The Dow Chemical Company (NYSE:DOW) reported strong fourth quarter results on thicker plastics margins and higher agricultural sales. The company’s adjusted diluted earnings per share (EPS) of $2.47 for the full year grew by 31% y-o-y. It also expanded the authorized share repurchase program from $1.5 to $4.5 billion. Based on the strong performance in 2013 and improving demand outlook across all of its operating segments, we have updated our price estimate for Dow to $47 a share, which is ~16x our 2014 adjusted EPS estimate of $3.00 for the company. 
Plastics Margins Continued To Expand
- Dow Q2 Earnings: Higher Margins Offset Revenue Decline, Dow-Dupont Merger On Pace For Year-End Close
- Dow Q1 Earnings: Higher Margins Offset Revenue & EBITDA Decline, Management Confident Of Dow-Dupont Merger Synergies
- What Has Led To A ~9% Decrease In Dow Chemical’s Revenues In The Last Five Years?
- How Much Can Dow Chemical’s Revenues Grow Over the Next Five Years?
- How Are Dow Chemical’s Revenue & EBITDA Composition Expected To Change By 2020?
- How Has Dow Chemical’s Revenue Composition Changed In The Last Five Years?
Dow’s performance plastics division primarily sells elastomers, polypropylene and other products used in electrical, telecommunication and packaging industries. While it contributes just around 25% to the company’s total sales revenue, its EBITDA contribution is around 50%. This is primarily due to Dow’s extensively integrated plastics operations with differentiated end products and growing feedstock advantage in the U.S. 
Most of the products sold by the division are derivatives of the simplest unsaturated hydrocarbon, ethylene, which 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.
Now, the outlook for U.S. natural gas supply has changed significantly over the past few years, primarily due to the evolution of horizontal drilling and hydraulic fracturing techniques that have enabled energy companies to tap the huge shale gas reserves in the U.S. at commercially sustainable rates. The widespread use of these techniques started only during the early 2000s in the Barnett shale play in north-central Texas. However, since then, natural gas production in the U.S. has ramped up much faster than the growth in consumption, which has led to severely depressed commodity prices by international standards. This has resulted in lower feedstock costs for the petrochemical industry in the U.S.
Dow, being one of the largest players in the industry, is also 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. Therefore, lower ethane prices in the U.S. have helped the company expand its operating margins significantly. According to our estimates, in 2013, Dow’s performance plastics EBITDA margins swelled by more than 650 basis points over the previous year, which led to a 150 basis points improvement in companywide EBITDA margins. We expect Dow’s plastics margins to improve further over the coming years, as the company expands its ethylene capacity on the U.S. Gulf Coast.  (See: Dow Continues Its Expansion In The U.S. Gulf Coast On Favorable Feedstock)
Robust Seeds Demand Drove Sales Growth
Dow’s agricultural sales grew strongly during the fourth quarter on increased demand for its seeds and crop protection products. At $1.8 billion, sales from the division were up 13% y-o-y despite a 2% decline in prices. Although a bulk of the division’s sales currently comes from selling crop protection products such as insecticides and herbicides, its seeds sales have been growing much faster over the past few years. In 2013, crop protection sales grew by 10% y-o-y, while seeds sales grew by 19%. Because of the robust demand for genetically modified (GM) seeds, and the kind of product pipeline that Dow currently has, specifically the Enlist weed control system, we believe that the division’s growth would be primarily driven by seeds sales in the coming years.  (See: The Challenges and Opportunities For Dow’s Weed Control System)
During the fourth quarter, Dow’s seeds sales grew 20% y-o-y, primarily driven by the increased demand for its SmartStax corn hybrids, which were developed by the company in collaboration with Monsanto (NYSE:MON). These seeds have eight GM traits combined or ‘stacked’ together, two for herbicide tolerance and six for insect resistance. These traits were combined through the conventional breeding processes instead of the genetic transformation of a single strain.
First commercially planted in 2010, SmartStax contributed significantly towards boosting Dow’s seeds sales volume by 27% y-o-y in 2011. 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 field) in North America. We believe that the growing penetration of SmartStax seeds would continue to drive sales growth for Dow over the coming years as well.Notes: