Dow Chemical’s Third Quarter Earnings Surge Higher On Margin Expansion

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The Dow Chemical Company’s (NYSE:DOW) third quarter earnings surged higher on thicker margins due to higher net pricing and cost savings through productivity improvements and higher capacity utilization. The company’s adjusted earnings per share (EPS) jumped by $0.22 or 44% y-o-y to $0.72. Although, its sales revenue grew by just over 5%, the company’s adjusted EBITDA margin improved by over 240 basis points year-on-year. [1] We attribute a majority of the net increase in Dow’s adjusted EBITDA during the third quarter (around 45%) to higher operating leverage or increased use of fixed assets, which results in a decrease in marginal production costs. According to the company’s recent presentation at the Credit Suisse Basic Materials Conference, a 100 basis points improvement in the annual operating rate boosts its EBITDA by more than $200 million. [2] During the third quarter, Dow’s operating rate stood at 86%, up by 400 basis points over the same period last year. [3]

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 $51/share, which is 16.6x our 2014 full-year adjusted diluted EPS estimate of $3.07 for the company.

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Most of the growth in Dow’s consolidated adjusted EBITDA during the third quarter came from the Performance Plastics and Performance Materials 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 third quarter and what the long-term operating margin outlook for these divisions are.

Performance Plastics

During the third quarter, Dow’s Performance Plastics adjusted EBITDA increased by around 31% y-o-y, as sales increased by almost 9% and margins expanded by more than 560 basis points. Here, the key driving factor was pricing. The company’s average net pricing for the division was up 6% y-o-y, mainly driven by the fast-growing demand for packaging and specialty plastics products. [1] 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]

Most of the margin expansion at Dow’s Performance Plastics division is 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 in June this year and it is expected to come online by 2017. [4]

Performance Materials

Dow’s Performance Materials adjusted EBITDA also surged by more than 60% y-o-y during the third quarter. This was primarily due to better margins since sales revenue increased by just 8%. The division’s adjusted EBITDA margin improved by more than 460 basis points by our estimates. [1] 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 400 basis points over last year by 2017. [2]

Most of this margin expansion is also 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 by mid next year. The company expects to generate incremental EBITDA of $450 million annually on a run rate basis from this backward integration move. [5]

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Notes:
  1. Dow Reports Third Quarter Results, dow.com [] [] []
  2. Credit Suisse 2014 Basic materials Conference, dow.com [] [] []
  3. Dow Chemical 2014 Q2 Earnings Call Presentation, dow.com []
  4. Dow Chemical 2014 Q3 Earnings Call Presentation, dow.com []
  5. Dow’s Performance Plastics Advantage, dow.com []