Shares of The Dow Chemical Company (NYSE:DOW) have risen more than 10% over the last couple of months. However, even after considering the positive impacts of various initiatives such as its debt restructuring plan, profitability gains in its performance plastics business and strong agricultural demand for its seed technologies our price estimate of $35 apiece, implies that the company is fairly valued currently.
Dow Chemical is a diversified chemical industry giant operating in specialty chemicals, advanced materials, agro-sciences and plastics business segments. It delivers a broad range of technology-based products and solutions to customers in approximately 160 countries, and in high growth sectors such as electronics, water, energy and agriculture. In 2012, Dow reported annual sales of approximately $57 billion earning adjusted net income of around $2.6 billion.
Below we look at the some of the positive factors and the impact on our analysis.
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Dow received $2.2 billion in cash from its Kuwaiti partner, Petrochemical Industries Company (PIC) as an arbitration payment, after the latter pulled out from a $17.4 billion joint venture deal with it. The company announced recently that it would use a part of this cash to pay down its higher-cost debt in order to reduce its annual interest expense and lower the debt to capital ratio.
Dow plans to reduce its debt by $2 billion in 2013 alone, of which it has already redeemed as much as $1.6 billion worth of debt in the current quarter itself. With the full implementation of its plan, the company expects to bring down its annual interest expense by $100 million and its debt to total capital ratio “well” below 40%. 
Performance Plastics Profitability
Apart from the debt reduction plan discussed above, bright prospects of two of Dow’s most prominent growth engines, performance plastics and agro-science divisions, are also priced in at current levels in our view. Profitability gains from the feedstock advantage available to Dow’s vertically integrated plastics operations in the U.S. are expected to drive significantly higher net earnings over the coming years. (See: Dow’s Earnings: Agricultural Growth & Thicker Plastics Margins Expected) However, lower natural gas prices are the key to its feedstock advantage and would also depend upon the amount of LNG export allowed by the U.S. Department of Energy.
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Dow reported a sharp 33% jump in adjusted EBITDA from the performance plastics division during the first quarter this year, even as revenues decreased by 3%. We forecast Dow’s performance plastics and materials division’s adjusted EBITDA margin to improve by as much as 550 basis points over the forecast period. The division makes up more than 55% of our valuation estimate for the company.
Strong Fundamentals Driving Agricultural Products Growth
The advent of genetically modified (GM) seeds has changed the agricultural landscape completely by providing farmers with higher yields, lower susceptibility to insects, increased tolerance to chemicals used for eliminating weeds (herbicides) and extreme climatic conditions such as drought. We believe that this trend will only flourish even more going forward due to the advancements in biotechnology as the economic benefits clearly outweigh suspected disadvantages of the use of GM seeds. Moreover, the rising population and declining availability of arable land also point towards higher demand for more sustainable technological solutions for the agriculture sector.
Dow’s agro-science division has been an important growth contributor over the last few years and makes up more than 15% of our valuation estimate for the company. Revenues from the division have grown at almost 13% CAGR since 2009, while EBITDA margin has increased from around 8.5% in 2009 to almost 13% in 2012.
SmartStax, a brand of genetically modified seeds launched by Dow in collaboration with Monsanto in 2010, contributed significantly towards increasing volumes by 27% y-o-y in 2011 for the company’s seeds, traits and the oil business. The technology used in SmartStax takes advantage of multiple modes of insect protection and herbicide tolerance by stacking multiple traits together. Its success in 2012 was reflected in more than double technology sales as compared to 2011, driven by the introduction of POWERCORE (an extension of the SmartStax family that contains five traits, two herbicide-tolerant genes plus three genes resistant to pests) in Latin America and REFUGE ADVANCED (a blend of 95% SmartStax corn seed and 5% refuge (non-Bt) seed that farmers can plant across their entire fields) in North America.
Going forward, we estimate the division to see top line growth of more than 12% CAGR over the forecast period as we see big growth potential in the segment backed by robust fundamentals. Moreover, increasing penetration of its SmartStax technology based products will also strengthen Dow’s position in the seeds market.
We are also closely watching the approval process of Dow’s Enlist corn trait by the USDA as a successful Enlist launch can unlock significant upside potential for its agricultural products business in the long run. (See: Dow And Monsanto Deal Sets The Stage For Next Generation Of GM Seeds) The success of the company’s recent cross-licensing agreement with Monsanto also hinges on the approval of this particular trait.Notes:
- Dow Begins Deploying K-Dow Award to Balance Sheet, www.dow.com [↩]