Avoid These 2 Highly Risky Chemical Stocks

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

If the fiscal cliff has you worried about the financial markets, chemicals is certainly not where you should be. This heavily-leveraged industry faces considerable volatility and drastic demand cuts in plastics. While some companies have been speculated to be future takeover plays, negative catalysts seem to outweigh positive ones. Below, I review two large chemicals producers that I am bearish about.

A Look at DuPont (NYSE: DD)

Despite falling 14.5% from the 52-week high, DuPont still trades fairly high at 15.1x past earnings. Its P/B multiple of 4.3x is well above the 3x industry average, and this is particularly disconcerting in light of how volatile chemicals are--the diversified producer has a beta of 1.5. 10 of 17 reporting analysts rate DuPont a "hold," and the consensus price target is only $49.57, a dismal 10% premium to the prevailing price. 4.8% annual EPS growth is forecasted over the next five years, which is not nearly enough for outperformance, even when factoring in the 3.8% dividend yield.

There are several variables to consider about DuPont. First, management has showcased pessimism with the recent announcement that they will spend less on capital expenditures next year in light of the fiscal cliff and macro uncertainty. While this was largely counteracted by the board authorization of a $1 billion stock repurchase program and rosier forecasts than expected, there are still major headwinds looming in key geographies. China is stalling infrastructure projects, and this issue is compounded by uncertainty over the leadership changes. Management's poor third quarter performance erased all of the company's gains and was largely the result of a large volume decline in PV materials and a 28% top-line decline in electronics & communications. Revenue of $7.5 billion, down 9% y-o-y, was $750 million below expectations.

Going forward, however, management believes it is on track to realize productivity targets in its cost structure while steepening its future growth curve. In particular, the company is looking towards higher-margin areas, like nutrition, agriculture, and biotech. Again, however, growth would have to be significantly higher to justify an active investment for 150% of the broader market's volatility.

Why You Should Avoid Dow Chemical (NYSE: DOW)

Dow is a peer stock worth considering. It trades at 13.4x past earnings and a reasonable book ratio of 1.6x. But analysts are no more bullish on the stock compared to DuPont, with 12 of 16 reporting analysts calling it a "hold" or worse; one of which even encourages investors to "sell." And for good reason: The company's return on invested capital of 7.9% is well below what is required for a 2.3 beta stock, and it is also below the 14% industry average. Profit margins are nearly 400 bps below the industry average, which makes it considerably more vulnerable to pricing erosion for a challenging economy.

There are several variables to consider before investing in Dow. The company has been downsizing with a plan announced in early December to sell off businesses with more than $1 billion in annual revenue. It is also closing 20 plants and eliminating thousands of workers, which marks the second restructuring in 2012 attempting to address weakening demand for plastics. The reason for this goes beyond just a weak economy; it is because of the firm's poor financial position. Net debt stands at a staggering $16.7 billion, which represent more than two-fifths of the market capitalization. That said, Huntsman (NYSE: HUN) has net debt of $3.3 billion, which is 86% of the market capitalization, and many speculators view the company as being in play. Its strong free cash flow yield of 11.2% and 7.6x PE multiple have contributed to this bullish outlook.

Dow's management is committed to focusing on projects that generate positive returns in the "far-distant future." Especially in light of the fiscal cliff, why would you get in now if the returns are so distant that the market will struggle to assess them? There could be more pain from failing to generate returns from companies that may outperform in the next one to two years. Assuming Huntsman grows EPS by 7.4% over the next five years, 2016 EPS will come out to $2.51, which, at a multiple of just 10x, translates to a future stock value of $25.10. This provides for around 14% average annual returns when you factor in dividends. Add in the possibility of a takeover, and you can get some strong annualized returns.

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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