The Dow Chemical Company (NYSE:DOW) is scheduled to announce its second quarter earnings on July 25. We expect Dow to realize the benefits of its extensively integrated plastics operations and growing feedstock advantage in the U.S. through better profitability. We also expect the company’s successful seed traits and robust industry fundamentals to drive agricultural products revenue higher.
Chemicals such as ethylene, propylene and chlorine are the foundation of Dow Chemical’s value-adding chemical chains and key enablers of its downstream businesses. They serve as raw materials for the production of a variety of products that support a wide range of industries including appliance, automotive, agriculture, building and construction, oil and gas, packaging, paints, personal care, etc. The company’s strategy has been to integrate extensively into these basic chemicals, which provide both supply certainty as well as cost advantage to its downstream businesses.
Ethylene, one of the most important building blocks of the plastics industry, is most commonly derived from steam cracking of either naphtha or ethane. Naphtha is derived from crude oil (naphtha constitutes around 15-30% of crude oil by weight) while ethane is the second-largest component of natural gas after methane. With the shale gas supply boost in the U.S. resulting in a cheap source of ethane, there has been a divergence in operating margins between naphtha and ethane based ethylene production plants in the U.S.
Hence, Dow is focusing on realizing better margins on its plastics business by increasing its ethylene capacity in the U.S. Dow currently has 70% of its ethylene production in cost-advantaged regions. Last year, the company restarted its St. Charles Olefins 2 plant in Louisiana, in a bid to lower its operating costs by reducing the amount of ethylene purchased.
Apart from this, Dow has an extensive plan to leverage this feedstock advantage in the U.S., which comprises of a number of projects listed below. 
- Improving ethane feedstock flexibility for ethylene crackers at its Louisiana and Texas operations by 2014 and 2016 respectively.
- Construction of a new, world-scale ethylene production facility in the U.S. Gulf Coast – slated for start-up in 2017.
- Construction of a new, on-purpose propylene production facility at Dow Texas operations – slated for start-up in 2015.
These investments will increase Dow’s ethylene production capacity by ~20% over the next three years, while also boosting the company’s on-purpose propylene production. Dow expects to realize incremental EBITDA of at least $2 billion in 2017 from these investments.
According to our estimates, Dow Chemical’s agricultural products business contributes ~15% to its total value. We see a huge growth potential in this segment, primarily due to the growing adoption of genetically modified seeds for higher yields and better traits. The rising global population and declining availability of arable land both point towards higher demand for more sustainable technological solutions for the agriculture sector. We expect increasing penetration of SmartStax brand of seeds to drive revenue growth for the company’s seeds business.
Dow launched SmartStax, a brand of genetically modified seed made in collaboration with Monsanto, in 2010. The technology takes advantage of multiple modes of insect protection and herbicide tolerance by stacking multiple traits together. The product contributed significantly towards increasing volumes by 27% y-o-y in 2011 for Dow Chemicals’ seeds, traits and the oil business. 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. Dow was able to further its market share in the American corn seed market with these products in 2012, and we expect the positive trend to continue through 2013 as well. 
We currently have $35 price estimate for Dow, which we will be soon updating based on the second quarter earnings results.Notes: