Dow Chemical Earnings Preview: Margin Expansion To Drive Growth

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The Dow Chemical Company (NYSE:DOW) is scheduled to announce its 2014 fourth quarter earnings on January 29. We expect the company to primarily draw growth from margin expansion, as a result of productivity cost savings from higher operating leverage. According to Dow’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. [1] During the first nine months of this year, Dow’s operating rate stood at 85%, up by 400 basis points from the same period last year. This was the key factor that drove the net improvement of around 115 basis points in the company’s consolidated adjusted EBITDA margin over last year. We expect to see a similar margin improvement during the fourth quarter, primarily driven by higher polyethylene plant operating rates, as the growth in global demand for plastics is currently outpacing supply additions. 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 its long-term cash flow growth. [2]

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 and earning adjusted net income of around $2.9 billion. We currently have a $50/share price estimate for Dow, which is almost 16.3x our 2014 full-year adjusted diluted EPS estimate of $3.07 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 over the past several years, in March 2013 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 the 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]

In March 2014, 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. (See: How Does Dow Chemical Plan To Expand Its Performance Materials Margins?) In October last year, Dow announced that it is actively marketing three of its non-core businesses for divestment and expects proceeds of more than $2 billion by early 2015. [3] Most recently, the company further raised its divestiture target by $2.5 billion as it plans to cut its stake in two Kuwaiti joint ventures, MEGlobal and Equate Petrochemical. Andrew Liveris, the company’s CEO, said that Dow will still retain a substantial share in both the joint ventures and that the pull back is primarily aimed at freeing up some capital for new, more lucrative investments. [4]

Through these divestments, Dow is diverting 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% in 2013, 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 the 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 adjusted EBITDA stood around $7.8 billion in 2013, by our estimates. Therefore, we currently believe that Dow is on track to achieve significant EBITDA growth in the next few years. (See: Cheap U.S. Natural Gas Is Attracting Huge Investments From Chemical Companies)

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Notes:
  1. Credit Suisse 2014 Basic materials Conference, dow.com []
  2. Q3 2013 The Dow Chemical Company Earnings Release, dow.com [] []
  3. Dow Chemical To Divest Three More Businesses, wsj.com []
  4. The Dow Chemical Company Investor Forum 2014 Presentation, dow.com []