Dow – A More Optimal Path, But a Hard Destination to Reach

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 24th, 2014

Dow – A More Optimal Path, But a Hard Destination to Reach

  • Our proposed path for Dow would involve selling/spinning the Ag Science and Electronics/ Functional Chemicals businesses and then running the balance of the company as a low cost but high quality commodity business.
  • We would not separate the Coatings and Intermediates business. Dow is right here in that integration is important. Moreover, we believe that much of this business is commoditizing and should be managed on that basis.
  • As we have indicated in other research, we think that Dow’s current quest – to upgrade the whole portfolio to hopefully enjoy better margins, is likely unachievable and pursuit of this goal is destroying value each year and resulting in the serious misallocation of capital.
  • LYB has a great commodity chemical business with good and growing margins as well as growth and great free cash flow. Arguably, Dow’s portfolio is better and with a similar approach to management should generate better margins and more free cash than LYB.
  • The challenge is how to get there – LYB had to go through bankruptcy. The US shale advantage gives Dow a large cash cushion and no fear of financial failure, so the risk is that the money just keeps getting spent inefficiently.
  • Without radical change we have a stock that is more than fully valued – with the change suggested by Third Point there is a risk that the specialty piece does not command the multiple premium expected, but there is still upside from where we sit currently.
  • Our plan, if executed well could create more than 100% upside.

Exhibit 1

Overview

In
recent research
we expressed a view that we thought that neither the Dow Chemical management strategy nor the proposal put forward by Third Point was the optimal path for the company. Having made that statement we felt that we should probably explain why and show our preferred path. Like Third Point, we do not have access to any data that is not public and this forces us to make assumptions, which we will clearly identify as we run through the analysis.

Our approach is similar to Third Point’s – run the commodity business like it is a commodity business – but we differ on where to make the split and what to do with the rest. Our proposal involves a significant amount of cost cutting in large part coming from a significantly reduced work force. It would involve the company drastically cutting its R&D budget and significantly reducing the share count through buybacks.

Step 1 would be a spin out or sale of the Agricultural Science business. It is worth more to someone else or as a stand-alone business and would allow Dow to either split/swap stock or buyback with cash proceeds.

Step 2 would be the divestment of the electronics business – either as an outright sale or in JV with another company. Dow and DuPont had a successful elastomers joint venture for a number of years, they should look at the same option for electronics – ultimately taking the business public or selling it to a third party.

Step 3 coincident with steps 1 and 2 – draw up a plan to become the lowest cost producer of everything left in the portfolio and stop trying to incrementally improve every product through expensive R&D in the hope of putting a brand name on it and then eventually only selling it for a few pennies more than the generics.

Step 3 is by far the hardest as it would involve dramatic cuts in R&D and SG&A; head office costs would need to be cut dramatically.

Our rough estimates would see Dow able to reduce its share count by as much as 35% through divestments and buybacks. Further focus on running the commodity business with an appropriate cost structure could add $2-3 billion to EBITDA, not including the capacity growth plans that the company already has in place. On this basis we have a 2013 equivalent based value of as much as $87 per share (after share count reduction), ahead of any EBITDA growth from new capacity.

We do not believe that splitting the company in two would yield as high a value unless there was very strong and prioritized cost reduction focus in both companies.

Agricultural Chemicals – A stand-alone or a sale

Dow Chemical’s agricultural sector is a good business; it is relatively separate from the rest of the company and has seen strong growth over the last several years, benefiting from favorable trends in agriculture but also some good legacy products and new products.

The company has a revenue growth rate that is not dissimilar to either Monsanto or Syngenta – two pure play agriculture comps – Exhibit 2. Consequently, it would not be unreasonable to value this business in a similar way to the others – Monsanto trades at just over 13x EV/EBITDA and Syngenta just under 13x EV/EBITDA – so let’s take 13x as a reference.

Exhibit 2

Source: Capital IQ and SSR Analysis

Dow has a lower EBITDA margin in its Ag business than the other two, even if we do not allocate for corporate overheads, which would bring down the margin – Exhibit 3. There are a couple of ways to look at this – either Dow’s collection of products and overall business mix limits the EBITDA margin, or this is another opportunity to lower costs. Certainly a buyer of the business would expect to get synergies, so 13x EBITDA should be thought of as a minimum price.

Exhibit 3

Source: Capital IQ and SSR Analysis

Dow had just under $1bn of EBITDA from this business in 2013, so we should think about a minimum value of $13bn.

Electronics and Functional Materials

In earlier work we struggled to find the right comps for this business and perhaps it makes sense to think about the two pieces separately.

Electronics

The electronics segment was 47% of the segment revenue is 2012 – so $2.1bn. With a 23% EBITDA margin this business generated around $490 million of EBITDA in 2012. Sales were flat in 2013 according to the recent 10K, and 2012 sales were down 2% from 2011. EBITDA was higher in 2013 because of higher Dow Corning equity income.

We could reasonably put an 11-12x EBITDA multiple on this business, despite the low growth, valuing it at around $5.5 billion. (Dow paid around a 13x multiple for Rohm and Haas and the bulk of this Dow segment was one of the crown jewels in that portfolio).

Functional Materials

We could make a case that this stays with the commodity piece as there is some integration benefit. However, it is a higher service/SG&A business and if we are ultimately trying to create a focused commodity mindset in the core business this would likely be a distraction.

Sales are around $2.5bn – 5 percent higher in 2013 than in 2012, and EBITDA was around $550 million, but this would be inflated from the practice of transferring products internally at cost. It is unlikely that DOW could sell this business based on the published EBITDA number as it would have to give away all of the margin in all of the materials that flow through. We will assume the EBITDA above for illustration – if we lowered it, the commodity EBITDA would increase.

If we average the EBITDA multiples of the specialty companies that make up our index we get 12x – the details are provided in Exhibit 4. We have excluded EMN in the average as we are still not sure that EMN fits the specialty definition and have only recently included it in the group. At 12x we get a value of $6.5bn.

Exhibit 4

Source: Capital IQ and SSR Analysis

Selling or spinning off pieces could meaningfully reduce the share count:

  1. Spin/swap out Ag – at $13bn it would be possible to reduce the DOW share count by as much as 280 million – almost 22% of the fully diluted shares outstanding and leaving Dow with an outstanding share count of around 1.0bn. (This takes care of the preferred stock conversion also).
    • Selling Ag would be less attractive as it has a low asset base and there would likely be a high tax bill.
  2. Selling Electronics and Functional Materials is a real option as the asset base is high and the tax liability would be small.
    • Assume that DOW realizes $10bn conservatively. This would allow the company to buy back another 220 million shares.
  3. So now we have a residual business with roughly 800 million shares.

Alternatively, the Function Chemicals business separately – or combined with Electronics – could be expanded before sale, by including the elements of Dow’s “Performance” businesses that are unique and have a stable and very profitable margin structure; some engineering plastics, wire and cable polymers, pieces of the materials business. The dilemma with this however is that every business thinks it is a specialty at Dow and it is unlikely that a sensible split could be agreed. Perhaps it would be better to sell off small pieces of what we will define as the commodity portfolio below over time as higher value owners emerge.

The Rest – Low Cost Does Not Mean Low Quality

The balance of Dow’s businesses should stay together in our view – with the exception of some smaller targeted divestments where a sale can yield a much higher earnings multiple. Dow should embrace the idea that it cannot stop commoditization, regardless of how much it spends and it should run the business as a very good – growing – cash cow.

Firstly – why would we include Coatings and Infrastructure?

Option 1 – Keep with commodities

  • Coatings and Infrastructure Solutions is commoditizing and many of the products no longer command the pricing premium that they did. Advances in paint formulation and the higher price of acrylates relative to other latexes suggest that this business should be run on a much leaner basis, with a focus on costs and product standardization.
  • While it may still be a “better” business than many of the performance chemicals and materials businesses, it is on a poor path – limited growth over the last few years and very poor operating margins, even if one accounts for the high D&A.
  • Propylene prices are going to remain high relative to ethylene in our view – changing the dynamics of most of this business dramatically. Dow was wise to exit polypropylene as it saw the relative cost issue emerging. The same focus applied to this business should result in a changed approach to managing the business.
  • Integration is important, as Dow suggests, but the focus needs to be on streamlining rather than up-selling this business.

Option 2 – Spin of as part of a specialty business – Third Point suggestion

  • It would increase the size of the specialty business, but in our view it would be the ugly step-child, as it would be the one with consistently disappointing earnings.
  • As is always the case, all investor attention would be on the business with the most uncertainty – this one – and it would drag down the overall multiple of the company.
  • Add

Option 3 – Try and sell it – set a reasonable but ambitious target price – if you fail revert to Option 1

  • Maybe others do not think that the acrylates business is as structurally damaged as we do. If so, there should be a buyer who would place a higher multiple on it than would be implied in a “commodity Dow” multiple.

The “New Dow” as we propose it has better assets and better products than LYB, yet makes less money. This is totally fixable – but it is a difficult path:

We have created pro-forma commodity chemical simplified financials for both companies by stripping the refining business out of LYB and the Ag and Electronics and Functional Materials business out of Dow. In both cases we have stripped out equity income so that we can arrive at a fair EBITDA margin for the wholly owned businesses. We look at the last three years of data.

As we think about the comparison:

  • DOW and LYB have similar levels of revenue per pound of ethylene capacity – around $2.25.
  • Both companies have assets outside the US with DOW slightly more exposed to Europe than LYB and also more exposed to the rest of the world. LYB’s Chemical business has around 55-60% of its sales outside the US – for DOW the share is higher at around 65% of sales.
  • Major products for both include: ethylene, polyethylene and propylene oxide and polyurethane intermediates. LYB has a big polypropylene business – DOW divested its polypropylene business in 2011.
  • LYB has a meaningful methanol and acetic acid business. Dow has acrylates, amines, chlor-alkali and chlorine derivatives, specialty polymers and rubbers, polyurethanes, epoxy resins, and acrylics, as well as many related and derivative products.

On the surface, Dow looks like it has the much higher value added portfolio, but is making less money – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

The obvious first step in any plan here would be to get to the EBITDA margins that Lyondell enjoys. A reasonable secondary goal would be to get to higher margins given the business mix.

Based on the sale proceeds and actions outlined earlier, the Dow Commodity Company would have EBITDA per share of around $8.20, versus the 2013 actual number of $5.40 assuming no change to the cost base. If the EBITDA margin could be raised to the LYB level we would have EBITDA per share of around $11.50. This would generate EPS of around $5.40 per share.

At a 15x multiple this generates $81 per share.

At 9x EV/EBITDA – you get $87 per share.

If we are out by 25%, the math is still compelling. We would argue that the Dow portfolio should ultimately be able to realize a better margin than Lyondell and that would push valuation towards $100 per share.

Clearly the value comes in two pockets – first exiting businesses for which Dow is not the high value owner and second driving the cost base of the remaining business lower.

Great in Theory – Highly Unlikely In Practice

Dow is underperforming LYB for two reasons in our view.

  • The cost base is too high.
  • The management mindset is not focused on squeezing the most out of what it has. Instead it is focused on what the company could be – it is a mindset of hoping for the future rather than driving value today.

It is easy to forget that LYB is where it is today only in part because of a robust current strategy and focused management team. The company went through bankruptcy which focuses everyone on how to run the business more efficiently and primarily for cash. In Exhibit 6, we show a very rough pro-forma for the LyondellBasell that went in to Bankruptcy and the one that we have today.

The gain in EBITDA has a great deal to do with US natural gas falling from almost $7.00 per MMBTU in 2006 to current levels, but note the lower R&D, SG&A and headcount. These are all difficult things to do, but relatively easy when you have a gun to your head.

Exhibit 6

Source: Capital IQ and SSR Analysis

Dow would need to be run with a vision that is very different from the vision today and would need to go through some major upheaval to get on a new path. We recently identified a couple of companies that were running their businesses very differently today than they had in the past, and with great success, PX and EMN. In the case of EMN, an overly optimistic view of PET resulted in a near-death experience in the late 1990s, forcing change – new management, in part from outside the company made the difference. In the case of PX, again new management, from outside the company, radically changed the approach to business – the results have been very positive but at the time the changes were painful.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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