Dow Continues Margin Expansion But Lower Oil Prices Weigh On Outlook

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The Dow Chemical Company (NYSE:DOW) recently announced its 2014 fourth quarter and full-year earnings results. Its earnings per share (EPS) adjusted for non-operating items increased by almost 31% year-on-year to $0.85. As expected, the company’s results continued to benefit from margin expansion, primarily driven by productivity cost savings from higher operating leverage. During a recent presentation at the Credit Suisse Basic Materials Conference, Dow officials pointed out that a 100 basis points improvement in the annual operating rate boosts its EBITDA by more than $200 million. During the fourth quarter, Dow’s global operating rate stood at 86%, up 400 basis points from the year-ago quarter. This was the key factor that drove the net improvement of around 220 basis points in its consolidated adjusted EBITDA margin over the last three months of 2013.  Q4 2014 was Dow’s ninth consecutive quarter of year-on-year EBITDA margin growth. However, we believe that margin pressures due to lower oil prices, especially in the Performance Plastics division, could spoil its party this year. [1]

Dow is a diversified chemical industry giant operating in basic and 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 over $58 billion and adjusted net income of around $3.7 billion. Based on the most recent earnings announcement, we have updated our price estimate for Dow to $45.50/share, which is almost 14.8x our 2015 full-year adjusted diluted EPS estimate of $3.08 for the company.

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Lower Oil Prices Weigh On Outlook

Being in the petrochemical business, Dow relies heavily on hydrocarbon feedstocks for manufacturing its end products like packaging films and elastomers. As a result, dynamics in the oil and gas industry impact its results significantly. For example, the company has gained enormously from lower natural gas prices in the U.S. over the past few quarters, as it resulted in thicker margins on the production of ethylene – a key ingredient in the manufacturing of almost all plastic products. According to our estimates, the company’s Performance Plastics adjusted EBITDA margins grew by over 800 basis points since 2012.  Most of the products sold by the division are derivatives of the simplest unsaturated hydrocarbon, ethylene, which is most commonly derived from steam cracking of either naphtha or ethane. While naphtha is derived from crude oil (naphtha constitutes around 15-30% of crude oil by weight), ethane is a natural gas liquid that is extracted from raw gas streams at natural gas processing plants.

With the shale gas revolution in the U.S., the production of ethane and other NGLs has also grown significantly, which has weighed on their prices. According to a consultancy firm, Envantage, ethane extraction capacity in the U.S. has risen by almost 60% over the past 8 years to over 1.23 million barrels per day (bpd) currently, and is expected to hit 2.2 million bpd by 2020. [2]  This has created a lot of incentive for chemical producers in the U.S. to crack ethane for producing ethylene and even led to a slew of new project announcements on the Gulf Coast. (See: Cheap U.S. Natural Gas Is Attracting Huge Investments From Chemical Companies)

However, the recent decline in oil prices has resulted in the flattening of the global ethylene cost curve, as naphtha prices have come down along with crude oil. This is expected to reflect in the pricing of ethylene and its derivative products, which will pressurize Dow’s top-line growth. In addition, it is also expected to slow down the rate of development of shale reserves in the U.S., which could further diminish the low-cost advantage enjoyed by the U.S.-based ethane-cracking plants.  However, during the fourth quarter earnings conference call, Dow’s CEO, Andrew Liveris pointed out that the company’s shrinking exposure to commoditized end products, as a result of the ongoing divestment program, and an anticipated pick up in demand growth fueled by lower oil prices should mitigate the impact of the changed oil price environment on its profits. [3]

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Notes:
  1. Dow Reports Fourth Quarter and Full-Year Results, dow.com []
  2. The Impending Boom of U.S. Ethane Exports, wallstreetdaily.com []
  3. Dow Chemical 2014 Q4 Earnings Call Presentation, dow.com []