Yielding Almost 5%, This Undervalued Dividend Stock Is a Buy

A weak economic environment worldwide has damped Dow’s DOW recent results, but we’re optimistic about the company’s long-term prospects. We expect Dow to enjoy a recovery in profits once the global economy improves—and the narrow-moat company’s shares are a bargain today. This undervalued dividend stock appears on our analysts’ list of this quarter’s 33 undervalued stocks; it’s also one of Morningstar chief US market strategist Dave Sekera’s five undervalued stocks to buy during the second quarter.

Dow is one of the largest chemical producers in the world. It makes key components for a broad range of industrial and consumer chemical and plastic products. Over half of its customer base is in the plastic packaging and polyurethane industries; the rest is diversified among several industrial and consumer end markets. The company is focusing on the consumer packaging, infrastructure, and automotive markets to drive revenue expansion. Its strategy is to grow profits through incremental operational improvements. The company’s growth capital expenditures have been allocated to capacity expansions and efficiency improvements that will enhance profitability over time. Over the long run, Dow plans to expand its ability to recycle plastic as feedstock for its manufacturing operations. This should help it capitalize on accelerating demand for more environmentally friendly products as a result of evolving regulations and consumer preferences.

Key Morningstar Metrics for Dow

• Fair Value Estimate: $68
• Star Rating: 4 Stars
• Economic Moat Rating: Narrow
• Uncertainty Rating: Medium

Economic Moat Rating

We believe Dow has a narrow economic moat based on the cost advantage of its ethylene and propylene manufacturing operations in North America. The company produces these chemicals and also uses them as inputs for its remaining business lines, leveraging its cost advantage. Low-cost North American natural gas-based feedstocks allow Dow to manufacture at a significant cost advantage to marginal-cost producers that rely on higher-cost crude oil-based feedstocks to make the same products. Higher production margins in North America are supported on both the cost side and on the pricing side. Also, Dow is able to substitute a variety of inputs in its production processes. Such operational flexibility maximizes profitability by allowing the company to optimize its operations in response to market fluctuations. Given this and the substantial raw material cost advantage, we expect Dow will generate excess returns on invested capital over the next decade, averaging 13% per year through 2028.

Read more about Dow’s moat rating.

Fair Value Estimate for Dow Stock

Our fair value estimate is $68 per share. We forecast top-line growth will average 3% per year through 2028. Supply chain disruptions and a broader economic slowdown have constrained customer demand in recent quarters. We assume lower volume will continue to weigh on early 2024 results, with a slow but steady recovery through the year as these challenges abate. Dow’s asset-heavy commodity chemical manufacturing plants are subject to a high degree of operating leverage. As a result, plant capacity utilization is a key profit driver. Even in a favorable cost environment, reduced volume can drive margin contraction due to high operating leverage. We expect Dow’s operating margin will average around 11% over the next five years, reaching 12.5% by 2028, as the operating environment improves and efficiency initiatives take hold.

Read more about Dow’s fair value estimate.

Risk and Uncertainty

Dow’s heavy reliance on fossil fuels as feedstocks exposes the company to the inherently volatile oil and gas markets. Input costs and the price the company receives for its commodity chemicals can vary widely. Increasingly stringent regulations on energy efficiency and emissions management could increase operational costs. Many of the chemical compounds that the company manufactures are known to pose hazards to human health and the environment. Improper management of its products and services could leave Dow liable for associated damages in the event of an incident that involves hefty fines and lawsuits. The company also risks an outright ban on certain products or chemicals, forcing reformulations that could require considerable R&D investments as well as capital expenditures to retrofit plants.

Read more about Dow’s risk and uncertainty.

Dow Bulls Say

• Dow benefits from its cost-advantaged North American operations, which use low-cost natural gas-based feedstocks.
• Dow maintains exposure to a wide variety of industrial and consumer end markets, mitigating the risk of an industry-specific downturn.
• Dow’s process technologies should improve profitability while providing an asset-light revenue stream through licensing agreements with other chemical manufacturers.

Dow Bears Say

• Most of the company’s products are commodities whose prices move with Brent oil prices. As Brent oil prices fall, Dow’s realized prices and profits will fall accordingly.
• Dow’s cost advantage will erode over time due to a permanent increase in North American natural gas prices. This will lead to margin compression over the long run.
• Tightening regulations around hazardous chemicals may force Dow to invest significant resources in developing alternative products that may raise operational costs over time.

This article was compiled by Susan Dziubinski and Sylvia Hauser.