Should Dow Be In Your Portfolio?

Economic statistics say that inflation is low, but a look at Dow Chemical (NYSE: DOW) reveals a 19% price increase in 2011. And after reporting a huge profit rise Wednesday, Dow stock could keep rising. Should you invest?

What's behind Dow's great performance? Dow is expanding in Saudi Arabia and on the U.S. Gulf Coast to turn low-cost natural gas into chemicals used in food packaging and auto parts. And Dow's profit in the basic plastics and chemicals units rose, contrary to expectations of those betting on weaker Chinese demand, according to Bloomberg.

Here are three reasons to consider an investment in Dow:

• Great second quarter earnings report. Dow's second quarter net income was $1.07 billion, or 84 cents a share, 64% more than its 2010 Q2 earnings of $651 million, or 50 cents. Its adjusted EPS of 85 cents a share were 8% above the 79-cent average estimate of 12 analysts in a Bloomberg survey. Dow's revenue rose 18% to $16 billion from $13.6 billion.
• Cheap stock. Dow's price to earnings to growth (PEG) ratio of 0.88 makes it inexpensive (a PEG of 1.0 is considered fairly priced). Dow's P/E is 19.4 and its earnings per share are expected to grow 22.1% to $3.58 in 2012.
• Decent dividend. Dow pays a 2.79% dividend yield and it's been raising that dividend at a 3.9% annual rate over the last five years.

Here are two negatives for the stock:

• Under-earned its capital cost. Dow is earning less than its cost of capital – but it’s improving. How so? It produced positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In the first half 2011, Dow’s EVA momentum was 3%, based on first six months' 2010 annualized revenue of $54.1 billion, and EVA that improved from negative $3.1 billion annualizing the first six months of 2010 to negative $1.3 billion annualizing the first six months of 2011, using an 11% weighted average cost of capital.
• Solid growth but declining profits and more debt-laden balance sheet. Dow has grown solidly. Its $55 billion in revenues have increased at an average rate of 3% over the last five years and its net income of $2.1 billion has declined at a 15% annual rate over that period. Its debt has grown faster than its cash. Its debt climbed at 26.7% annual rate from $8 billion (2009) to $20.6 billion (2010) while its cash rose at a 24.7% annual rate from $2.9 billion to $7 billion. The good news in 2011 is that Dow is trying to pay down that debt.

Dow is in a boom and bust industry. And its last five years were the bust part. If its second quarter report is any indication, the boom could be just beginning. This suggests that Dow's current bargain price will not last long.