Dow – Better Earnings – But Probably Only Adds Fuel To The Debate

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Dow reported better than expected earnings and in the accompanying conference call CEO Andrew Liveris went to great lengths to explain the stagey, implicit in which were the reasons why Dow sees benefit in keeping its portfolio together.

Not to take anything away from DOW, these were much better numbers – the cash flow was good and the increased dividend and share buy-back will be popular.  However, we do not think that this will do anything to stop or slow the debate, raised loudly by Third Point last week, and debated among Dow watchers for years.  The question is simple – “Is there a better way?”

The critics of the Dow strategy will raise the following arguments:

  • For a company supposedly going after costs in an aggressive way and selling assets, both SG&A and R&D costs increased quarter on quarter and year on year.
  • The real earnings gain came in the more commodity sectors – possibly inviting the argument that the portfolio remains cyclical.
    • The swing in equity earnings (almost all commodity) accounted for as much as 20 cents of the quarter on quarter gain – 60% of the gain (assuming that taxes on these income streams are minimal) and almost all of the annual gain.  As was pointed out in a question on the call – most of these ventures are commodity in nature and in Dow’s own words probable divestment targets if the right deal can be found.
    • Year on Year, EBITDA margins fell in the three businesses that Third Point wants to separate as a specialty company – Electronic and Functional Materials, Coatings and Infrastructure Solutions and Ag Science.  Q4 versus Q4 they generally increased.
      • Sales rose year on year but margins fell – this could be where the increased SG&A and R&D costs are going.
      • Too complex to understand and to manage.
      • Capital spending ramping up as cash flows improve – chart.
        • Dow has a habit of spending once it has capacity – either on acquisitions or on new plant and equipment.  While the buyback and higher dividend will be popular, capital spending and acquisitions have historically been less obvious value drivers.

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The supporters will say that the strategy is starting to deliver:

  • Higher cash flows – lower debt – increased dividend – increased buyback – nothing wrong there and this is a theme in the sector – DD, DOW and PX have highlighted buy-backs.
  • Improving return on capital.
  • More capital discipline.

The other risk is that the enthusiasm shown by Dow today influences estimates and creates expectation that are hard to meet in 2014.  We have identified Dow as a serial optimist – which means that the company (as reflected in analyst estimates) overestimates annual earnings growth more frequently than it underestimates – see chart.

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As we have indicated in prior research, we think the issue at Dow is primarily a cost issue and whether Dow is really achieving an adequate return on investment, whether that be new capital spending, acquisition or R&D.  It is likely that a less complex company (or less complex companies) could address these issues more easily, but unless these issues are addressed we see no real incremental value in breaking up the company.

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