Tuesday, April 18, 2006

Wall Street hates the Dow - “Dow Chemical Company”

Here is a company that had record revenues and earnings in 2005, is expected to do the same in 2006, is a Fortune 50 company, has great brands and is a well known innovator.
Trades at an incredibly low P/E of 8.5, P/S of 0.8 pays a rich dividend of 3.5%. So why is Dow Chemical (NYSE:DOW) ($39.8), the largest chemicals/plastics company being ignored by wall street, because of a few reasons:
-high costs of natural gas and oil increase the costs of production
-perceived as commodity, boring businesses no sex appeal at all

Our retorts to the above:
-Dow is in a boring business, we actually like boring.
-Not all of it is commodity businesses, they have specialty agriculture, automotive and coatings also the company is investing in performance businesses to avoid the cyclical gyrations of the bulk chemicals business.
-Dow Chemical has been one of the engines of innovation in the specialty materials sector.
-The cost of oil and gas is a concern; here are two recent articles both could be construed as positives for DOW.

According to the Barron'’s article "“Natural Gas: Lower Still"” dated April 15th by Spencer Jakab (subscription required) -"“Despite falling nearly 60% from their December peak to a recent $7.135 per million BTU'’s, gas futures may need to go below $5.50 to soak up a surplus unlike any ever seen by the industry. Total gas in underground storage at end of March, the official end of the heating season, was 1.695 trillion cubic feet, a whopping 63% above the average for the past five years and 13% more than the previous record high."

And then today'’s New York Times article "“Chemical Companies Look to Coal as an Oil Substitute"” by Claudia Deutsch has a quote from Dow'’s CEO Andrew N. Liveris "We want to be economically feasible in the United States, and coal enables us to do that," The article further goes on to say Dow Chemical, has tripled its research into coal-based ingredients. – I will grant that this is perhaps a pipe dream or a long term soultion. Also I do not expect oil prices to fall but then chemicals and speciality derivatives are a part and parcel of our lives and eventually DOW will be able to pass the costs down to the consumer.

So we took a detailed look using Valueline data at DOW Chemicals

As seen on the left Free cash flow to Equity DCF value stands at $44, The stock trades at $39.8 close to its 52 week low and a 10% discount to the DCF value of $44. This is a classic Buffet/Graham situation where a gem is out of favor with the street, on basis of exagerated pessimism regarding high oil and gas prices. This company will deliver rich gains to investors in the next 5 years, and while you wait for it a 3.5% dividend is icing on the cake. (Disclaimer : I will take a position in DOW soon)

Wednesday, April 12, 2006

Eye of the Storm
Bausch and Lomb (NYSE:BOL) ($45.6) the eyecare maker has been in a lot of news more so since the story of the fungal infection broke two weeks ago. The infection has afflicted 109 patients using its ReNu with MoistureLoc solution. However the company has been in trouble since a few months ago. Here is the chronology with closing prices

23 December 2005 - BOL moved to restate financial results back to 2000 because of accounting shenanigans at its Brazilian unit. Stock price falls from $79 to $72.

26 January 2006 - BOL says it will postpone its earnings filing to investigate improper booking of sales at its South Korean subsidiary. ($68.56)

2 March 2006 - declares dividend $0.13

31 March 2006 - First reports of fungal infections surface ($63.70)

10 April 2006 - BOL suspends shipments of ReNu ($57.44)

11 April 2006 - Company defends ReNu, says all tests are negative, Walgreen pulls entire line of ReNu, WalMart pulls the specific product. ($45.60)

These events usually qualify as one time opportunistic buys in my book, the previous call we made in a similar situation with Sherwin Williams on Feb 24 has paid us handsomely with a 25% gain in five weeks. However this is one is much harder to call. Here are the facts:

According to the 10Q filling dated 28 July 2005 (last filling on record). The six month revenues were broken out as follows:
Contact Lenses $359 M
Lens Care $269 M
Pharmaceuticals $ 278 M
Cataract & Vitreoretinal $ 185 M
Refractive $ 72 M
Total (6 months) $1163 M

Lens care generated about 23% of the company's revenue. 2005 Revenues from ReNu are estimated at $45 M about 2.25% of the total $2.3B. In the US there are reportedly 109 cases of "Fusarium" fungal infection reported by the CDC and according to a Business Week article about 36 million Americans wear contact lenses. Of the 30 cases investigated to date by the Food & Drug Administration, 28 wore contact lenses, and 26 of those patients used Bausch's popular ReNu products to clean and store their lenses. To date no direct link has been found to the usage of ReNu and the fungal infections. From the numbers and the facts it seems like this may not be a big deal.

The key here though is the statement from Walgreens released today -"There's a lot of customer confusion out there, which is why we decided to remove the entire ReNu line, - a Walgreen spokesman told Reuters." What is it that first comes to mind when you hear the words Baush & Lomb? Eyes, eyecare, contacts!!!! right. So calling this a Tylenol scare like situation that J&J was in is incorrect - afterall J&J is a very well diversified company selling Cordis heart stents, baby lotions and Band-Aids.

Although ReNu may be only 2% of revenue as the Walgreen statement implies Bausch &Lomb means eyecare to most customers and spillover effetcs are bound to affect sales in general. Moreover according to the 10Q "Growth for the first six months of 2005 was driven by share gains attributable to the Comapny's ReNu with MoistureLoc brand, the ReNu franchise gained 2% market share in Q2 05" So this was a major growth engine for the company.

Back to the fundamentals before the fungus story broke but after the accounting irregularities were uncovered the company traded around $65 a share - market cap of $3.5 B on sales of $2.3B a P/S ratio of 1.52

Lets look at the most pessimistic scenario for this company, assume that the company loses all of its share of lens care of about $ 500M and spillover into other areas, legal liabilities causes loss of another 15% of revenues $300M. This would imply a 2006 revenue number of about $1.5B (assuming no growth in other areas).

Now at today's price $45.6 (Market cap $2.45B) this gives the company a P/S of 1.63, still higher than the 1.52 it sported on March 30th. At $42.5 the stock should reflect its pre infection value.

So in conclusion, the company is in deep trouble has a great brand & franchise but its entire identity is associated with this franchise "eyecare" something people take very seriously. I believe that the company will recover and thrive but I want the classic "Margin of safety" before I play this one, I'll assign a 20% margin of safety and using $42.5 as my benchmark I would be a buyer at anything south of $34 a share. Speaking of J&J, once the air on this issue clears up they may just swoop in and buy BOL.