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Dow Chemical Lagging Behind Peers

Jeff Bagley

Editor's note: This column by Jeff Bagley is a special bonus for TheStreet.com and RealMoney readers. It first appeared on Street Insight on April 26 at 11:09 a.m. EDT. To sign up for Street Insight, where you can read Jeff Bagley's commentary in real time, please click here.

Have we already seen the peak of the cycle? That's what most chemical investors -- and an increasing contingent of sell-side analysts -- seem to be saying. In the lucrative but often frustrating world of cyclical investing, one wonders how a company such as Dow Chemical DOW, which has been doing all the right things in recent years, can trade at only 8.5 times earnings.

Investors are clearly looking for earnings to decline, and Thursday morning's earnings report from the chemical giant will hopefully give us clues as to the longevity of the cycle. We've had a couple of good earnings reports from the chemical industry thus far this quarter, but can Dow keep up the pace set by DuPont DD and PPG IndustriesPPG? More importantly, can management assuage investors' fears regarding the cyclical peak?

Analysts are looking for Dow to report first-quarter earnings of $1.17 a share on revenue of $12.3 billion. First-quarter estimates, as well as those for the full year, have declined steadily recently, based on the recent fall in chemical prices, particularly those in the ethylene chain, to which Dow is highly levered.

If Dow reports in line with expectations, that would represent the first year-over-year decline in quarterly EPS in several quarters. Although analysts collectively expect the company to resume its profit growth in the second quarter, profits are expected to decline next year compared to 2006 levels. In other words, many believe that we've already seen peak earnings for this cycle.

Demand for chemicals -- especially ethylene -- has been soft for most of the first quarter, so investors should not be surprised to see very weak volume. Chemical buyers have learned to run on very low inventory, and many have deferred purchases as prices have declined, hoping to lock in lower prices for their conversion needs. That decision, it turns out, has worked very well.

Thankfully, natural gas prices have declined significantly from their peak last fall, so ethylene margins were likely very high during the first quarter. That should help offset weaker margins, allowing Dow to at least reach its earnings targets. Note, also, that the company has undergone severe restructuring in recent years in an effort to reduce its costs.

Demand Rebounds, but Margins Contract

Dow and its brethren should feel the full negative effect of declining pricing in the second quarter. According to most industry experts and channel checks, volume remains relatively weak and pricing has fallen further. Feedstock costs have remained low -- again, thankfully -- but that probably hasn't been enough to offset the negatives. The result is lower margins.

There is some good news, however. First, the margin difficulties have been well telegraphed, so expectations are already low. It can be argued that this has already been priced into the stock.

Second, and very importantly, demand should start to rebound in the latter half of the second quarter and continue strong into the summer months as buyers replenish their inventories ahead of the hurricane season. This should lead to better pricing as many don't want to be caught without product. Buyers were burned by storm-induced supply disruptions last year, and they don't want that to happen again.

Many analysts believe that any rebound in demand and pricing will prove temporary. An important factor in this thesis is that there will be a great deal of capacity coming on line in the second half of 2006, especially in ethylene.

The negative effects of such a scenario should not be underestimated. In fact, Citigroup C analyst P.J. Juvekar has taken a very bearish stance on the commodities chemical sector, and sees Dow's earnings falling to $3.33 a share in 2007. Current consensus for 2007 stands at $4.65, down from $4.86 this year. He is clearly going out on a limb.

Management has done a great job in getting Dow Chemical in fighting shape, given the severe increase in energy and other feedstock costs in recent years. They've been helped by a strong economy and tight supply, to be sure, which has led to very firm pricing.

Listening to their presentations, it becomes clear that they are very proud of their work, and up to this point, have continued to forecast more good times for the industry.

For the most part, this good performance and positive rhetoric has fallen on deaf ears. The stock is down substantially in recent months, and is trading near its 52-week low.

I expect management to continue to say good things, with an up-tick in demand on the horizon. Keep in mind, also, that the company's profit performance has been great; it's the expectations that have suffered. But will management's positive comments matter?

I'm not sure, but I believe that investor expectations are very low at this juncture, and that's why I'm long. I don't believe Dow represents a potential home run by any means, but a little more optimism can go a long way.

Editor's note: This column by Jeff Bagley is a special bonus for TheStreet.com and RealMoney readers. It first appeared on Street Insight on April 26 at 11:09 a.m. EDT. To sign up for Street Insight, where you can read Jeff Bagley's commentary in real time, please click here.