Dow Earnings Review: Margin Expansion Drives Earnings Growth

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The Dow Chemical Company’s (NYSE:DOW) second quarter earnings surged higher on thicker margins due to higher pricing and cost savings through productivity improvements and higher capacity utilization. The company’s adjusted earnings per share (EPS) jumped by $0.10 or 16% y-o-y to $0.74. Although, its sales revenue grew by just over 2%, the company’s adjusted EBITDA margin improved by almost 40 basis points year-on-year. [1]

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. Based on the recent earnings announcement, we have updated our price estimate for Dow to $53/share, which is 18.9x our 2014 full-year adjusted diluted EPS estimate of $2.80 for the company.

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Most of the growth in Dow’s consolidated adjusted EBITDA during the second quarter came from the performance materials and performance plastics divisions. Together, these two divisions contribute almost 70% to the company’s total value by our estimates. While the performance materials division serves a wide range of market sectors including agriculture, mining, construction, and electronics and entertainment, the performance plastics division primarily sells flexible plastic packaging products and elastomers. Here, we take a closer look at what drove operating income from these divisions higher during the second quarter and what’s the long-term operating margin outlook for these divisions.

Performance Materials

Dow’s performance materials division saw a more than 36% y-o-y jump in adjusted EBITDA during the second quarter. This was primarily due to better margins since sales revenue increased by just 1.5% y-o-y. The division’s adjusted EBITDA margin improved by 280 basis points by our estimates. The company attributed this sharp increase in margins to cost savings from productivity improvements and higher asset utilization. Going forward, Dow expects to expand its performance materials adjusted EBITDA margins by as much as a 400 basis points over last year by 2017. [2]

Most of this margin expansion is expected to come from a reduction in raw material costs for the division because of the integration of a new on-purpose propylene production facility at Dow Texas Operations in Freeport. Propylene is a key raw material used by Dow’s performance materials division. It is primarily used in the production of propylene oxide, epoxy, and plastics additives. These chemicals derived from propylene are used in the manufacturing of various end products including automobiles. With the new propylene dehydration (PDH) plant, Dow would be able to shift its feedstock exposure from volatile propylene to abundant propane, a natural gas liquid. Construction on the PDH plant is more than 20% complete and it is expected to come online some time next year. The company expects to generate incremental EBITDA of $450 million annually on a run rate basis from this backward integration move. [3]

Performance Plastics

Dow’s performance plastics adjusted EBITDA was also up around 6% y-o-y, as sales increased by almost 2% and margins expanded by a 100 basis points. Here, the key driving factor was pricing. The company’s average pricing for the division was up 7% y-o-y, mainly driven by the fast-growing demand for packaging and specialty plastics products. These products find use in food packaging and medical and hygiene equipment and make up around 80% of the division’s total sales revenue. The key growth drivers for these products include global population growth, the need to reduce food waste, a growing focus on consumer convenience, and improving socioeconomic status due to the rising middle class. Going forward, Dow expects to improve its performance plastics adjusted EBITDA margins by 200-400 basis points over 2013 levels by 2017. [2]

Again, most of the margin expansion at Dow’s performance plastics division is also expected to come from lower raw materials costs as a result of the growth in the company’s ethylene production capacity on the U.S. Gulf Coast. Ethylene, the simplest unsaturated hydrocarbon, is one of the most important feedstock in the plastics value chain. It is used in the manufacture of polyethylene, also called polythene, which is the most widely used plastic in the world. Ethylene 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 also improving feedstock flexibility of its existing ethylene production facilities to leverage the favorable feedstock scenario. 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. Going forward, Dow plans to increase its ethylene production capacity by almost 20% over the next three years, most of which would come from the start-up of a new world-scale ethylene production facility in Texas. Dow started construction work on the project last month and it is expected to come online by 2017. [3]

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Notes:
  1. Q2 2014 The Dow Chemical Company Earnings Release, dow.com []
  2. Dow Chemical 2014 Q2 Earnings Call Presentation, dow.com [] []
  3. Dow’s Performance Plastics Advantage, dow.com [] []