The Dow Chemical Company (NYSE:DOW) is scheduled to announce its third quarter earnings on October 24. 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.
Our $37 price estimate for Dow Chemical is almost 10% below its current market price.
Agricultural Products To Drive Sales Growth
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 (GM) 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. GM seeds provide farmers with higher yields, lower susceptibility to insects, increased tolerance to chemicals used for eliminating weeds (herbicides) and extreme climatic conditions such as drought. As a result, farmers in developed countries have largely adopted GM seeds. GM corn varieties make up ~90% of the total corn planted in the U.S.  We expect increasing penetration of Dow’s 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 doubling technology sales as compared to the 2011 levels. This was 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. 
Performance Plastics To Drive Margin Expansion
Unlocking of the shale gas resources has created a supply glut in the U.S. As a result, natural gas prices in the country are sharply lower compared to the rest of the world. This has provided manufacturers such as Dow with an opportunity to expand their operating margins on lower feedstock costs. The company is therefore pursuing huge investments (more than $4 billion) in the U.S. Gulf Coast region to tap into this opportunity. The chemical giant expects to generate incremental EBITDA of $2.5 billion by ramping up its plastics operations in the U.S. Gulf Coast region. 
Ethylene, one of the most important feedstock in the plastics value chain, is used in the manufacture of polyethylene, also called polythene, which is the most widely used plastic in the world. Dow Chemical is one of the largest ethylene producers in the world, as this provides the company’s differentiated performance plastic manufacturing capacities 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 capacity in the U.S. while improving feedstock flexibility of its existing ethylene production facilities, to leverage the favorable feedstock scenario. The company 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. Dow plans to increase its ethylene production capacity by ~20% over the next three years. 
Furthermore, in order to take full advantage of the low feedstock costs, Dow also plans to expand its capacity on the other end of the plastics value chain. The company will be increasing its capacity for Elite brand enhanced polyethylene resins and Affinity brand polyolefin plastomers at its Freeport, Texas facility. It will also be expanding its capacity for low-density polyethylene materials like the ones sold under the Agility brand and for specialized hydrocarbon rubber (mEPDM: metallocene ethylene propylene diene monomer) sold under the Nordel brand at its Plaquemine, Louisiana facility.
Dow derives almost ~25% of its sales revenue from selling elastomers, polypropylene and other products used in electrical, telecommunication and packaging industries. The company’s extensively integrated performance plastics operations 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 third quarter as well.Notes:
- Adoption of Genetically Engineered Crops in the U.S., ers.usda.gov [↩]
- Dow AgroSciences Advances Corn Seed Performance in the Americas, Dow AgroSciences [↩]
- Dow Confirms U.S. Site Selections for Expansions to Leading Plastics Brands, dow.com [↩]
- Dow’s Performance Plastics Advantage, dow.com [↩]
- Dow SEC Filings, sec.gov [↩]