, which is never a good sign. The dividend now appears to be back on a growth track.

So there is a little justifiable concern about the company's recent moves, but they all appear to be moving it in the right direction. The biggest problem right now, then, is that Dow Chemical operates in a cyclical industry that is suffering through one of the worst global economic slumps in recent history. So long as the world economy limps along, Dow Chemical is going to feel the pinch.

The current share price malaise, however, could be an opening for investors with long time horizons. Indeed, with a yield over 4%, now could be a good time to step in and get paid to wait for an economic turnaround. Moreover, if the company's business shift toward specialty chemicals proves worthwhile, dividends will likely continue on their current upward path.

Not the Only Game in Town

Of course Dow Chemical isn't the only chemicals company having a hard time of it. In fact, Dow is doing reasonably well compared to DuPont (NYSE: DD), which recently reported pretty bad earnings results. Shares of DuPont fell sharply on the news and now yield about 4%, too. DuPont is also broadly diversified with a global scope to its operations. 

While both Dow and DuPont are innovators, DuPont has an impressive track record of bringing out new products. For example, in 2011, the company reports to have introduced 1,700 new products. In the industries in which these companies compete, that's impressive and could make DuPont a better option.

It's The Economy Stupid

Both companies are large and well known. While Dow appears to be getting itself back on track after a difficult acquisition, DuPont seems to have had a recent stumble. Either way, both are in the bargain bin right now and aren't likely to find their way out until the economy shows some signs of improvement. An investor interested in either chemicals company should be ready to wait for the global slowdown to run its course if he or she is going to buy in now. That said, 4% plus dividend yields that seem set to grow over time make waiting a bit easier. And knowing the team at Dodge & Cox is also a shareholder can help make the wait a little more bearable.

Yours,


ReubenGBrewer 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.

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