Conclusion

Cyclical company, at the bottom of their earnings cycle with historically low ratios, like P/E, P/B, P/S and P/FCF. Close to upswing in their earnings cycle due to probable margin expansion. Will also benefit from ratio expansion. Both fundamental and technical conditions in place for substantial price rise.

Investment in-line with my general thesis that commodity prices, DOW inputs, will fall as demand falls. The expanding margins should more than offset any softening in demand for DOW products. The agreed Rohm and Haas acquisition is an added risk with the massive debt load it would entail; however, as discussed here the deal is far from done.

Analysis

I am not familiar with DOW or its competitors. However, a quick comparison to DuPont shows that margin expansion should be possible as DuPont’s gross margins are over 2.5x and their operating margins over 2x that of Dow. Value Line predict rising sales, earnings and cash flow for DuPont.

Price/sales sits at seemingly crazy low of 0.38.

The key factor is margin expansion. If that occurs all else is likely to follow. The following chart show margins over the last 10 years. Note how when margins expanded in 2003 the price shot higher; however 2001-02 shows that Dow can swing to losses during a recession. There may have been many other factors at play then and reading through the annual reports from that time would be worthwhile. (2002 10-K) Also note the margins never expanded anywhere near DuPont’s healthy margins, so there must be some fundamental differences in their businesses.

Earnings and dividends since 2000. Earnings due this week 23 October BMO.

Q2 2008 Earnings Transcript from Seeking Alpha. Estimate of $0.58 compared to last years $0.84. Estimates for Q4 of $0.62 and 2009 of $2.84 show analysts already viewing Q3 as the cyclical low point.

Insider Buying: In early 2003 directors where large buyers of DOW stock. While two directors did buy in late July early August, there is not yet the same level of insider buying going on.

From 2002 10-K Difficult year, with prices falling. Asbestos claims. Integrated Union Carbide purchase. See my DOW spreadsheet for selected financial data 2007-1998.
It appears the 2001 and 2002 negative earnings were a result of falling prices, asbestos claims and merger charges. Given the agreed Rohm and Haas acquisition as kelbon commented on here the near future may hold further merger related write-offs.

LEAP Options

Covered Calls: Jan 2010 $30 and $35 will return 41% and 54% if called. For equivalent gains in direct stock would need prices of $34 and $37, which is possible. Need to weigh potential forfeit of profit against small downside hedge from call lowering cost price.

Calls: Jan 2010 $20 Call has spread of $6.50-7.00. The following table shows the returns compared to outright stock ownership (dividends ignored). The calls outperform at a price over $28.50. For that out performance you risk a 100% capital loss.

Bull Spread: 2010 $30-$35 Call spread (buy $30 sell $35) A price over $35 will result in a 250% return, under $30 a 100% loss and $31.40 breakeven.

Puts: 2010 $20 has spread of $3.60 - 4.00

Synthetic Long: Sell $25 Puts buy $25 calls. This would net a credit and cost basis would be below current stock. Considering you’re forfeiting dividends in return for lower interest they’re equivalent. The benefit/risk is the leverage this would allow or the possibility of buying now prior to having cash available.

Options Summary: As you’d expect the higher the risk the greater potential reward. From the above selection, the Puts have the lowest risk, lowest return, while the bull spread has the highest risk, highest likely return. I say likely as if DOW trades over $45 then the $20 calls will have a higher return.

More

Excellent write-up on DOW at Prudent Speculations