Dow Earnings Preview: Margin Improvement, Divestiture Progress In Focus

The Dow Chemical Company (NYSE:DOW) is scheduled to announce its 2014 second quarter earnings on July 23. We expect the company to primarily draw growth from thicker margins as a result of higher operating leverage. According to Dow’s recent presentation at the Goldman Sachs European Chemicals 2020 Vision Conference, 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. This drove the company’s adjusted EBITDA margins higher by around 60 basis points over last year. We expect to see a similar margin improvement during the second quarter. ^[1]

However, during the earnings call presentation, we will be closely watching for any updates on Dow’s ongoing divestiture program and the U.S. Gulf Coast expansion plan, which is expected to play a key role in driving long-term cash flow growth at the company.

Dow is a diversified chemical industry giant operating in specialty chemicals, advanced materials, agro-sciences and plastics business segments. It delivers a broad range of technology-based products and solutions to customers in approximately 160 countries, and in high growth sectors such as electronics, water, energy and agriculture. Last year, Dow reported annual sales of approximately $57 billion earning adjusted net income of around $2.9 billion.

We currently have a $48 price estimate for Dow, which is ~16x our 2014 adjusted EPS estimate of $3 for the company.

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We believe that Dow’s long-term growth potential and its valuation depends significantly upon the successful implementation of its margin expansion plan in the short to medium term. The company 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. ^[2]

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. ^[3]

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 more than $2.5 billion (on a run rate basis by 2017) by ramping up its plastics operations in the U.S. Gulf Coast region. Just to give some perspective, the company’s consolidated EBITDA stood around $7.8 billion last year by our estimates. (See: Cheap U.S. Natural Gas Is Attracting Huge Investments From Chemical Companies)

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1. Goldman Sachs European Chemicals 2020 Vision Conference, dow.com [↩]
2. Q3 2013 The Dow Chemical Company Earnings Release, dow.com [↩]
3. Dow Strategic Update, dow.com [↩]