Chemical Stocks are Undervalued, so Buy this Takeover Play
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As the economy moves towards a full recovery, chemicals are well positioned to rebound from their depressed multiples. Some are even takeover plays, given the growth trajectory ahead. I recommend investing broadly in the industry and avoiding producers that have overly mature operations, which have likely already been assessed (and, presumably, appreciated) by the market.
Takeover Suitors Hunting Huntsman (NYSE: HUN)
At a respective 10.6x and 7.3x past and forward earnings, with a PEG ratio of 0.8, a Huntsman takeover can easily pay for itself fairly quickly. The stock is 130% more volatile than the broader market, but this has already been priced into the valuation. Accordingly, from a risk/reward perspective, Huntsman is very compelling, not only as a corporate combination but also in a private equity buyout. While the former is preferred in the sense that it could generate revenue synergies, the latter will still have to pony up some money to account for exiting the business in such a market.
Analysts forecast Huntsman to grow EPS by 13.5% annually over the next 5 years. Assuming expectations are met, EPS for 2016 will come out to $3.07. At a 15x multiple, this translates to a future stock value of $46.05. Discounting backwards by an aggressive 12% yields a present value of $26.13. That's at more than a 70% premium to the current market cap! I even believe there could be a potential short squeeze of the 5.8% short interest on the float based on increased speculation.
Moreover, although the company has already risen a dramatic 58.7% over the past 12 months, it is not resting on its laurels. Rather, the producer is looking to expand its Geismar plant to increase output of methylene biphenyl diisocyanate to meet demand for foam insulation. Solid performance has been consistent over the last four quarters, with EPSgenerally beating expectations in the high single-digits.
DuPont (NYSE: DOW) More Undervalued Than Dow (NYSE: DOW)
Of course, chemicals are very volatile, and this warrants diversification to hedge against any one stock heading south. DuPont recently had its injunction against South Korean Kolon Industries stayed. This will unfortunately enable the Korean producer to continue to sell Heracron fiber products during the appeal. As irritating as this headwind is, the company still has a solid track record of outperforming competitors.
In agriculture, which represents the biggest part of the conglomerate, DuPont has grown the top-line event faster than pure plays like Monsanto. Moreover, DuPont has been able to increase prices, while competitors have had to cut them, so relative margins are going up substantially.
Ultimately, I find DuPont's value proposition to be more compelling than Dow's. The former trades at a respective 13.4x and 11.4x past and forward earnings with a dividend yield of 3.5%. Analysts forecast 7.9% annual EPS growth over the next 5 years, which is more than 100 bps greater than what is forecasted for Dow. And yet Dow manages to trade at a premium of 18.1x past earnings. Analysts currently rate Dow a "sell," and this is not a pretty rating in light of the 2.3 beta.
And fundamentally, Dow has shown operational problems. The second quarter was a fiasco, with EPS 14.1% below consensus. This was preceded by weak business from 3Q 2011 to 1Q12. The recent rise in natural gas, which can be used as feedstock for ammonia, will drag down revenue realization in 4Q. In my view, Dow is the worst positioned to handle this higher input cost.
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