In 2024, I am placing more emphasis on value investing. I do this because of the high stock valuation, which increases the likelihood of moderate total returns over the long term, making stock selection more important.
I discussed that in my Outlook 2024written on December 5, that’s when I got the quote below:
I like depressed cyclical stocks. This includes railroads, machinery companies, and some proven consumer stocks that I’m buying because of their weakness. This is based on the aforementioned phenomenon, whereby cyclical stocks price in a recession well before it occurs. I don’t go all out, but I gradually buy these stocks when the valuation offers a significant margin of safety.
I am also looking for higher income opportunities:
Although I’m not a high-yield investor (I prefer dividend growth over dividend yield), I’m increasingly looking for income. plays an important role, as I believe a much larger share of the total return over the next 10 years will come from dividends.
As we can see in the chart below, during periods of prolonged high inflation, a larger share of the total return tends to come from dividends.
It’s there that Dow Inc. (NYSE:DOW) comes into play, which is a cyclical stock with a dividend above 5%.
My most recent article on the stock was written on July 9, entitled “The Dow’s juicy 5% return would be a no-brainer without the economy“.
In this article, I’ll expand on this point, dive into its dividend, and explain how I would manage this income stock based on current headwinds and tailwinds.
So let’s go !
The attractiveness of the Dow dividend
There are 5% yields that are attractive and 5% yields that are not.
It all depends on the bigger picture.
Dow currently pays $0.70 per share per quarter. This translates to a yield of 5.1%.
- This dividend is protected by $2.7 billion in 2023E free cash flow, resulting in an FCF yield of 7.0% and a cash payout ratio of 73%.
- Using its earnings payout ratio, we are looking at a payout ratio of 88% using 2024E EPS. This figure is expected to drop to 62% using 2025 figures.
- The company has a 2023E net leverage ratio of 2.2x, which is extremely healthy and indicates that DOW does not need to prioritize creditors over shareholders.
However, since the company split from DowDuPont in 2019, it has never increased its dividend.
This is why its dividend history is a horizontal line.
The good news is that DOW is increasingly well-positioned to increase shareholder returns.
During its third-quarter earnings conference call, the company highlighted a cash flow conversion of 129%, proving its ability to convert earnings into operating cash.
The balance sheet has been described as the healthiest in four decades, supported by strong investment grade credit ratings (BBB+) with no significant long-term debt maturities before 2027.
Unfortunately, dividend growth is unlikely to occur in this economic environment.
A difficult environment
The ISM Manufacturing Index, the main economic index, has experienced a contraction (below 50) every month in 2023. It is currently near a multi-year low, indicating very weak demand in the manufacturing sector. This also impacts the chemical industry and most companies with a cyclical business profile.
As a result, Dow’s third quarter financial performance reflects this challenging global economic environment.
Net sales for the quarter were $10.7 billion, a 24% year-over-year decline.
This decline is attributed to slowing global macroeconomic activity, leading to lower local volumes and prices across all operating segments and regions.
Operating EBIT for the quarter was $626 million, down significantly from $1.2 billion in the prior year, primarily due to lower pricing and demand in key segments .
Despite headwinds, the company implemented targeted actions to achieve $1 billion in cost savings in 2023, contributing to a sequential improvement in operating cash flow of more than $300 million.
What’s interesting is that during its press conference, the company also acknowledged the 13th consecutive monthly decline (it’s currently worse) in the global manufacturing PMI.
Weak demand in Europe, a slower than expected recovery in China and continued challenges in various regions were highlighted.
We can see these results in the graph below.
Dow also provided insight into its outlook for the fourth quarter.
The company anticipates continued challenging macroeconomic dynamics, including sluggish industrial activity and weak demand in certain regions.
Despite these challenges, Dow expressed confidence in its ability to weather economic headwinds, which were reiterated at the Citi Basic Materials conference.
Dow Poised for Long-Term Growth
Instead of waiting for cyclical headwinds to turn into tailwinds, Dow invests in future growth.
For example, at the Citi conference, the company announced the final investment decision for the Path2Zero project in Fort Saskatchewan, Alberta, where it is leveraging lessons learned from the success of the Texas-9 cracker.
This project is expected to generate underlying earnings growth of more than $1 billion per year.
Benefits include lower cash costs, 20-year raw material contracts and partnerships with industry leaders such as Linde, Fluor, Wolf Midstream and Ravago.
The Alberta Path2Zero project includes two phases, with total capital expenditures of $6.5 billion. Dow expects to receive more than $1.5 billion in government support, and the majority of incentives closely align with the project’s CapEx deployment.
Additionally, regarding the aforementioned cost savings, Dow maintains a disciplined approach to financial and operational matters.
The company is on track to achieve $1 billion in cost savings in 2023, improving its financial flexibility by reducing net debt and pension liabilities by more than $10 billion.
This strategic approach has positioned Dow well to address near-term macroeconomic challenges and continue to generate shareholder value.
Additionally, in the polyethylene market, Dow is well positioned for growth.
Despite some pressure on prices due to the drop in oil prices, the company sees a strong evolution in volumes.
Export strength has been consistently positive, with consecutive monthly records in exports of polyethylene products from the United States.
Additionally, high demand for wire and cable products, silicon in chip manufacturing, and infrastructure-related products contribute to a diversified revenue stream.
Although housing and home construction have been challenging, the company believes potential new growth in the housing sector offers growth opportunities, especially if interest rates fall. I agree with that.
It must also be said that despite the current headwinds, DOW has made enormous progress since its split.
- Free cash flow more than doubled.
- The cash conversion rate is now close to 100%.
- The free cash flow yield is close to 10% (this also indicates dividend safety).
- Net debt was reduced by almost $6 billion.
- Pension liabilities are now less than $3 billion.
- The company reduced the number of shares outstanding.
So, what about its valuation?
Dow isn’t the only one optimistic about its future.
As the chart below shows, analysts expect EPS growth to exceed 40% in 2024 and 2025, after a potential decline of 64% in 2023.
- DOW stock currently trades at a blended P/E ratio of 24.5x.
- The normalized valuation is 15.8x, which I think fits the company’s growth profile quite well.
- A multiple of 15.8x (lower than its current blended valuation) could result in a fair price target of $70 when factoring in the expected EPS recovery. This would imply growth of around 25% from its current price.
Currently, the stock has a fair price target of $55, where it is currently trading.
The last time the stock hit targets near $70 was in early 2023, when analysts were unaware of declining global economic growth.
Therefore, I expect DOW stock to rise to $70 as soon as economic growth expectations bottom out.
For now, I expect the stock to remain in a volatile sideways trend.
If I were in the DOW stock market, I would buy a small position and gradually add to it over time. If the stock continues to fall, investors go lower on average. If the stock suddenly takes off, investors have a foot in the door and a 5% return.
My Bullish the objective reflects the long-term potential of the company.
In my investment strategy for 2024, I focus on value investments due to the high stock market valuation.
Struggling cyclical stocks like DOW, with a 5% dividend yield, get my attention.
Although its challenging environment, marked by a global economic slowdown, impacts near-term performance, Dow’s resilience is evident.
The company’s strategic initiatives, cost savings and investments in projects like Path2Zero position it for long-term growth.
Despite near-term uncertainties, Dow’s financial health, impressive free cash flow, and growth prospects make it an attractive long-term opportunity.