Dow: Our Top Pick in This Inflationary Environment

Dow Inc.NYSE:DOW) provides materials science solutions through the following three business units:

1. Packaging & Specialty PlasticsIt supplies ethylene and propylene, polyethylene and polyolefins, as well as polyethylene, polyethylene, polyolefins, polyolefins, polyolefins, polyolefins, polyolefins, elastomers, ethylene Vinyl Acetate, and ethylene Propylene Diene Monomer Rubber. It also offers aromatics products (117% of turnover).
2. Industrial Intermediates & InfrastructureThis segment provides ethylene oxides. propylene oxide, ethylene glycol, propylene oil, and polyetherpolols. It also supplies aromatic isocyanates. This segment also supplies caustic soda, ethylene dichloride, vinyl chloride monomers, and many other items; 30% of turnover
3. Performance Materials & CoatingsWe offer industrial coatings, architectural paints, and coatings that are used in the maintenance and repair of buildings. ProtectiveIndustries, wood, metal packaging and traffic marking; high-performance silicones and monomers; independent silicones; solutions for home care and personal care; (53% turnover).

The DowDuPont spin-off created the company we know today. Dow was established in Midland (Michigan) in 2018. This image shows Dow at a glance. It is easy to see that Dow is well-diversified around the Globe and is well-positioned to create shareholder wealth across the cycle.

Source: Dow 2021 results

Why is Dow the value pick in this inflationary environment for Dow?

First of all, chemistry can be found everywhere. All products we use every day contain basic chemicals. This is a very important consideration. However, we also have a top quality analysis that will attract investors. We have conducted intensive Q&A sessions with small-medium chemical CEOs. We now have some intellectual property that we can share with our readers. We now know Dow will see an exponential increase in inflation. Inflation will cause more inflation, and Dow is expected to be a key value driver in the future. These assumptions are based in part on the following two new approaches that we have seen in the chemical space:

1. New revenue model
2. The economy of scale disruption

New revenue model and sales contracts

Our main investment thesis is based in a major shift in the contractual terms for chemical sales contracts. The chemical market is dominated by large players. These companies are those that operate in what we refer to as the “first value production chains.”Producing companies“of basic chemicals. The product is often processed by other players in specialised verticals. These smaller companies, which are often smaller than the former, make these markets highly competitive and fragmented. Large companies like Dow have been forced to operate in an oligopoly environment, which is characterized by inelastic demand. Price is largely determined by supply.

Until now, product sales agreements between Dow and its clients were based on either annual or half-yearly contracts. Volume was also an important factor. It could be called usual wholesale logic. Companies such as Dow have started to sell their products through contracts we could call spot prices contracts, because they are based upon very short periods. This means that the price between counterparties can be extremely volatile. It is affected by changes in the prices for materials. Thus, the market logic can be reached, regardless of how much was purchased.

These contracts also contain clauses that allow for an increase in sale price when the spot cost of the raw materials rises. In addition, the contract does not allow for decrementing in the event that raw material or energy prices fall. This change will be allowed by Dow’s oligopolistic structure, which allows the chemical company to regulate its price, making it less cyclical and ensuring stable revenues and cash flows over the long-term. This change will give Dow an excellent protection against inflation. Dow’s revenues will be tied to the price of raw materials it produces. Dow will benefit almost immediately from this sudden rise in prices.

The economy of scale disruption

This logic was complemented by another logic that we can all draw from our daily lives. The proportional effect of how much you buy on your monthly expenses is that you pay less. This is a financial concept called economy of scale. It is one of the first lessons in finance. Recently, we have seen that large chemical customers have not been able benefit from discounts because they have not bought large product slots. The new logic is:

The more you buy the more you will pay.

Dow will reap the benefits of the fact that its products will all be sold at the same prices, thereby increasing margins over time and profit.

Dow’s valuation: From a cyclical company, to a margin moat valuation

COVID-19 has reshaped some industries, and a huge imbalance in supply and demand within the chemical sector has greatly influenced Dow’s pricing power. Similar results were seen for Maersk, another company operating in an oligopolistic marketplace. Maersk was priced in by the market in the Logistics sector. There are significant barriers to entry in terms of capital and time, and both are vital and essential sectors for the real economy. We believe Dow is very undervalued for all of the reasons mentioned above.

Our valuation is primarily driven by the qualitative changes in business that were just described. Dow’s growth has been largely driven by price increases and not volume growth. This makes it almost stable over the long-term. This assumption has made Dow a highly cyclical business that is dependent on commodity prices and linked to the macroeconomic cycles. Dow’s margins, profitability, and valuation have always been affected by these macro-variables. We have spoken with many CEOs and we understand the impact of these new contracts. We believe these major changes will bring Dow’s revenues, margins, and profitability to a higher level over time. We are basically estimating that Dow will be less cyclical, and less sensitive to sudden changes at the cost of goods. Dow currently trades at an “end of cycle” market valuation, with an EV/EBITDA 2021 just 5.15x. This despite the significant debt reduction and an increase in margins.

Source: Mare Evidence Lab analysis

We believe the current valuation is too low for the company’s intrinsic value. Dow’s 2019 value was used as a proxy for our expected value. The company was not experiencing favourable momentum in that year and Dow was priced at 7.99x EV/EBITDA, which is well above its current valuation of 5.15x. Based on our internal forecast for 2022 EBITDA, Dow has an EV/EBITDA goal equal to 2019. We value Dow with a market capitalization of approximately $76B, which translates into a 53% upside over its current valuation.

Source: Mare Evidence Lab analysis

We can only confirm that Dow is an excellent inflation protector if we also include a juicy Dividend Policy in this valuation. This yields higher than the sector average.

We also did a quantitative analysis using a linear regression between Dow Inc.’s monthly capitalization, and the monthly inflation in America. The two variables were proportional in their relationship. We also found that the adjusted R2 was close to 60%. This shows how inflation is a powerful explanatory factor in relation to Dow’s market cap.

Source: Mare Evidence Lab analysis

Conclusion and risks

Solid balance sheet, solid performance quarter-by-quarter, compelling valuation, delicious dividend yield and buyback in place, quantitative analytics supported by qualitative Q&A we say no more.

Dow is our choice for high-inflation environments.

The main risks that could affect Dow stock price include:

1. Global macro demand for chemicals is declining
2. New and prolonged COVID restrictions
3. Polyethylene margin decrease
4. Lack of recovery in industrial intermediates
5. Potential for M&A
6. Exposure to FX
7. Failure to increase cash flow