Dow Q4 Earnings: Higher Margins Offset Revenue Decline, Management Confident Of Dow-Dupont Merger Synergies

The Dow Chemical Company (NYSE:DOW) released its 2015 fourth quarter and full year earnings report recently. ^[1] Dow management spoke briefly about the proposed merger with DuPont (NYSE:DD), stating that the companies’ estimates of $3 billion in cost synergies and $1 billion in growth synergies are their most conservative estimates. Dupont management had earlier stated on the company’s Q4 earnings call that it is confident the companies will get the required clearances without major asset sales and the deal will be completed in the second half of 2016. As for the quarter in question, Dow was able to grow its earnings through margin expansion despite a decline in revenues precipitated by local price declines and currency headwinds. Q4 2015 was Dow’s 13th 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.

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Dow management spoke briefly about their proposed merger with Dupont, stating the company intends to “move swiftly through the key stage gates of the Dow-DuPont transaction.” ^[2] They also stated that the synergy estimates of “$3 billion cost and $1 billion growth are indeed a floor not a ceiling.” Dupont management had also appeared confident in their Q4 earnings call, stating that the merger will be completed in the second half of 2016. ^[3] Dupont Chief Executive Edward Breen recently stated that he believes that there is “very little” which would concern regulators about the two companies’ pending merger. ^[4] He also stated that it was unlikely that the merger would require any significant asset sales. Once the merger is completed, the combined company subsequently plans to split into three businesses which would each be individually focused on agriculture products, materials, and specialty products.

Higher Margins Driven By Better Capacity Utilization And Productivity Improvements

Dow’s fourth quarter earnings beat analysts’ consensus estimates on the back of thicker margins due to higher specialty plastics sales volume, efficient capacity utilization, and cost savings through productivity improvements. Although Dow’s Q4 sales revenue declined by 20% due to local price declines and currency headwinds, the company’s operating earnings per share (EPS) increased by 9.4% y-o-y to $0.93. ^[1] The company’s higher EBITDA margin is partly due to a 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. ^[5] Dow’s operating rate for the second half of 2015 stood at 86%, up by 200 basis points over the first half of the year. In addition to higher operating leverage, profitability was also boosted by the cost savings from the ongoing 3-year productivity program at the company. Cost savings from the program amounted to $345 million for the full year 2015, and are expected to be upwards of $300 million for the current year. ^[6]

Profitability Gains Driven By High-Value Specialty Products

We estimate that Performance Plastics is Dow’s most valuable operating division, constituting more than 31% 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 600 basis points over the prior year quarter. ^[6] 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. ^[5] Dow’s management noted on the earnings conference call that growth in elastomers was propelled by customer demand in the transportation and infrastructure sectors. ^[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 impressive EBITDA growth during the quarter, benefiting from the 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. ^[7]

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1. Dow Reports Fourth Quarter and Full-Year Results, February 6, 2016, Dow Investor Relations [↩] [↩]
2. Dow Chemical’s (DOW) CEO Andrew Liveris on Q4 2015 Results – Earnings Call Transcript, February 2, 2016, Seeking Alpha [↩] [↩]
3. DuPont’s (DD) CEO Ed Breen on Q4 2015 Results – Earnings Call Transcript, January 26, 2016, Seeking Alpha [↩]
4. DuPont CEO sees ‘very little’ to concern regulators in Dow merger, January 26, 2016, Reuters [↩]
5. Dow CEO and CFO Analyze First Quarter Earnings, Dow Investor Relations [↩] [↩]
6. 4Q2015 Webcast Slide Deck, Dow Investor Relations [↩] [↩]
7. Q1 2015 The Dow Chemical Company Earnings Conference Call, April 23, 2015, Dow Investor Relations [↩]