04/29/13 Covered Call Pick: Dow Chemical (DOW)

Dow Chemical (DOW) is an American-based multinational chemical corporation that manufactures plastics, chemicals, and agricultural products for the global markets. With a massively diverse product line that includes plastics, specialty chemicals, catalysts, and industrial coatings, DOW is present in over 160 countries employing over 50,000 people. This makes it the second largest chemical company in the world and a company that has penetrated the global food, transportation, and energy markets.

Dow Chemical currently has a market capitalization of $40.37 billion with 1.2 billion outstanding shares.

DOW currently pays a $0.32 quarterly dividend for a current yield of 3.8%.

With a beta of 1.29, DOW currently trades with approximately 30% more volatility than the current market.

We've talked in the past about certain companies that act as barometers for the health and direction of the global economy. A common term for these companies are "bellwethers" and the market tends to pay a bit more attention to them when they report earnings and make announcements. When these companies do well, it is usually a good sign for the economy. This is because many of them deal with the beginning of the business cycle. That means they feel the effects of changes in the cycle before the wide market and the general consumer is affected. These companies are involved in the manufacture of industrial or construction equipment (CAT), provide a fundamental service for businesses across industries (UPS), or even create the very compounds that help us sustain and advance the civilization we know. This is where DOW comes in.

We can't sit here and list all the things DOW makes or is involved in, or it'd take us all week to write this article. They make chemicals that go into the manufacturing of plastics - just think about how much is made out of plastic nowadays. They are involved in the the manufacture of agricultural chemicals in the form or fertilizers and pesticides, as well as the development of genetically enhanced crops. They also are involved in the production of fuel, oil, and natural gas products. They have a lot of fingers in a lot of pies, and on a very basic level - a fact that is a double-edged sword. While their products and services are highly integral for the operation of many businesses, it also means that their products are the first to feel a slack of new orders as business slows down. This is one of the reasons why we haven't recommended DOW in the past, as the global economic outlook has not been healthy and DOW suffered with a 25% decrease in earnings in 2012.

Looking out at the macroeconomic environment we still think it is quite weak.

This should be the point where you are confused.

Why are we recommending DOW if the company is tightly tied to the macroeconomic environment and we don't think that the environment is all that strong? The company reported Q1 earnings last Thursday and the results were overall positive. The company beat on EPS by $0.07, with revenue coming in shy of $0.48 billion. Not a home-run, but when you compare to the abysmal year they had in 2012, of which only the fourth quarter saw growth in earnings, we believe the company has started to gain a foothold once again. Sales fell 2% overall, but gross margins increased to 18.6% from 16.5%, mainly due to a fall in input costs. This has been a common story for companies (as we mentioned this past Friday), as cost-cutting and increased efficiency has been driving earnings. What is a brighter note is that while there was a 13% decrease in Feedstock and Energy sales, there was a 14% increase in Agriculture Sciences, a field that we feel is becoming more and more important as population levels increase and food supplies become even more stretched. The company is taking advantage of the low price of natural gas, hence the lowered input costs, and is also working on selling off some of its segments in an effort to focus on return on capital. The company also plans to repurchase $1.5 billion of outstanding common stock, helping to return value to shareholders.

Because of the higher beta that DOW supports, this is a riskier strategy than the majority of our recommendations. Yet even with the global headwinds that the company faces, earnings are expected to grow by 25% this year, giving it a PEG ratio of 0.68, a heavy discount to what some consider is an expensive market. The company also sees a cash flow of over $2/share over these earnings, giving it a healthy cash position. While we've seen price targets that put DOW in the low $40 range, we're going for a $36 strike pricein order to receive a worthwhile premium and some additional downside protection. This is closest strike to the stock's 52-week high, a level we believe it will probably bounce up against before breaking out. That is why we are recommending buying DOW and selling the January 2014 $36 Call.



Scenario:

  • Buy 100 shares of DOW @ $33.04 = $3,304 + Commission ($12.95) = $3,316.95
  • Write 1 DOW January 2014 $36 Call @ $131 - Commission ($8.70) = $122.30

Note: Prices may vary from the time of post. Actual commissions paid will vary returns. 


Static Return (Not Called):

(Call + Dividend)/Stock Price   X    (Days/Year)/Days to Expiration

(1.22 + (3*0.32))/33.17      X    (365)/263

9.12% Static Return


If-Called Return:

(Call + Dividend + Strike Price - Stock Price)/Stock Price       X        (Days/Year)/Days to Expiration

(1.22 + (3*0.32) + 36 - 33.17)/33.17       X      (365)/263

20.96% If-Called Return



Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual’s personal investment goals and risk tolerance.

 

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