Dow Chemical: Margin Expansion Continues In 2Q

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The Dow Chemical Company’s (NYSE:DOW) 2015 second quarter earnings beat analysts’ consensus estimates on the back of thicker margins due to feedstock flexibility, 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 $0.17 or almost 23% y-o-y to $0.91. Although its sales revenue, excluding acquisitions and divestitures, declined by 9% due to lower oil prices and a negative currency translation impact – because of the appreciation of the U.S. Dollar – the company’s adjusted EBITDA margin improved by over 396 basis points year-on-year. This was Dow’s 11th consecutive quarter of year-on-year adjusted EBITDA margin expansion. [1]

Some of the increase in Dow’s adjusted EBITDA during the second 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.  During the second quarter, Dow’s operating rate stood at 84%, up by 200 basis points over the same period last year. [2] 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 are expected to amount to $300 million for the whole year. Apart from higher operating leverage and productivity cost savings, Dow’s second quarter adjusted EBITDA margin was also boosted by its increasing feedstock flexibility and 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 $55/share, which is approximately 17.6x our 2015 full-year adjusted diluted EPS estimate of $3.13 for the company.

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Feedstock Flexibility, 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 second quarter, Dow’s Performance Plastics EBITDA increased by almost 15% y-o-y, even while sales revenue from the division declined by almost 16%. This is because the division’s adjusted EBITDA margin improved by 646 basis points over the year-ago quarter. Most of this margin expansion could be attributed to Dow’s increasing feedstock flexibility and higher demand for the company’s high-value plastics products, especially packaging products and elastomers. First, lets discuss feedstock flexibility. Over the past few years, Dow has significantly increased its capability to quickly switch to the lowest-cost feedstock for its crackers, which is paying back immensely even in the current volatile commodity price environment. Despite the recent decline in end-product prices because of the fall in global crude oil prices, the company’s increasing capability to crack propane (a natural gas liquid), which is currently oversupplied in the U.S., is helping it expand operating margins. The trend is expected to continue for a while because the propane oversupply situation is not expected to improve significantly in the short to medium term. [2]

Now, lets move on to increasing end-products demand. During the earnings conference call, Dow’s management noted that both Packaging and Specialty Plastics as well as Elastomers units delivered record EBITDA in 2Q, driven by strong volume growth. The Performance Plastics division’s sales volume, excluding acquisitions and divestitures, increased by 9% y-o-y during the quarter. 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. However, the company stated that during the second 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 second 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 second 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 44% 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 Second Quarter Results, dow.com []
  2. Dow Chemical 2Q 2015 Earnings Call Presentation, dow.com [] []
  3. Dow Chemical 2Q 2015 Earnings Call Webcast, dow.com [] []