Bill Cara: Chemical companies lack pricing power and market shine, Mon., July 31, 2006, 11:40 PM

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July 31, 2006

Chemical companies lack pricing power and market shine, Mon., July 31, 2006, 11:40 PM

There is always a good time to buy, and that's usually when Wall Street is downgrading and most traders are selling. I think that's the situation today with Dow Chemical.

UBS defines Dow Chemical Co as such: "(This) is a top-tier, diverse, global chemical company with a track record of growth and technical innovation. The company has transformed itself from a U.S.-based commodity chemical producer to a global provider of engineered products and services. The company provides increasingly global sourcing of products through assets in developing regions with access to cost-advantaged feed-stocks. Business segments include Performance Plastics (polyurethanes, epoxies, and engineering plastics), Plastics (polyethylene and others), Ag Chemicals, and Chemicals (chlorine, caustic, and VCM)."

You know, I like two chemical companies in particular " Dow Chemical and Lyondell Chemical. I prefer them to the Dow 30 index component Dupont (DD) on the basis of financial strength and operating metrics.

So when UBS publishes a report on Cara 100 Dow Chemical, I will compare the situation to Lyondell (another Cara 100) and Dupont. When business is bad for the one, it's usually bad for the others. Download UBS July 28 DOW report.

And when it's bad, share prices sink for all of them. That's when I like to avoid these stocks. Of course, sometimes one company will report that things are not bad, while the others complain that it's not so good. But I'll go with the weight of the evidence, which typically shows up in a common cyclic pattern of declining share prices.

All these stocks peaked in March 2005 and then plunged in price. The charts show that Dow Chemical has fallen most steeply this year. But now we are at the Accumulation zone for Dow Chemical.

For DOW/LYO/DD the Monthly data Relative Strength Index is 21.4/43.1/38.3 while for the weekly it is 24.0/48.4/33.0. So there is no comparison; Dow Chemical is clearly in the Accumulation zone and the others are not.

Here is where I'd go to my institutional clients armed with all the current and historical fundamental and quantitative data plus the research department opinions, and sell the managers on the idea to sell LYO and buy DOW.

I'd show how earnings were falling for all three of these companies because they had no pricing power, which is just another way of saying that inflated costs could not be passed on to customers in the form of higher prices. So margins decline " for now, but they'll start to improve when the economy picks up and when crude oil prices start to drop. The point is to be early.

The UBS research department thinks that Dow Chemical's revenues will pick up a little next year, but their earnings will grow a lot from $4.25 est. for 2006 to $5.00 est. for 2007. But the stock price is down from a peak of about $56.75 (March-05) to just $34.58 this week (-39.1 pct) in 17 months.

UBS has set a 12-month target of $50 (down from prior forecast of $60). From today's price of $34.58, that would represent a gain of +44.6 pct. The quarter yearly dividend of $0.375 is secure, so the next four quarters, the dividend income will be $1.50, which represents a yield of +4.34 pct, which is higher than the 5-year average (+3.8 pct) because the share price is so low.

From the DOW charts, and my sense of the overall market (oil prices, interest rates, economy, etc), I'm afraid I cannot agree with the UBS 12-month target. I think it is overly generous. But I'll forecast $47. So with my cost base (buying today) at $34.58 plus $1.50 dividend, my total return on an ultimate sale at $47 would be +39.1 pct.

I would be very happy with that performance in my portfolio.

So the deal is that you sell LYO (at $22.27) and buy DOW (at $34.58).

You want to buy LYO at something like $19 (about a -15 pct haircut from here), which you might accomplish by writing puts, or maybe on its own. And then with the $0.90 dividend over the next year, you could likely sell it for $26 for a total return of about +43.6 pct.

But you want to wait until LYO drops to a Monthly/Weekly RSI of 30/30, and today it stands at 43.1/48.4. Now if you get LYO at your price, you are happy to add a second strong chemical company, but if you don't, you take the premiums you earned on the LYO put writes and deduct them from your DOW cost base, which increases your total return on the DOW even more.

The point to all this is that (i) you wait til the stock of a quality company comes to you, and (ii) you do some simple arithmetic to calculate your potential return, which if it's potentially in the +40 pct range for the next year would put you in the top 2 or 3 percentile group of professional money managers.

If you can net +24 pct after tax, by using the Rule of 72, you would know that your portfolio will double every 3 years. That might happen once in a lifetime to your house price, but in the market, if you trade prudently, it can happen every year.

And the stocks you trade can be old fogey types like DOW and LYO. You just need a sense of what makes these companies tick, and to do that you need to read Wall Street research plus the Value Line reports. That and some charts of different time horizons with technical indicators like RSI and you can do this.

Dow Chemical Co. [GICS 15, Cara 100]
(DOW: Yahoo Finance file)
(DOW: StockChart chart)
(DOW: Investertech chart)
(DOW: ADVFN Financial Data)(DOW: ADVFN Financial Data)

Lyondell Chemical Co. [GICS 15, Cara 100]
(LYO: Yahoo Finance file)
(LYO: StockChart chart)
(LYO: Investertech chart)
(LYO: ADVFN Financial Data)(LYO: ADVFN Financial Data)

Dupont [GICS 15, Dow 30]
(DD: Yahoo Finance file)
(DD: StockChart chart)
(DD: Investertech chart)
(DD: ADVFN Financial Data)(DD: ADVFN Financial Data)
(DD: Value Line Report Jul. 21: next one is due Oct. 20)

Posted by Posted by Bill Cara on July 31, 2006 11:40:31 PM | Category: 15 Materials , Cara Global 100 Best Companies

Discourse

Bill - as always - thank you for making it so clear and simple...

Posted by: sergio at August 1, 2006 12:11 AM [link]

Bill,
My God, you are so good and so generous. I am only reading your blog since May and have learned so much. Your method is so intelligent. Even if you closed your blog today, I will be grateful to you for ever for your lessons. Thanks,
Bala

Posted by: ghosalb at August 1, 2006 12:48 AM [link]

COMEX silver inventories now under 100 mil oz.

http://www.nymex.com/sil_fut_wareho.aspx

Posted by: DollarBill at August 1, 2006 3:05 AM [link]

Guys-

I hope you take the time to go through Bill's content in his archives but also his sector headings. There are TONS of good stuff there. Trading Tools and Cycles are my favorites. If you want a real treat just read through his Quarterly report from Spring of last year.

Posted by: MarkM at August 1, 2006 5:18 AM [link]

Guys-

A couple of comments on this posting.

Bill wants to teach you how to fish. If you have his Cara 100 stocks charted and saved, you would have been wondering about his view on this stock due to it's technically oversold level. You can save the charts of his Cara 100 list, plus his "Cara 250" stocks on your desktop and then use his fundamental and technical "filters" to add your own stocks to your watch list. Use the search key to find what he looks at and then you can do it yourself. Then learn how he calculates future price targets and potential gains.

Also, just because DOW is in his accumulation zone does not mean that this is the bottom of it's price pattern. That is why Bill uses options to lower his cost basis. He explains his option techniques in recent articles.

Also, he mentions LYO and DOW as a switch, you could also pair the trade, shorting LYO and going long DOW. This is what some hedge funds and traders do.

Also, a risk in this trade is the companies energy costs. If the middle east conflict escalates further and pushes oil prices to new highs, Dow's margins will be squeezed further. But, that makes this a nice pair with any oil or oil stocks that you may own at a low cost basis (not a recommendation, just a thought that may help someone).

Remember, this blog is supposed to be a learning experience.

Thanks Bill!

Posted by: g034 at August 1, 2006 8:23 AM [link]

Bill...

Great, great post and information. I continue to be amazed at your generosity in sharing information designed to make us money.

Your Cara 100 list is fantastic and a great help to knowing these companies.

I commend you for your continued efforts to help us out here. No one else does it, that's for sure...

Bill

Posted by: AlaBill at August 1, 2006 8:44 AM [link]

It should be noted, LYO still owns the largest oil refinery for heavy crude in the USA and it's contribution to the bottom line was very helpful.

Posted by: C.Note at August 1, 2006 8:55 AM [link]

DOW:

Geoffery E. Merszei (CFO) BUY 15.0K @ $34.10 $511.5K form 4 report- Jul-31

Posted by: stockman at August 1, 2006 10:55 AM [link]

Dow:

C.Note (OldGuy) BUY (not as many as Merszei) @ $34.10 form 4 report@Bill's Blog August 1, 2006 ;)

Posted by: C.Note at August 1, 2006 2:24 PM [link]

DOW:

Andrew N. Liveris (CEO) BUY 20.0K $34.45 $688.9K form 4 report Jul-31

Posted by: stockman at August 1, 2006 3:06 PM [link]

DOW: Also a leader in sustainabilty, as Barron's pointed out this weekend:

Â«IT MAY HAVE TO USE PIPES that have been criticized as potentially contaminating to bring safe drinking water to the nearly 20% of the world's people who don't have it, but Dow Chemical is joining the effort.

Dow, whose name was once associated with such nasty chemicals as dioxin-based Agent Orange, has been on something of an environmental tear. Since it announced its 2005 sustainability goals in 1993, Dow has been able to reduce its energy intensity (or units of energy per pound of product) by 20%. Its new goals, set for 2015, are for a further 25% reduction and to reach at least three "breakthrough solutions" in four areas, including economically viable desalination efforts of local water supplies.

As part of the water effort, Dow's chairman and CEO, Andrew Liveris, announced at the United Nations a partnership with a nonprofit, Blue Planet Run, to focus awareness on the need for safe drinking water. Next June the group will kick off a worldwide run to raise money for safe-drinking-water projects. The U.N. will oversee spending of money raised.

Though Liveris said in an interview that Dow's water-solutions business constitutes a mere drop in the bucket of its $50 billion in annual revenues, it is putting more resources into it. The partnership with Blue Planet Run and the U.N. "highlights our name against a very noble goal," said Liveris. He said the unit, along with other noncommodity units, would get preferential investment dollars. (Those "performance" units actually underperformed the basic segments when Dow last week posted a 19% drop in second-quarter net.)Â«

But the investment in sustainability appears to have paid off. Liveris said a $1 billion investment in that area has yielded a $5 billion return.

Posted by: tinman at August 1, 2006 3:07 PM [link]

FWIW on Insider trading data-

Insiders are not traders. They tend to buy weakness (falling knives). They buy what they see as long term value.

From a long term track record perspective- insiders historically have outperformed the market- 3, 6 and 12 months (on AVERAGE taking all transactions).

The insiders with the best track record are the most senior level executives.

The transactions with the best record are the largest in $.

Posted by: stockman at August 1, 2006 5:28 PM [link]

fyi

Insiders Step Up at Dow Chemical
David Peltier
8/1/06 3:20 PM EDT

A 20,000-share open-market purchase by Dow Chemical (DOW) CEO Andrew Liveris just hit the wires. This is in addition to the 15,000 shares CFO Geoffery Merszei bought Monday.

This is a stock I've followed for several quarters now in the TheStreet.com Dividend Stock Advisor. The company reported soft second-quarter results July 27, and management also said it could fall short of full-year earnings expectations.

While Dow raised prices 5%, it faced an $800 million annual increase in feedstock prices.

If you like Dow because it trades at eight times earnings, I feel you're at risk of stepping into a value trap. That said, when you figure the company has an A-rated balance sheet and 37.5-cent quarterly dividend (4.3% yield) and is otherwise covered a comfortable 2.8 times with expected 2006 earnings of $4.27 a share, it's hard to ignore here around $34, given the added confidence of the insider buying.

Posted by: glenn-mp at August 1, 2006 5:30 PM [link]

DOW:

Charles J. Kalil (Corp VP & General Counsel) BUY 10.0K $34.28 $342.8K form 4 Aug-01

Posted by: stockman at August 2, 2006 10:50 AM [link]

LYO will buy out Citgo's (Venezuela) minority portion of the heavy crude oil refinery in Houston per info released today (8/2);stock up $0.39 at noon. Meanwhile DOW up $0.81 at noon. Thank you again Bill ;)

Posted by: C.Note at August 2, 2006 12:39 PM [link]