Dow Chemical Earnings: Demand For Specialty Products Drives Growth Amid Lower Oil Prices

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The Dow Chemical Company’s (NYSE:DOW) 2015 first quarter earnings beat analysts’ consensus estimates on the back of thicker margins due to higher specialty products sales volume, cost savings through productivity improvements, and higher capacity utilization. The company’s adjusted diluted earnings per share (EPS) increased by $0.05 or 6.33% y-o-y to $0.84. Although its sales revenue declined by 14% due to lower oil prices and negative currency translation impact – because of the appreciation of the U.S. Dollar – the company’s adjusted EBITDA margin improved by over 284 basis points year-on-year. [1] Some of the increase in Dow’s adjusted EBITDA during the first quarter could be attributed 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 earnings call presentation, a 100 basis points improvement in its annual operating rate boosts its full-year EBITDA by more than $200 million. [2] During the first quarter, Dow’s operating rate stood at 84%, up by 100 basis points over the same period last year. In addition to higher operating leverage, cost savings from the ongoing 3-year, $1 billion productivity drive at the company, also boosted its profitability during the quarter. Cost savings from the program added up to $57 million during the quarter, and are expected to ramp up to $300 through the year. Apart from higher operating leverage and productivity cost savings, Dow’s first quarter adjusted EBITDA margin was also boosted by the higher demand for its high-value, differentiated end products, which is something we discuss in more detail below. [3]

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 recent earnings announcement, we have updated our price estimate for Dow to $56/share, which is approximately 18.7x our 2015 full-year adjusted diluted EPS estimate of $3.00 for the company.

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High-Value, Specialty Products Drive Profitability Gains

According to our estimates, Performance Plastics is Dow’s most valuable operating division, contributing more than 30% to its total value. The division primarily sells flexible plastic packaging products, hydrocarbons, and elastomers. During the first quarter, Dow’s Performance Plastics EBITDA increased by almost 2% y-o-y, even while sales revenue from the division declined by almost 23%. This is because the division’s adjusted EBITDA margin improved by 558 basis points over the year-ago quarter. Most of this margin expansion could be attributed to higher demand for Dow’s high-value plastics products, especially elastomers.  Dow’s management noted that EBITDA from the Elastomers unit increased by nearly 60% year-on-year during the first quarter and stood at its highest level since 2012. Elastomers are natural or synthetic polymers that have elastic properties. Dow sells a variety of elastomers including polyolefin plastomers and ethylene propylene diene monomer elastomers (“EPDMs”). These products find applications in many end markets like adhesives, transportation, footwear, housewares, and infrastructure. [2] However, the company stated that during the first quarter, elastomers demand was particularly strong in the transportation sector, which also reflected in the performance of its Dow Automotive Systems unit that is a part of Dow’s Electronics and Functional Materials division. Dow Automotive systems also delivered record EBITDA during the first quarter, benefiting from auto industry trends toward light weighting as well as a growing preference for larger, premium vehicles, driven in part by lower oil prices. These vehicles tend to feature both more, and higher margin, Dow materials, which resulted in a better sales volume-mix for the company, driving thicker margins. [3]

Overall, the significance of Dow’s first quarter results lies in the fact that the company was able to grow its earnings through margin expansion despite such a volatile commodity cost environment. 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 operations significantly. However, despite the 50% y-o-y decline in oil prices, the company was able to maintain its earnings growth momentum. This clearly indicates that it has made great progress over the last few years to shift its focus away from low-margin, commoditized end products, to more differentiated, high-value products. These specialized end products have increased Dow’s price-taking ability and partially insulated it from the volatility in input commodity costs, while increasing the marginal benefit of backward integration into the manufacture of basic chemicals like ethylene.

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Notes:
  1. Dow Reports First Quarter Results, dow.com []
  2. Dow CEO and CFO Analyze First Quarter Earnings, dow.com [] []
  3. Dow Chemical 2015 Q1 Earnings Call Webcast, dow.com [] []