1 Takeover Target, 1 Stock to Avoid in Chemicals

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

In light of market uncertainty in chemicals, investors have generally avoided the market. From DuPont's weak earnings report to corporate asset sales to hungry PE buyers, this negative outlook has been validated in the near-term. However, stocks are valued based on their long-term potential. I find that there are some high FCF yielding stocks out there that are bound to surge in value once takeover markets begin to become more active (that is, full sale liquidity increases). With this in mind, I review two large chemical producers below to see where they are and what their futures hold.

DuPont (NYSE: DD): Weak Outlook Makes it a Stock to Avoid

Among the leading chemical producers, DuPont has a powerful economic moat. It is diversified in the manufacture of a variety of segments ranging from performance materials to agriculture and industrial biosciences. At a respective 14.4x and 11.5x past and forward earnings, coupled with a 4% dividend yield, DuPont may look fairly attractive. But investors should bear in mind two things: (1) The growth rate is in the low- to mid-digits, and (2) free cash flow yield is at just 7.3%.

Should these two cons be enough to deter you from making an investment? In my view, they should be when combined with the fundamentals. In the third quarter, EPS of $0.32 was 17 cents below expectations--a result that caused DuPont to slide 9% in value. Chemicals are tremendously volatile, so it is particularly disappointing that  infrastructure projects have stalled in China--the one key "emerging market" that was supposed to hedge against downside. According to management, 2012 productivity targets will be realized, as the business transitions into higher-margin areas, like biotech, nutrition, and agriculture. By selling Performance Coatings to a PE firm for $4.9 billion, DuPont has mitigated its risk exposure. The 28% decline in electronics & communication, however, suggest the company is struggling with gaining a foothold in fast-growing markets.

Thus far, DuPont has been challenged to drive profitability in the electronics, protection, and safety segments. The decision to lay off 1,500 workers is indicative of downsizing and a weakened market outlook. Construction-related business is in a tailspin, and it should preclude any investment.

Huntsman (NYSE: HUN): A Possible Buyout Play

Dow (NYSE: DOW) and Huntsman are equally challenged. Dow trades at 11.6x forward earnings while Huntsman trades at 7.8x forward earnings. In my view, the latter is likely to be a takeover play. It was recently upgraded to a "hold" by Monness Crespi & Hardt with a $18 price target, but I believe it has a lot more value. Thus far, it has rallied tremendously, gaining 81.5% in value from the 52-week low. The stock is so cheap at $4 billion that a PE buyer would be in a strong position to make a strong profit off of just taking advantage of the market environment. Right now, everyone is uncertain in chemicals, and this has caused the market to become overly discounted. When industrial activity reaches full levels, the market will be bullish on chemicals. At a beta of 2.3, Huntsman has strong room to cover.

And, in particular, chemical producers with the capital, like Dow, would be interested in smaller growing businesses like Huntsman. Analysts forecast Huntsman growing EPS by 7.4% annually over the next half decade. The rate is only 5% for DuPont and 6.4% for Dow. In addition, Huntsman generates tremendous free cash flow, which makes it easy to pay off interest expenses in a "going private" transaction. In fact, FCF has done a mirror flip from around -$514 million in mid-2010 to $535 million today. This represents a terrific 13.5% yield against the market capitalization. Research has shown that these kind of high FCF yielding stocks outperform broader indices.

It should be noted that Huntsman is more leveraged than peers. However, leverage isn't always a bad thing; it is used to help companies grow. With the economy improving, this kind of aggressive financing is likely to pay off big from greater industrial demand. With a short interest of 5.8% of the float (a significant, although not huge amount), there could be an upcoming short squeeze from emerging takeover chatter. I encourage buying before that happens.

TakeoverAnalyst 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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