Dow’s Earnings Swell On Thicker Plastics Margins

The Dow Chemical Company (NYSE:DOW) reported higher second quarter earnings on better margins and an arbitration award. Reported earnings per share (EPS) were $1.87 and received a significant boost from the final resolution of the K-Dow arbitration, which resulted in cash payment of ~$2.2 billion to the company. The second quarter EPS (adjusted for one-time items) at $0.64 was up 16% y-o-y. Sales revenue grew marginally as growth from agricultural sales was more than offset by declines in performance plastics and feedstock and energy divisions. ^[1]

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Thicker Plastics Margins

Ethylene, an important feedstock in the plastics value chain, is used in the manufacture of polyethylene, or polythene, which is the most widely used plastic in the world. Dow Chemical is one of the largest ethylene producers globally as it provides the company’s differentiated performance plastic products manufacturing units with a low-cost advantage.

The simplest unsaturated hydrocarbon 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.

Dow is therefore growing its ethylene production capacity in the U.S. while improving feedstock flexibility of its existing production facilities in the Gulf Coast region to leverage the favorable feedstock scenario. Currently the company has ~70% of its ethylene production in cost-advantaged regions. Last year Dow restarted its St. Charles Olefins 2 plant in Louisiana in a bid to lower its operating costs by reducing the amount of ethylene purchased. The company plans to increase its ethylene production capacity by ~20% over the next three years.

Dow derives almost ~25% of its sales revenue from selling elastomers, polypropylene and other performance plastic products used in electrical, telecommunication and packaging industries. However, the division contributed ~45% to its total adjusted EBITDA for the fist half of the year as margins expanded by more than 700 basis points y-o-y. We expect thicker performance plastics margins to boost the company’s profits during the second half of the year as well.

Higher Agricultural Sales

The agricultural products segment has huge growth potential as rising global population and declining availability of arable land point towards higher demand for more sustainable technological solutions for the agriculture sector. The growing adoption of genetically modified seeds for higher yields and better traits as well as advanced crop protection solutions to tackle resistant weeds and insects is primarily driving growth in the segment.

According to our estimates, the agricultural products division contributes more than 15% to Dow’s total value. The company’s agricultural sales revenue grew more than 10% during the second quarter on strong industry fundamentals and robust demand for its crop protection and seed products. Seeds, traits and oils sales were up 4% during the quarter on strong demand for SmartStax corn hybrids while crop protection sales rose 12% on healthy demand for new products. We expect to see continued strength in Dow’s agricultural products division during the second half of the year as well.

Debt Reduction Plan

Dow received $2.2 billion in cash from its Kuwaiti partner Petrochemical Industries Company (PIC) as arbitration payment after the latter pulled out from a $17.4 billion joint venture deal. The company used this cash to pay down higher-cost debt to reduce its annual interest expense. Dow plans to reduce its debt by $2 billion in 2013, of which it has already redeemed as much as $1.6 billion. With the full implementation of its debt reduction plan, the company expects to bring down its annual interest expense by $150 million this year.

We currently have a price estimate of $35 for Dow, which we will revise soon based on the latest results.

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1. Second Quarter 2013 Earnings Statement, dow.com [↩]