Gene Marcial's Stock Picks July 20, 2009, 12:01AM EST

Marcial: Pros See Catalysts for Improvement at Dow Chemical

The stock has fallen far from its 52-week high, but contrarian investors like its prospects thanks to the diversified chemical giant's ongoing strategic overhaul

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Dow Chemical (DOW), the largest U.S. chemical company, was once a high-flying blue chip stock. It's cruising closer to earth these days, with its stock smacked down to an all-time low of 5.89 a share on Mar. 10. True, it has since tripled, to 16, but the stock is still deeply depressed from its 52-week high of 40 in mid-September 2008. In 2005, Dow shares hit an all-time high of 58.

So what lies ahead for the diversified chemical giant?

Wall Street analysts aren't quite sanguine: Only three of the 14 Dow Chemical watchers rate the stock a buy, eight tag it a hold, and two recommend selling it. But to the contrarians, who frown on stocks the bulls love, analysts' wariness is a big positive. And Dow Chemical is definitely a contrarian play, argue some pros. They think the company is one of the most unappreciated and underpriced stocks around.

Higher-Margin Strategy

Here's why: Although CEO Andrew Liveris has been pursuing a strategy of switching the company away from basic chemicals that are low-margin and volatile products to more profitable and higher-margin customized or specialized chemicals (such as epoxy coating and water-treatment products), the stock hasn't reflected the strategic value of such a move.

Moreover, management has improved the company's capital structure by reducing its financial leverage in the wake of its $16.2 billion purchase of specialty chemicals maker Rohm & Haas in April 2009, shrinking near-term debt obligations, and eliminating high-cost debt by issuing $2.25 billion in equity and $6 billion in bonds in public offerings.

"We are raising our rating on Dow to outperform [from hold] given the improved risk-reward profile of the company" because of such important strategic moves, says analyst John P. McNulty of Credit Suisse (CS). He also raised his 12-month price target for Dow (a client) to 21 a share from 12.

He has adjusted his 2009 and 2010 earnings estimates to reflect a modest recovery in Dow's businesses and those of Rohm & Haas. Rohm generated sales of $9.6 billion in 2008.

Benefits from Rohm acquisition

McNulty believes Dow will be successful in deriving synergies from Rohm, which he projects will result in total savings of $1.3 billion. Dow has in place a restructuring program that aims to cut $2.5 billion from overall costs by the end of 2010.

"We view the purchase of Rohm & Haas as positive for the company longer-term as the less cyclical specialty products now account for about 60% of annual revenues, up from 51% in 2008, and represent a larger percentage of profits," notes analyst Richard O'Reilly of Standard & Poor's Equity Research. He rates Dow a hold, however, as he expects "business conditions to remain challenging well into 2009 amid soft conditions in the U.S. and Europe."

Analyst Stephen O'Neill of investment firm Hilliard-Lyons, who rates Dow a long-term buy with a target of 20 a share, says the acquisition of Rohm will result in Dow's generating about two-thirds of its profits from high-margin, performance-based businesses, including electronic chemicals, coatings and coating additives, adhesives and other products used in packaging, and specialty chemicals used in personal-care products and water treatment.