Dow – Loeb versus Liveris – Watch From A Distance

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 17th, 2014

Dow – Loeb versus Liveris – Watch From A Distance

In the last few days we have seen opening salvoes from both sides as Third Point tries to get Dow Chemical to think about its strategy more radically.

  • Dow has rejected Third Point’s break-up idea, faulting the suggestion because of lost purchasing and research synergies. Dow suggests that shareholders would lose out.
  • Third Point has countered by suggesting that Dow’s reporting of results is so opaque that it is impossible to understand how that conclusion was reached. Third Point has offered to sign an NDA in order to get a closer look at the logic and the analysis done by Dow.
  • Third Point was also quotes as saying “Transparency is essential considering Dow’s undistinguished track record of capital allocation decisions.”

Broadly, we have to come down on the side of Third Point. We believe that there is value to be unlocked at Dow and that the current strategy, while perhaps different and more articulate than in the past, is no less flawed than the strategies of the past. At a more granular level we would differ from Third Point in that we believe that the commodity piece is bigger than Third Point suggests and much bigger than Dow suggests.

If this debate escalates, we believe that there is risk that Dow makes an acquisition to supports its “integrated” strategy, either at the front end or the back end of the value chain (NGL fractionation, pipelines, E&P, packaging, more Ag). Dow has a lot of borrowing capacity given cash flows and the strength of its balance sheet. This would make Third Point’s job much harder, but given valuations, would likely be reasonably dilutive, sending the stock lower. We think that the stock has much more risk to the downside than the upside at this point.
See also our recent piece on higher Q1 costs for US commodity producers
.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Stepping back, the fact that Dow has underperformed is undeniable. Over the last ten years the company has created shareholder value that is a low percentage of the capital it has spent (as was illustrated in Exhibit 1). There are other examples of chemical companies that have done poorly, but Dow sticks out.

  • The speed with which general chemicals and polymers commoditize is part of the problem. R&D and SG&A costs are inflated at Dow, chasing a specialty dream that has failed to materialize – i.e. the money spent has not (and will not in our view) create enough value to generate an adequate return on the investment – the customer may benefit as may the final consumer, but the shareholder does not.
    • Dow may be able to point to specific products that are making an impact, but they are too small in a portfolio that is too large and the overall numbers suggest that the strategy is destroying value.
  • The low cost synergy argument is also flawed in our view because Dow’s basic chemical footprint is significantly oversized versus any specialty elements of the portfolio. Others that have the vertical integration strategy have right sized their commodity footprint to meet their true added value demand – DuPont has as much ethylene in the US as it needs internally; BASF has divested ethylene – through Basell – such that it has as much as it needs to support its specialty portfolio. At the same time, Dow is talking about divesting its chlorine business without any logical accompanying ethylene capacity
    • In our long term observation of the company, Dow has a habit of playing the current market trend, and the current market says that ethylene is profitable. Consequently the company is trying to sell chlorine without ethylene because it wants to keep the ethylene profits. In our view this is strategically flawed and very short sighted.

So what to do with the stock?

If Third Point is going to make any progress from here it is going to need support, as it is unlikely that it has enough ownership to mount a proxy fight alone. It is clear to us – through our client discussions – that there are plenty of disgruntled longer-term holders of DOW, not unhappy with the last 12 months but unhappy with the longer-term. What is less clear is whether they would be willing to support change pro-actively. The more traditional holders know Dow Chemical better than any, and generally play for the cycle and buy on valuation lows. They also know the challenges facing anyone trying to make more radical change – probably better than Third Point does at this stage.

Dow’s strategy will not benefit from tweaking, in our view, but it would benefit from a radical rethink. It is clear that Dow management is opposed to a radical rethink – so what are Dow’s options if Third Point does not go away?

Dow is very under-levered today and in the past has not been shy about acquisitions. Today, an acquisition, in line with the current strategy – so at the front end of at the back end of the chain – might be enough to complicate the story and encourage Third Point to seek opportunities elsewhere. Dow could move downstream into more Ag or more electronics or more specialty polymers or packaging. It could also move upstream to secure US feedstock, though an MLP acquisition or JV or an E&P purchase. Or it could take an equity ownership in or accept an equity investment from an oil and gas producer. All of these would be consistent with the currently stated strategy but would be at odds with the recent guidance towards share buy-back and disciplined use of capital – however, things change.

Dow’s acquisition track record is one of the poorest in the Industrials and Materials sector and the company has destroyed more value buying than it ever has building. Interestingly, Dow’s stock was in the low 40s when it announced the Union Carbide acquisition in 1999 and was again in the low 40s when the Rohm and Haas discussions were ongoing. The Rohm and Haas story is recent and should be well known – for Union Carbide, Dow’s stock did not return to the low 40s until 5 years after the deal was announced – part of that was cyclical, but most was dilution and leverage.

We would not own the stock today, we think that the downside risk far outweighs the upside. If Third Point can get some other shareholder support quickly, we might change our view.

We will follow-up shortly with a piece outlining what we suggest would be a better course.

Where Loeb Is Probably Right – Complexity and Value Destruction

In our view, Third Point has addressed two core truths about Dow – that the company has a very poor track record of capital allocation, and that the complexity of the company and the reporting structure makes it very difficult to understand where the real profit is being made and where capital is well allocated and poorly allocated. As Third Point states, investors do not have either enough or appropriate data to be able to judge the assertions made by Dow management that the Third Point suggestion is not as good for shareholders as the current strategy.

It is hard to push back on the value destruction issue. As shown in Exhibit 2, Dow has consistently failed to deliver value for its shareholders when put in the context of the money it has spent. We have written on an industry basis about many of the reasons for this – which in our view include:

  • Optimism – Dow’s glass is always more than half full and the company tends to look too positively on its environment, leading to assumptions that are generally too optimistic as it comes to capital allocation decisions. The recent bout of conservatism for Dow with regard to the global economy is unusual, but at the same time self-serving, in that it might discourage others from going down the same new capacity path that Dow is on.
    • Dow’s recent rhetoric might be conservative, but its investment actions are not.
  • Innovation/R&D – This is a huge expense for Dow as it tries to “up-sell” it’s plastics and chemicals portfolios – i.e. as it tries to make its “performance” businesses live up to their titles.
    • The best large companies have a negative return on R&D spend and in our view DOW is compounding the problem but using its strategy to justify an oversized cost base in terms of SG&A as well as R&D.
    • Note that for a company with a started goal of cutting costs in 2013 and an assertion that the cost base was reduced by $500 million over the year – during which it divested its polypropylene technology business (SG&A and R&D intensive) – both SG&A and R&D rose year on year in Q4 2013.

Exhibit 2

Source: Capital IQ and SSR Analysis

The Complexity Makes It Hard to Understand Why Things are Not Working

Dow has changed its reporting structure and format three times since 2007, which is a lot; but the way in which it reports segment results has always been opaque, as the company choses to transfer products from one business to another at “cost”. As we are not sure whether costs are actual or some sort of standard, this adds to the confusion, but the bigger impediment to understanding what is going on is the lack of clarity around where the real value lies in the chain. If the company was transferring product at alternative free market prices we would be able to judge whether the integration was indeed bringing any benefit to overall margins. The reality is that overall margins at Dow, as well as returns on capital, are low, and it is hard to identify why.

In the middle of 2013 we published a piece of
research on “complexity”
, concluding that the market was becoming increasingly leery of complex stories and awarding such companies with progressively lower relative multiples. Our key conclusions were best summarized in the charts shown as Exhibits 3 and 4. Our assertion at the beginning of the piece was that complexity impacted in two ways – it made the story hard to understand from an investor perspective and it made the company hard to manage.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

The best example of a complex story that worked was GE in the 1990s. This was a complex company that got increasingly complex over time – no one cared and the stock rallied because the company consistently put up the numbers. The moment the earnings consistency stopped the stock dropped dramatically because investors do not want to own something they do not understand.

In our analysis we defined complexity by dividing the number of reporting segments by the percent of business that is in the US. On that basis Dow screened as one of the most complex stories in Industrials and Materials – as did DuPont, ITW, GE, MMM and CAT. Note that DD and ITW are in the process of divesting meaningful businesses today. Dow’s proposed divestment of its chlorine business would not make the company meaningfully less complex to understand in our view and could make matters worse.

BUT…What if Liveris is Right?

If we were to take all of history off the table and we were to look at Dow’s stated strategy and assume that the company does have many of the answers – what could the future look like?

Dow believes that it can add value to – or “up-sell” – its basic chemicals and consequently integration is the key. Dow today generates around $2.85 of revenue for every pound of ethylene capacity it wholly owns globally (not including capacity owned through JVs for which the company does not report revenue). LyondellBasell is slightly higher at just over $3.00 per pound. BASF, on the other hand, generates $18 per pound of ethylene and DuPont $24.

Given that LYB is happily in the commodity business – i.e. purposefully and deliberately selling commodity chemicals and plastics – this analysis shows Dow in a poor light – Exhibit 5.

Exhibit 5

Source: SSR Analysis

Note: LYB’s revenues are helped by its refining business – approximately 25% of sales, which are unrelated to commodity and intermediate chemicals. DOW’s are helped by Agricultural Sciences and Electronic and Functional Material – approximately 20% of sales. Taking these pieces out a more direct comparison would place both companies at around $2.3 per pound of ethylene.

So, we have two possible conclusions here – either Dow truly fails to understand the nature of its business and is pursuing a strategy doomed to failure – OR – Dow has the ability to upgrade its portfolio dramatically, moving on a path towards BASF and the potential upside is huge!

If Dow could double the revenue it generates per pound of ethylene capacity, and maintain its current EBITDA margin, it would still be well behind BASF from a revenue per pound perspective, but would generate EBITDA of around $13bn and earnings per share of close to $7.00.

Dow historically trades at a discount to the market multiple, but if we assume a 16x multiple for the market and a 10% discount for Dow you would get a value of $112 per share.

(This math generates an EBITDA margin for a possible Dow that is slightly lower than the current BASF EBITDA margin of approximately 14.5%)

The flaws in this analysis are many – it is simplistic, at best – but it does provide a frame of reference and perhaps insight into the thinking at Dow’s head-office. If this is the case, it illustrates why Dow would be so quick to dismiss other strategic options and be so keen to defend its own position.

This sort of conviction could easily push Dow down a path of defense through acquisition.

©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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