Should I Do It? DuPont Gets a Look

This stock, which already provides a secure dividend, looks likely to grow in 2006.
Author:
Publish date:

Editor's note: Beginning today, we will run a "Should I Do It?" column every Wednesday by David Peltier, our value stocks expert. In the column, David will take a look at a value stock and explain if you should snap up shares or pass it over.Peltier has been a regular on RealMoney for a while and also writes TheStreet.com Value Investor.

This morning,

DuPont

(DD) - Get Report

warned that fourth-quarter earnings will come in at 10 cents a share, falling short of the consensus analyst earnings estimate of 24 cents. Management said the $200 million discrepancy was divided between hurricane-related disruptions, unplanned outages at two foreign plants, and weaker sales in two divisions. As a result, the stock fell almost 3% Wednesday afternoon, to $41.28 a share.

With a 3.6% dividend yield, DuPont is one of the dogs of the

Dow Jones Industrial Average

. At current levels, the stock is up 13% from its October lows yet down 23% from where the company was trading last March. At 15 times the 2006 consensus analyst earnings estimate of $2.89 a share, DuPont trades below its average historical valuation, even though the third-largest U.S. chemicals maker is on track to post its third straight annual earnings increase in 2006.

That said, does DuPont hold value for investors?

The chemicals sector took off about a year ago, after leaders like DuPont and

Dow Chemical

(DOW) - Get Report

put together a few strong quarters. Even so, the enthusiasm left this sector by the spring of 2005, as natural gas prices -- which are large component costs for chemicals producers -- began soaring. Around $9.30 per million BTU, natural gas futures contracts are trading well above their historical average of $2 to $4. Even so, the commodity is a far cry from the $15 level at which it was trading less than a month ago.

The good news is that DuPont has been able to pass along much of the higher costs to its customers. Most recently, the company boosted prices for white pigment titanium dioxide on Jan. 1. DuPont sees about $2 billion of annual revenue from this compound. This increase is possible, because production capacity is very tight relative to the strong demand out of China -- where DuPont logged $1.4 billion of annual revenue last year -- and other emerging economies. The company is looking to take advantage of this boom by investing $1 billion in a new pigment plant in Dongying, China. Expected to open by 2010, the site represents DuPont's largest current single investment project.

To view David Peltier's video take on DuPont, click here

.

As evidenced by Wednesday's profit warning, Hurricane Katrina and the other major storms that hit the Gulf of Mexico in 2005 changed the landscape of the chemicals industry. The silver lining in this perfect storm of problems is that the company believes most of them will be short-lived. The hurricane-related weakness DuPont talked about was a carryover from the third quarter, when it quantified the damage at $146 million, while posting its first quarterly loss in two years.

Management said on a conference call this morning it will likely adjust higher its storm damage insurance claims, and expects the company can regain customer sales as the affected sites return to full capacity. The same goes for the unplanned outages in Brazil and the Netherlands, which should not have a material effect on 2006 results.

While the weakness in protection chemicals and performance coatings and surfaces cannot be explained away as easily, it is worth noting that these units were earmarked by DuPont as underperforming assets last November. The company announced a plan at its November investor meeting to reduce fixed costs by $1 billion over the next three years. DuPont is looking to improve its return on assets (net income divided by total assets) in its businesses that have dropped below the company's target of 12% ROA. This represents one-third of its total assets.

Performance coatings relates directly to the automotive industry, where demand has been inconsistent for a couple of years now. In saying he was extremely disappointed with the quarter, CEO Charles Holliday said the company knows it has some tough decisions to make in these areas -- including a potential sale of the worst performers.

The company's largest division is its Agriculture and Nutrition group. This includes a hybrid seed business focused on corn that competes directly with

Monsanto

(MON)

-- a company that's seen its shares rise 48% over the past year because of its success in bioengineering. DuPont spent $1.33 billion on research and development during 2004, and regularly introduces new value-added products to complement its core portfolio of commodity chemicals.

DuPont has also pledged to buy back $5 billion worth of stock over the next two years. This includes $3 billion by the end of July through an accelerated program managed by Goldman Sachs, as well as $2 billion more on the open market afterward. Thanks in part to the repatriation of overseas earnings, DuPont's cash balance has improved from $3.5 billion at the beginning of 2005 to $5 billion as of the end of the third quarter.

In addition to benefiting from a potential rise in DuPont's share price, investors will also receive the company's 3.5% dividend yield. Management will likely declare its next 37-cent quarterly dividend at the end of January, and DuPont is on track to cover the payment two times with expected 2006 earnings. This coverage is within the realm of what I consider a secure dividend, but it's also worth noting the company's balance sheet is graded an "A" by the four major debt rating agencies and that operating cash flow has been 9% greater than net income over the past four quarters.

In my opinion, this latest warning is not enough to knock DuPont off of its road to recovery. Between the company's strong pricing power, growth in the agriculture business and aggressive share buyback program, I believe management can still post double-digit earnings growth in 2006. If natural gas prices remain below $10 and the chemicals producers are able to sustain recent price increases, the strong global demand environment should drive margin gains over the next several quarters. Under that scenario, DuPont could see $48 by the end of the year, indicating a 20% total return (including the dividend).

Should you invest in DuPont? The answer is yes.

For more information on TheStreet.com Value Investor, click here.

David Peltier is a research associate at TheStreet.com In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback;

click here

to send him an email.