Novice Investing - Finding A Good Chemistry at Dow

Date: Sunday 20th 2008f July 2008 12:45:14 PM

Finding A Good Chemistry at Dow - 11/05/2007

By: Hari Wibowo

With oil price moving up, rather than down, I had to revise fair valuation for Dow Chemical Co (DOW). Previously, we felt that Dow might earn $ 10. 7 Billion should oil price goes down to $ 50 per barrel. Even when we compared it with GE plastics purchase, Dow stocks look undervalued. Things changed when the US federal reserve cuts its key fund rate by 50 basis points in September 2007. With interest cutting campaign, you would expect other assets to take off, including commodities (crude oil, gold, copper, timber etc.) as investors found it less attractive to hold the dollars. The fed cut another 25 basis points in October 2007 which causes oil price to reach $ 95 per barrel.

At this point, no analysts are predicting a $ 50 per barrels for crude oil. While oil price does not rise as significantly in euro price, most of the widely traded commodities are dollar denominated. As you may recall, when price of oil increases, downstream prices seldom increase immediately. In the beginning, producers are unwilling to pass on the production cost to its downstream customers.

Six months ago, oil hovered around $ 64 per barrel and analysts expect $ 3.96 earning per share for Dow for fiscal year 2007. Recently, this estimate has come down to $ 3.77 per share. As 2007 has almost come to a close, let's examine Dow's 2008 earning forecast from Yahoo! Finance. It is $ 3.52 per share now. Not surprising considering oil price almost breach $ 100 and we are not even in the driving season. My prediction for crude oil in 2008: $ 80 per barrels on average. With that in mind, what would you expect Dow's earning per share (EPS) would be?

We would merely look at Dow's upstream business (18.6% of total revenue) that is significantly affected by crude oil price while we assume that the rest of the business would stay flat as year 2006 (which may not be accurate). Dow's gross profit margin is ~ 15%. It is safe to assume that the upstream business generates less margin ~ 9 % while the rest is generating 17 % profit margin. With oil price assumption of $ 80 per barrel, we shall expect a reduced 7.5% gross margin for the upstream business while other business posts a 16% gross margin.

Dow Chemical Co.	Year 2006, 2008	2006 (in $ Millions)	2008 (in $ Millions)
Revenue	Total (2008 = + 10%)	49 124 000	54 036 000
Gross Profit	Upstream (9 %, 7.5%)	822 300	753 800
	Others (17%, 16%)	6 775 700	7 037 600
Other Operating Expense	2008 = + 10%	3 291 000	3 620 000
Interest Expense	2006 = 2008	616 000	616 000
Income Tax	~ 23% in 2006, 2008	1 155 000	888 800
Net Income		3 724 000	2 666 600
Earning per Share	Sharecount 2006 = 2008	$ 3.94	$ 2.82

As you see, Earning per share (EPS) gets squeezed when oil price skyrocketed. With $ 2.82 EPS, Dow's current share price looks overvalued. However, this assumes high oil price of $ 80 per barrel for 2008, 2009 and beyond and no passing of production cost to Dow's customers. In reality, if oil price hovers high enough for a significant period of time, Dow may have the time to pass on its production increase albeit slowly. Thus, as long as oil stays at $ 80 per barrels on average, Dow earning of $ 2.82 per share can be seen as the bottom earnings for this cyclical. Current share price of $ 43 per share represents price earning ratio of 15.56 which essentially gives you 6.42% of yield year in and year out.

Current treasury yield is around 4.3 % but 6.42% of yield may be too risky to some investors to get. In general, we would like to have at least 3% above treasury yield. This is up to each investors whether they want to accept this yield or wait until Dow stock price fall further. Currently, Dow may have some gas left over but I am not as bullish as I was last year.

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Dow Chemical Co. (DOW) or any other securities.

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