Last week I was supposed to be relaxing on holiday in Austria with my family. But my attention kept being drawn away from the Alps to the mountainous daily dips on the FTSE 100. My advice at times like these is to sit tight and don’t panic. But when it comes to tips, for the next few months at least, a safety-first approach is sensible. This industrial giant (annual sales are $53.5bn) is a relative safe haven due to its below-average volatility (or beta), geographical footprint, robust pricing power, pro-active management and attractive price.
Dow Chemical (NYSE:DOW), rated a BUY by S&P
Dow supplies a vast array of speciality and basic chemicals to customers in more than 180 countries. Its products are used to produce everything from fresh water, food and pharmaceuticals to paints, packaging and cosmetics. That means a large chunk of its sales come from consumer staples, as opposed to big-ticket items. That makes it less vulnerable in a downturn. What’s more, the board’s strategy is to cut its exposure to lower-margin commodities further and instead focus on more profitable niches that enhance its earnings quality. This has recently been furthered by two transformational deals.
On 10 July, Dow agreed an $18.8bn takeover of rival Rohm & Haas (R&H), creating the largest specialty chemicals company in America, with leading positions in performance products and advanced materials. This deal came hot on the heels of its $11bn joint venture with Petrochemical Industries of Kuwait. Dow’s exposure to cyclical industries has been cut from 49% to 31% of turnover.
So compelling are the benefits of combining the groups (generating at least $800m a year) that even Warren Buffett wants a piece of the action. His Berkshire Hathaway vehicle is pitching in $3bn and will become Dow’s largest shareholder, with a 9.5% stake. Main areas of cost savings include greater efficiency in the purchasing and supply chain, coupled with the elimination of duplicate overheads. The directors also believe the Rohm & Haas deal will deliver significant cross-marketing benefits by creating broader product offerings in fast-growing industry areas.
Wall Street expects 2008 revenues to come in at $58.3bn, generating an associated underlying earnings per share of $3.23 and paying a hefty $1.68 dividend. So, at $34, the shares trade on a prospective p/e of 10.5 and pay a near 5% yield, which looks good value. Such is the confidence of the board that it now believes earnings could even surpass $10 a share by 2015.
But what do we need to watch out for? The most significant risks relate to rising costs, especially from higher energy and oil-based raw materials, and unforeseen difficulties in integrating Rohm & Haas. That said, Dow has recently hiked its selling prices by up to 45% in response to surging inflation, while it also has an in-depth knowledge of Rohm & Haas and has a great track record in delivering acquisition synergies.
Another potential pitfall is that, regardless of its shift into more defensive sectors, the firm still wouldn’t be totally immune to a severe global slowdown. Investors should also keep an eye on Dow’s gearing levels (proforma net debt is around $17bn), together with legacy asbestos issues related to its purchase of Union Carbide back in 2001. All the same, with strong market positions on top of good cash generation, then long-term investors should follow Mr Buffett’s lead.
Recommendation: BUY at $34.85
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments