Dow – Lots of Talk – But Good Topics
In our recent research comparing the opportunity at DOW versus LYB we talked about the number of levers that DOW has available – other than the US ethylene margin – to add to earnings and value. Yesterday we saw another example of DOW talking the talk, with a statement suggesting that the company is exploring an MLP structure for some of its US Gulf ethylene assets – more on the specifics and our view in a moment.
Chemical companies and many other Materials and Industrials companies tend to focus on big stuff – investments, M&A, inventions, etc. that either cost a lot of money or cause a lot of distraction. Over the last 10 years it has become very clear that the better performers are those that also focus equally on the small stuff – the singles rather than the home runs. This has been a large part of the success at PX, is increasingly important at PPG and to an extent has helped at LYB. This is very much the way forward for DD and will be the only logical way forward for APD once a new leader and a new plan is in place.
DOW is still thinking about the big stuff – SADARA, US Gulf investments, divesting the chlorine business, divesting AG etc. – but is talking about some more interesting smaller stuff as well, such as further cost initiatives and select divestments of businesses or JV’s that show little value in DOW’s portfolio but could be worth much more to someone else.
The MLP idea is both a big and small idea. It could involve a lot of assets and it could have significant cash flows – but it will not materially impact the overall cash flows at DOW. It is more tactical and more about getting additional value for the cash flow rather than changing the cash flow itself. We are sure that there will be nay sayers in DOW, who see this as “financial engineering” and not “core”, but this is all about creating value, and it could create a lot.
One of the challenges for DOW in this MLP idea will be the need to price ethylene, propylene and co-products at market value, as product is transferred from the MLP to DOW. This is something investors have wanted DOW to do for a very long time, as the view has been that the cost based transfer that the company practices today is opaque and does not allow us to see the true profitability of the derivative businesses. The challenge that DOW faces here is that the derivative businesses, particularly Performance Polymers in our view, will look poor if base chemicals are transferred at market prices.
The other question we would raise is around the statement that only the new facilities are being considered for the MLP. We think that DOW should spin off all of its qualified North American ethylene, propylene and pipeline assets into an MLP and then have the MLP invest to build the new units:
- The MLP will need to rise equity to build – DOW should contribute its share of that equity – by raising debt and buying the new shares, but the independent investors will be asked to contribute proportionally. This may force DOW to be more open about the economics of the investments, which may not be a bad thing, but it will also reduce DOW’s direct exposure to what is a major capital plan, which is probably a good thing.
- By including all of the assets (where allowed), the MLP would be very large, more liquid and more interesting to investors.
- By including all assets – especially those that are fully depreciated – the earnings will be higher and the yield based value will increase.
- DOW’s 80% (our guess) ownership of a very valuable MLP could have a meaningful impact of DOW valuation.
The best thing about this MLP discussion in our view is that it shows that DOW is thinking and thinking down non-traditional paths for the company.
Today we have a lot of interesting talk – lots of topics – all of which could be pursued to ends that create value. But…some of this is already priced into the stock and so if all we have is talk and there is no action the stock will stumble.
However, we already see a more intense focus on costs, including a rethink about where to best allocate R&D dollars, and this has so far impacted the bottom line in Q4 2013 and Q1 2014.
In research that we published on February 24th, we suggested that DOW could restructure its portfolio and cut costs to such a degree that we could see the stock above $80 per share. We did not include an MLP structure in that thinking – in part because we do not have the data to model an MLP by virtue of the way that DOW reports earnings – however, in our view an MLP would increase this target.