Description

Overview

New Dow was spun out of DowDuPont on 4/1/19, opening the following day at ~$55/share, after a multi-year process of smashing Dow and DuPont together and creating three rejiggered companies from two. With the spins complete, I believe Dow to be the cheapest of the pieces.

Thesis

Materials generally and Basic/Commodity Chemicals specifically have been a terrible place to be for quite a while. Dow is a mispriced security in a bombed out sector. I believe most of the mispricing beyond the sector to be caused by pessimism around the ethylene/polyethylene (“E/PE”) business, which has pricing tied to oil and which has seen capacity expansion in the past few years. Also potentially contributing to the mispricing is the fact that Dow is a newly spun out security that is different enough from old Dow but perhaps still carries that taint (poor management and high on the cost curve - both no longer the case).

At today’s price you’re paying 6.7x/5.8x  2019/2020 consensus EBITDA and 11.9x/9.4x ‘19/’20 consensus EPS and getting a 5.5% dividend yield. I believe mid-cycle earnings power to be materially higher than 2020 consensus.
We’re at the tail end of global E/PE capacity additions, and once the market sees capacity utilization & margins move higher I believe the stock will re-rate.

Financial Overview

Dow and DowDuPont have recast their segments more than ten times, so you should note that the most recent segment statements provided in an 8-k on 6/3/19 will diverge from my historical statements by trivial amounts.
I’m providing my best crack at 10 years of financials for each segment because I think viewing commodity businesses through a cycle is important, and for the sake of continuity I haven’t followed the latest recast. In the Consolidated Results below you can compare my estimates to that 8-k for reference.

Also note that in my 2019E numbers I’m following the latest segment reporting. 

Finally, keep in mind that the Rohm & Haas deal in ‘09 distorts the ‘08 to ‘09 comparison, but the comparison of the business in ‘09 vs. ‘10 and ‘11 is valid and instructive. 

Performance Materials & Coatings

Financials:

Description:
Consumer solutions: polymers, emollients, chelants, dispersants to HPP companies. Goes into skincare products, soaps, sunscreen. A higher end business. 
Coatings & performance monomers: acrylics that go into paint & coatings, propylene based inputs & plenty of competition

Industrial Intermediates & Infrastructure

Financials:

Description:

Industrial Solutions: contains Amines, ethylene oxide / ethylene glycol (EO/EG), oxygenated solvents (divested), and polyglycols, surfectants & fluids. Also has smaller solar and oil & gas businesses.
Polyurethanes & CAV:

Construction chems including sealants and construction adhesives.

Polyurethanes includes 4 parts - Isocyanates, Propylene Oxide/ Propylene Glycol (PO/PG), Polyols, and Polyurethane Systems

CAV - only the European Chlor-alkali business as the North American business was sold to Olin in '15. 

Packaging & Specialty Plastics

Financials:

Description:
This is a straightforward segment containing ethylene crackers and related co-products. Economics are largely determined by the natural gas / oil spread (or more accurately the naphtha / NGL spread). 

Consolidated Results

Here is the 8-k on 6/3/19 showing the newest segment breakdown. You can compare ‘17 and ‘18 to my numbers, with the big adjustment being changes in transfer pricing of intermediate chems between the segments.

2019E and “Mid-cycle”

Two key considerations for me are the mid-cycle earnings power of the business and a reasonable downside scenario.

Management has set their dividend and buyback targets based on being able to keep the dividend and the investment grade rating in recession scenarios. They’ve also targeted total shareholder returns based on returning 65% of mid-cycle earnings, where approximately 45% should be the dividend and the remainder should be buybacks. With a 70c/q dividend, management implies mid-cycle EPS of $6.22 (2020 consensus is $5.45).

I’ve arrived at similar mid-cycle and downside scenarios:

For a downside scenario, check out 2009 EBITDA for the segments above vs. 2010 (better to look this way vs. ‘09 vs. ‘08 given the Rohm & Haas acquisition in early ‘09). EBITDA in ‘09 vs. ‘10 was almost 40% lower. Note that ‘09 doesn’t include a full year of Rohm & Haas and that it was probably more severe than a typical future recession might be. So Dow management’s estimates of a 30-35% compression in EBITDA seem reasonable to me. 

For mid-cycle, the key assumptions I’m making are around remaining synergies and stranded cost removal, a modest rebound in E/PE margins, and breakeven results at Sadara (vs. losses currently). 

Most synergies and stranded costs will be realized this year (see the 3/18 presentation) so I’m taking these values at face. 

E/PE margins are a bit trickier, but I’m essentially having them regain about $560mm in 2020 after declining $750mm in ‘18 (see Dow bridge below) and another estimated $750mm in 2019. 

I’m assuming that global operating rates in 2020 will at least match those in 2018 and most likely exceed those of 2018 and 2017. Despite that, I only have Dow recovering $559mm of E/PE margin in 2020 after $1.5b of E/PE margin compression from ‘17 to ‘19. 

Dow’s view (see below), and LYB’s view for that matter are that operating rates will actually improve.

Bear cases around E/PE operating rates and margins come from a few places: a bearish view on oil, a bullish view on ethane, or a view that capacity will come on as stated from various global players. I won’t make a call on oil besides using current prices for my estimates, but I think the view that ethane would spike as all the new capacity came is so far proving to be wrong (as we trade near fuel value currently). As for capacity, data providers like IHS basically have to take what companies say at face, because doing otherwise creates all sorts of political/relationship issues. Plus, it’s just easier for them. But the history of E/PE capacity has shown that capacity is almost always delayed and sometimes canceled and so with reasonable assumptions around normal timeframes for stated capacity adds we should see improving operating rates. 

With that said, here is my EBITDA bridge from 2018 to 2019E and 2020E (which doubles as my mid-cycle case). Keep in mind that if you’re comparing 2018 EBITDA to the segment results from the 8-k that I bridge from Form 10 EBITDA (rather than segment EBITDA) so I capture true standalone economics. 

My mid-cycle does result in a dividend close to the 45% payout contemplated by management, so I think I’m in the right ballpark.

Valuation

I like the fact that management has committed to keep capex under D&A for the next three years and that 2/3rds of Net Income is slated to be returned to shareholders through dividend and buyback. This is a marked difference from capital allocation at old Dow and gives me confidence that I don’t have to discount the multiple I use to account for poor capital allocation. 

Thus, I simply use 10x my 2020E / mid-cycle EPS number to get a price target of $61, making DOW an 83 cent dollar. 

Barring a global recession, I think we’re setting up for a tighter E/PE environment, which would bring EPS in 2020 $0.50-$1.00 higher.

We could also see multiple expansion in a tightening environment or simply from investors believing that 10x EPS 6.3x EBITDA is too low. 

Risks

Global recession. Larger than expected capacity expansions.

Catalyst

Ethylene / Polyethylene operating rates and margins tighten.