The Dow Chemical Company’s (NYSE:DOW) first quarter earnings adjusted for non-recurring items jumped $0.10 per share or 14.4% y-o-y on higher margins. Although, its sales revenue grew by just over 0.5%, the company’s adjusted EBITDA margin improved by ~60 basis points year-on-year due to lower marginal costs associated with higher operating rates and productivity gains from ongoing restructuring efforts. 
To be more specific, Dow’s adjusted EBITDA for the first quarter increased by around $100 million. A majority of this increase (~50%) can be attributed to operating leverage or increased use of fixed assets, which results in a decrease in marginal production costs. According to the company’s first quarter earnings call presentation; a 100 basis points improvement in the annual operating rate boosts its EBITDA by more than $200 million. During the first quarter, Dow’s operating rate was 83%, up by a 100 basis points from the same period last year. 
Apart from this, lower research and development costs (down 10%) also helped Dow expand its adjusted EBITDA margin despite higher feedstock and energy costs in North America. The prices of key feedstock materials, such as ethane and propane derivatives, and energy were pushed higher by unusually cold weather in North America during the first quarter.
Going forward, we expect Dow’s company-wide adjusted EBITDA margin to continue to expand in the short to medium term as it makes progress on the ongoing divestiture program and expands its operations on the U.S. Gulf Coast to take advantage of the favorable feedstock scenario.
We currently have a $48 price estimate for Dow, which is ~16x our 2014 adjusted EPS estimate of $3.00 for the company.
Margin Expansion Through Reallocation Of Resources
Dow is a diversified chemical industry giant that operates in specialty chemicals, advanced materials, agro-sciences and plastics business segments. It has been pursuing the divestment of slow growth, low-margin businesses over the last several years in order to increase its focus on more profitable, less volatile segments where it sells more differentiated end products. Having completed the divestiture of businesses generating more than $8 billion in revenues, in March last year, the company announced its plan to raise around $1.5 billion from further divestments.
However, looking at the volatile demand scenario in emerging markets and continued slowdown in the developed ones, during the 2013 third quarter earnings call, Dow announced an extension of its divestiture target to $3-4 billion. The company officials said that their focus would be on businesses that fall under the chlorine value chain, such as the chlorinated organics and epoxy businesses that generate single digit EBITDA margins, which compares to the more than 25% EBITDA margin that the company earns on its Performance Plastics business. 
Most recently, Dow further expanded its divestiture target to $4.5-6 billion. The company officials did not disclose the specific nature of the businesses that were added to the divestment plan. However, they did mention that these would be some smaller units from its Performance Materials division, which has an adjusted EBITDA margin of around 10%, compared to the company wide average of over 15%, by our estimates. 
Through these divestments, Dow aims to divert its resources towards more profitable segments, especially the Performance Plastics division, which best leverages its integrated value chain for a low-cost advantage and differentiated end products for higher margins. According to our estimates, the division’s adjusted EBITDA margin stood at around 26% last year, well above the company-wide average.
Most of the products sold by the Performance Plastics division are derivatives of the simplest unsaturated hydrocarbon, ethylene, which is most commonly derived from steam cracking of either naphtha or ethane. 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 pursuing huge investments (more than $4 billion) in the U.S. Gulf Coast region to tap into this opportunity. The company expects to generate incremental EBITDA of $2.5 billion by ramping up its plastics operations in the U.S. Gulf Coast region. (See: Cheap U.S. Natural Gas Is Attracting Huge Investments From Chemical Companies)Notes: