Dow’s Earnings Expected To Swell On Thicker Margins

The Dow Chemical Company (NYSE:DOW) is scheduled to announce its 2013 fourth quarter and full-year earnings on January 29. We expect the company to report full-year adjusted diluted earnings per share (EPS) of $2.51, compared to just $1.87 last year, which implies over 34% year-over-year growth. According to our estimates, Dow’s earnings growth will primarily come from thicker operating margins at its performance plastics business. However, we also expect the company’s successful seed traits and robust industry fundamentals to drive agricultural products revenue higher.

Dow is a diversified chemical industry giant operating in 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. The performance plastics and agricultural science products divisions account for ~65% of Dow’s total value by our estimates.

Our $42 price estimate for Dow Chemical is almost 5% below its current market price.

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Performance Plastics To Drive Margin Expansion

Dow’s performance plastics division primarily sells elastomers, polypropylene and other products used in electrical, telecommunication and packaging industries.  It contributes ~25% to its total sales revenue. 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. Naphtha is derived from crude oil (naphtha constitutes around 15-30% of crude oil by weight) while ethane is the second largest component of natural gas after methane.

Now, the outlook for U.S. natural gas supply has changed significantly over the past few years, primarily due to the evolution of horizontal drilling and hydraulic fracturing techniques that have enabled energy companies to tap the huge shale gas reserves in the U.S. at commercially sustainable rates. The widespread use of these techniques started only during the early 2000s in the Barnett shale play in north-central Texas. However, since then, natural gas production in the U.S. has ramped up much faster than the growth in consumption, which has led to severely depressed commodity prices by international standards. This has resulted in lower feedstock costs for the petrochemical industry in the U.S.

Dow, being one of the largest players in the industry, is also one of the largest ethylene producers in the world, as this provides the company’s differentiated performance plastic manufacturing capacities with a low-cost advantage. Therefore, lower ethane prices in the U.S. have helped the company expand its operating margins significantly. During the first three quarters of 2013, EBITDA margins of the performance plastics division at Dow swelled by more than 650 basis points over last year. We expect the division’s margins to expand by around 700 basis points for the full year, as we see the positive trend continuing during the fourth quarter as well. ^[1]

Dow is also pursuing huge investments (more than $4 billion) in the U.S. Gulf Coast region to grow its ethylene production capacity while improving feedstock flexibility of its existing ethylene production facilities. The company currently has 70% of its ethylene production in cost-advantaged regions. Last year, it restarted its St. Charles Olefins 2 plant in Louisiana in a bid to lower its operating costs by reducing the amount of ethylene purchased. The chemical giant expects to generate incremental EBITDA of $2.5 billion by ramping up its plastics operations in the U.S. Gulf Coast region. ^[2]

Agricultural Science Products To Drive Sales Growth

Dow’s agricultural science products business primarily deals in crop protection products, such as insecticides and herbicides, and genetically modified (GM) seeds. We see a huge growth potential for the company in this market, primarily due to the growing adoption of GM seeds for higher yields and better traits.

Rising global population and declining availability of arable land, both point towards higher demand for more sustainable technological solutions for the agriculture sector. GM seeds provide farmers with higher yields, lower susceptibility to insects, increased tolerance to chemicals used for eliminating weeds (herbicides) and extreme climatic conditions such as drought. As a result, farmers in developed countries have largely adopted GM seeds. GM corn varieties make up ~90% of the total corn planted in the U.S. ^[3]

The global agricultural area under biotech crops grew to over 420 million acres in 2012 from just 4.2 million acres in 1996. ^[4] It should also be noted that according to the estimates of the food and agriculture organization (FAO) of the United Nations, GM crops still make up just over 3% of the global agricultural area. ^[5] This implies a significant upside potential for GM seeds adoption even if we assume that their global penetration would approach just about half of what it is in the U.S. today (about 50%). ^[6]

Although GM seeds make up just around 20% of Dow’s total agricultural products sales, these are expected to be the primary growth driver for the division’s top line going forward, because of a relatively high growth potential and the company’s strengthening position in the segment. According to our estimates, Dow has been able to expand its share in the global agricultural products market by more than 100 basis points since 2010 on a very successful launch for the SmartStax seeds brand. ^[1]

First commercially planted in 2010, SmartStax contributed significantly towards increasing volumes by 27% year over year in 2011 for Dow Chemicals’ seeds, traits and the oil business. Its success in 2012 was reflected in more than double technology sales as compared to 2011, driven by the introduction of POWERCORE (an extension of the SmartStax family that contains five traits, two herbicide-tolerant genes plus three genes resistant to pests) in Latin America and REFUGE ADVANCED (a blend of 95% SmartStax corn seed and 5% refuge (non-Bt) seed that farmers can plant across their entire field) in North America. We expect the positive trend to manifest itself in Dow’s fourth quarter earnings as well. ^[7]

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1. Dow SEC Filings, sec.gov [↩] [↩]
2. Dow Confirms U.S. Site Selections for Expansions to Leading Plastics Brands, dow.com [↩]
3. Adoption of Genetically Engineered Crops in the U.S., ers.usda.gov [↩]
4. Global Status of Commercialized Biotech/GM Crops: 2012, isaaa.org [↩]
5. Genetic Engineering and Biotechnology, globalagriculture.org [↩]
6. Acreage 2013, usda.gov [↩]
7. 2012 Dow Annual Report, dow.com [↩]