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Investment Overview for The Dow Chemical Company (NYSE:DOW)
WHAT HAS CHANGED?
- Consistent margin expansion
Dow Chemical's adjusted EBITDA margin improved by over 396 basis points year-on-year during the second quarter. This was Dow’s 11th consecutive quarter of year-on-year adjusted EBITDA margin expansion. Some of the increase in Dow’s adjusted EBITDA during the second quarter could be attributed to higher operating leverage, or increased use of fixed assets, which results in a decrease in marginal production costs. In addition to higher operating leverage, cost savings from the ongoing 3-year, $1 billion productivity drive at the company, also boosted its profitability during the quarter. Cost savings from the program are expected to amount to $300 million for the whole year. Apart from higher operating leverage and productivity cost savings, Dow’s second quarter adjusted EBITDA margin was also boosted by its increasing feedstock flexibility and higher demand for its high-value, differentiated end products.
- Olin deal
Dow Chemical recently announced the spin-off of a significant portion of its chlorine business for a total consideration of $5 billion. The spun off business will be merged with a smaller chemical company, Olin Corp., in a tax-efficient Reverse Morris Trust (RMT) transaction. The merged entity will have annual sales revenue and EBITDA to the tune of $7 billion and $1 billion, respectively. The deal falls in line with Dow’s broader strategy to shift its focus away from more commoditized chemical businesses and divert its resources towards more profitable segments. This is a sweet deal for the company, since it values its rather low-growth, low-margin businesses at almost 7x trailing EBITDA, and provides for investment support to its more profitable divisions like Performance Plastics.
Below are the key drivers of Dow Chemical's value that present opportunities for upside or downside:
- Performance Plastics EBITDA margin: Performance Plastics EBITDA margin stood at around 12.2% in 2009. However, the profitability of the segment has grown significantly since then, primarily on account of lower feedstock costs, enabled by a surge in natural gas production in the U.S. from shale resources. In 2014, Dow's Performance Plastics EBITDA margin stood at around 20.3%. Going forward, we expect the division's EBITDA margin to increase to around 21% by the end of our forecast period. However, if margins increase at a much faster pace to around 28% by the end of our forecast period, we could see a 10% upside to our price estimate. On the other hand, if the company is unable to successfully tap the feedstock advantage, margins could decline to around 15%, and there could be a 10% downside to our current price estimate for Dow.
- Agricultural Science Products Market Share: Dow Chemical's market share in the global agricultural product market has seen a considerable rise in recent years, helped by heavy investment in the division and successful product launches. In 2014, the company's market share stood at 7.9% and we expect it to increase to around 8.9% by the end of our forecast period. If, however, the investments do not yield the desired results, and the market share falls to around 3.5%, there could be a downside of around 10% to our current price estimate. On the other hand, if the market share rises to around 12%, we could see an upside of around 10% to our current price estimate.
Dow Chemical makes money by supplying high performance chemicals and materials, commodity plastics (polyethylene and polypropylene), agricultural products, and key industrial chemicals to industries and consumers worldwide. The company relies on its research and development, and high-scale/low cost advantages to deliver products catered to market needs.
Dow Chemical is the world's largest producer of commodity plastics such as polyethylene. Its highly integrated operations (the company is also the world's largest ethylene producer, which is the key feedstock for manufacturing plastic polyethylene) help provide a low cost advantage for its commodity-based products. The company is also highly diversified in its performance chemicals/materials products, catering to a vast array of business sectors, including construction, packaging, consumer, institutional goods, electronics, water treatment, and alternative energy.
We believe that the Performance Plastics & Materials division is the largest contributor to the firm's total value. The key factors responsible for this are:
Higher margins in the performance plastics business
The performance plastics segment has significantly higher margins than other divisions. This is primarily attributable to two factors: high economies of scale (Dow Chemical is the largest polyethylene producer in the world) and a high degree of backward integration (both raw materials and energy for plastics is sourced internally rather than relying on external sources). We believe these competitive advantages should be able to sustain margins in the long run.
Market share for agricultural science products business
Dow's Agricultural Science Products division contributes more than 11% to the company's total sales. Its market share in the global agricultural market was just around 6.3% in 2009. Since then, the company's market share in the segment has grown to around 7.9% last year, primarily because of a successful launch of SmartStax seeds technology, which helped it grow sales volume significantly. Going forward, we expect Dow to gain further share of the agricultural products market with its Enlist corn launch, as more and more herbicide tolerant crops are failing due to increased tolerance of weeds towards glyphosate-based herbicides.
Protracted global slowdown in demand could hamper growth in the short run
The demand for chemicals and materials is strongly dependent on healthy macro-economic conditions such as GDP and industrial growth. The economic recession of 2008-2009 had significant adverse impacts on Dow Chemical's business, leading to a decline in revenues of over 23%. While the global economy has recovered quite significantly from its low point during the recession of 2008-2009, it is still not completely out of the woods and hence a majority of Dow's divisions, with the exception of Agricultural Products, are expected to continue to face an uncertain macro environment in the short to medium term.
Environmental regulations can restrict market share
In recent years, the global paints & coatings industry has seen increased monitoring from environmental agencies, primarily due to VOC (Volatile Organic Compounds) emissions which present a threat to the ozone layer. Restrictions also exist over the safety of genetically modified (GM) seeds/traits, which have to undergo a rigorous process for approval. Such regulatory actions have the potential to adversely impact both market share and margins for the company's key divisions, such as Performance Plastics & Materials and Agricultural Products.
Price uncertainty in hydrocarbon-based raw materials
Many of Dow Chemical's divisions rely on raw materials which are primarily hydrocarbon-based. This is especially applicable to the Performance Plastics and Performance Materials divisions, which together constitute almost 60% of our current price estimate for the company. Examples of hydrocarbon-based feedstock include ethylene, propylene, and benzene. Hydrocarbon prices are highly volatile due to their dependence on various macroeconomic and political factors, and therefore, any sudden fluctuations in commodity prices can lead to major changes in the operating margins of these divisions.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
See more on: DCF Methodology
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