How Does Dow Chemical Plan To Expand Its Performance Materials Margins?

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The Dow Chemical Company’s (NYSE:DOW) Performance Materials division primarily sells amines, chlorinated organics, automotive systems, epoxy and polyurethanes. These products serve a variety of end markets ranging from agriculture, consumer goods and construction to industrial materials, electronics and transportation. The Performance Materials division is the least profitable segment in Dow’s diversified chemicals portfolio. According to our estimates, the division’s adjusted EBITDA margin stood at just around 10% in 2013, compared to the company-wide figure of over 16.5%. Since it contributes around 23% to Dow’s consolidated sales revenue, thinner margins impact the company’s overall valuation significantly. Therefore, Dow is taking several measures like increasing feedstock integration and improving operating leverage and productivity of the division to expand its adjusted EBITDA margin by as much as 400 basis points over last year by 2017. In this article, we take a closer look at each of these measures. [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. We currently have a $53/share price estimate for Dow, which is 18.9x our 2014 full-year adjusted diluted EPS estimate of $2.80 for the company.

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Feedstock Integration

Most of the EBITDA margin expansion at Dow’s Performance Materials division is expected to come from a reduction in raw material costs 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. Once the new propylene dehydration (PDH) plant is operational, Dow will be able to shift its feedstock exposure from volatile propylene to abundant propane, a natural gas liquid (NGL). [2]

Over the past few years, the production of NGLs has increased sharply in the U.S. because of the ongoing shale boom, which has resulted in lower propane prices. Between January 2011 and June 2014, U.S. NGL production (including refinery gas) increased by more than 44% from 2.11 million barrels per day to 3.04 million barrels per day. As a result, NGL prices, which used to move more or less in line with West Texas Intermediate (WTI) crude oil prices earlier, have now moved away from WTI and trade roughly halfway between crude oil and natural gas prices. [3]

Construction on Dow’s new PDH plant is more than 20% complete currently 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. [1]

Higher Operating Leverage

In order to boost its EBITDA margins, Dow is also focusing on improving its operating leverage or increasing the use of fixed assets, which results in lower marginal production costs. According to the company, a 100 basis points improvement in the annual operating rate boosts its EBITDA by more than $200 million. During the first quarter of this year, Dow’s operating rate stood at 83%, up by a 100 basis points from the same period last year, which improved the company-wide EBITDA by around $50 million. [4]

During the second quarter, Dow’s Performance Materials division saw a more than 36% y-o-y jump in adjusted EBITDA, primarily because of 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. Dow attributed this sharp increase in margins to cost savings from productivity improvements and higher asset utilization. Going forward, we expect these operational improvements along with feedstock integration to boost the division’s adjusted EBITDA margin from around 10% in 2013 to 14% by the end of our forecast period. [5]

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Notes:
  1. Goldman Sachs European Chemicals 2020 Vision Conference Presentation, dow.com [] []
  2. Dow Progresses Its U.S. Gulf Coast Investments, dow.com []
  3. High Value of Liquids Drives U.S. Produces To Target Wet Natural Gas Resources, eia.gov []
  4. Dow Chemical Q1 2014 Earnings Call Webcast, dow.com []
  5. Q2 2014 The Dow Chemical Company Earnings Release, dow.com []