Dow Q3 Earnings: Higher Margins Drive Growth In Low Oil Price Environment

The Dow Chemical Company (NYSE:DOW) released its Q3 2015 earnings report recently. ^[1] Overall, the significance of the company’s latest quarterly 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, the oil and gas industry dynamics impact Dow’s operations significantly. However, despite a close to 50% drop in average oil prices as compared to last year, the company was able to maintain its earnings growth momentum. Q3 2015 was Dow’s 12th consecutive quarter of year-on-year adjusted EBITDA margin expansion. This clearly indicates that the company has made great progress over the last few years by shifting its focus away from low-margin, commoditized end products and into more differentiated, high-value products. These specialized end products have increased Dow’s price-taking ability and have partially insulated the company from the volatility in input commodity costs, while increasing the marginal benefit of backward integration into the manufacture of basic chemicals such as ethylene.

Our price estimate for Dow Our price estimate for Dow stands at $55, implying a premium of close to 10% to the market.

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Better Capacity Utilization And Productivity Improvements Drive Margins Higher

Dow’s Q3 2015 earnings beat analysts’ consensus estimates on the back of thicker margins due to higher specialty products sales volume, higher capacity utilization and cost savings through productivity improvements. Although Dow’s sales revenue declined by 16% due to a 50% year over year decline in oil prices and currency headwinds led by the appreciation of the U.S. Dollar, the company’s operating earnings per share (EPS) increased by 14% year over year to $0.82. ^[2] Dow’s adjusted EBITDA margin improved by over 370 basis points over the previous year period. ^[3] The company’s higher EBITDA margin is partly due to higher operating rate or increased use of fixed assets, which results in a decrease in marginal production costs. According to one of Dow’s previous earnings call presentations, a 100 basis points improvement in its annual operating rate boosts its full-year EBITDA by more than $200 million. ^[4] Dow’s operating rate stood at 86% for Q3 2015, up by 200 basis points over the previous two quarters. In addition to higher operating leverage, profitability was also boosted by the cost savings from the ongoing three-year $1 billion productivity program at the company. Cost savings from the program have amounted to $208 million year to date, and are expected to reach $300 million for the whole year. ^[5]

Profitability Gains Driven By High-Value Specialty Products

We estimate that Performance Plastics is Dow’s most valuable operating division, constituting more than 30% of the stock’s total value. The division primarily sells elastomers, flexible plastic packaging products and hydrocarbons. During the first quarter, Dow’s Performance Plastics EBITDA margin improved by an impressive 700 basis points over the prior year quarter. ^[5]   Most of this margin expansion could be attributed to higher demand for Dow’s high-value plastics products, especially elastomers. 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 such as adhesives, transportation, footwear, housewares, and infrastructure. ^[4] Dow’s management noted on the earnings conference call that elastomers unit delivered a second consecutive quarterly operating EBITDA record, propelled by the demand in key markets including transportation, high-end footwear and infrastructure. ^[2]

Elastomers demand was particularly strong in the transportation sector, as evidenced by the performance of its Dow Automotive Systems unit which is a part of Dow’s Electronics and Functional Materials division. Dow Automotive systems also delivered record operating EBITDA during the quarter, benefiting from auto industry shifting toward lighter weighting and growing preference for larger premium vehicles, driven partly by lower oil prices. These vehicles tend to feature a larger quantity of higher margin Dow materials, which results in a better sales volume-mix for the company and drives margins higher. ^[6]

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1. Dow Reports Third Quarter Results, October 22, 2015, Dow Investor Relations [↩]
2. Dow Chemical’s (DOW) CEO Andrew Liveris on Q3 2015 Results – Earnings Call Transcript, October 22, 2015, Seeking Alpha [↩] [↩]
3. Dow Chemical Company’s SEC Filings [↩]
4. Dow CEO and CFO Analyze First Quarter Earnings, Dow Investor Relations [↩] [↩]
5. 3Q2015 Webcast Slide Deck, Dow Investor Relations [↩] [↩]
6. Q1 2015 The Dow Chemical Company Earnings Conference Call, April 23, 2015, Dow Investor Relations [↩]