Dow Chemical. Key Statistics. Trading Statistics. Margins and Ratios. Investment Thesis. 20 November 2015 Major Diversified Chemicals

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1 20 November 2015 Major Diversified Chemicals Dow Chemical Ticker: DOW Current Price: $53.32 Recommendation: Outperform Price Target: $56.37 Investment Thesis Key Statistics 52 Week Price Range $35.11-$ Day Moving Average Estimated Beta 1.41 Dividend Yield 3.28% Market Capitalization (Mil) 3-Year Revenue CAGR -1.02% Trading Statistics Dow Chemical is shifting into producing higher margin performance plastics while moving out of the lower margin chemical commodity business. Dow will continue its goal to divest $7 billion to $8.5 billion worth of chlorine and caustic soda related businesses Dow Chemical is the second largest chemical producer in the world and the first largest domestic producer by sales. Dow continues to expand globally and works to enter new markets within emerging economies Dow is focusing its investments both in the U.S Gulf Coast and also with its joint venture with Sadara in Saudi Arabia. These two investments will supply Dow with low cost feedstocks, such as ethylene and polyethylene. These feedstocks are essential to the production of many of Dow s finished products Dow Chemical is on track to complete a $5 billion share buyback increasing its dividend to.46 cents a quarter, or $1.84 annum per share. Dow will buy back $1 billion shares in the fourth quarter of 2015 and another $.5 billion in the first quarter 2016 Diluted Shares Outstanding (Mil) Five-Year Stock Chart Average Volume (3-Month) Covering Analyst: Ryan Heiss rheiss@uoregon.edu 14.64(Mil) Institutional Ownership 69.64% Insider Ownership 30.36% EV/EBITDA (LTM) 7.87x Margins and Ratios Gross Margin (LTM) 27.43% EBITDA Margin (LTM) 18.39% Net Margin (LTM) 12.15% Debt to Enterprise Value.27x $ $50 80 $ $ $20 30 $ $0 0 11/2/ /2/ /2/ /2/ /2/ /2/2015 Volume (in MM) Adjusted Close 50-Day Avg 200-Day Avg 1 University of Oregon Investment Group

2 Business Overview Company History Figure 1: First Chemical Plant Source: Google Images Figure 2: Middle East Joint Ventures 2 5 Kuwait Saudi Arabia UAE 4 Dow Chemical Company is the largest chemical producer in the United States and the second largest in the world by sales. Dow is headquartered in Midland, Michigan and operates in 35 countries worldwide. In 2014 Dow had sales north of $58 billion employing over 53,000 people and offering more than 6,000 products in over 180 countries. Dow Chemical has an extensive product mix ranging from pesticides to plastics used in food packaging. Herbert H. Dow, a Canadian chemist, founded Dow Chemical in The company first started extracting chemicals such as chlorides, calcium, and many others from Michigan s rich brine deposits. Dow Chemical was incorporated in the early 1900s and worked alongside Midland Chemical in bromine extraction. In the early 1900s, Dow shifted its focus from extracting bromine to producing chemicals such as phenol and magnesium for the use in World War 1. During World War II, Dow Chemical secured a contract with the British to supply magnesium used in the manufacturing of airplanes. After the war, Dow moved forward with an emphasis on R&D since it had to share manufacturing secrets with competitors during the war. By the mid-1980s, Dow was receiving half of its income from supplying commodity chemicals mostly to foreign consumers. Throughout the 1990s, Dow continued to change its market focus through the sales and acquisitions of different commodity businesses such as foam products. Joint Ventures Dow Chemical has been active in both acquisitions, and divestments of businesses in order to achieve its operating goals. Dow Chemical s mission statement states, To passionately create innovation for our stakeholders at the intersection of chemistry, biology, and physics (Dow). Dow Chemical has most recently acquired ExxonMobil s 50% share of Univision Technologies LLC, which was previously a 50/50 joint venture between Dow and ExxonMobil. Currently, Dow is in talks of buying out Corning s stake of Dow Corning, a joint 50/50 venture between both Dow and Corning. Dow Corning is a global supplier of silicone-based materials and currently provides high value to Dow s downstream production. Dow has recently divested AgroFresh, a postharvest specialty chemical company. Dow recently sold ANGUS Chemical Company that operated under its materials and chemicals segment for $1.2 billion. Dow Chemical continues to divest and invest in assets in order to continue its trend into higher margin specialty plastics. Dow Chemical operates and sells its products under five main categories. These segments are in order as Agricultural Sciences, Consumer Solutions, Infrastructure Solutions, Performance Materials/Chemicals, and Performance Plastics. Dow Chemical has gone through recent restructuring and has moved from reporting its revenue in six main segments into five segments listed below. Agricultural Sciences Dow Chemical s Agricultural Sciences segment represents about 13% of its total operating revenue. This segment is a global competitor by providing countries around the world with crop protection, biotechnology, pest control, seeds and healthy oils such as omega-9. Dow Chemical achieves growth in this segment from new patent products. Research and Development is key to developing UOIG 2

3 value through innovative products. Innovative patent products and seeds allow farmers to further bushel yields, while also protecting crops from disease. Figure 3: 2014 Revenue by Segment Source: DOW Filings Figure 4: Agricultural Sciences Revenue (USD in Billions) % % 13% Agricultural Sciences Consumer Solutions Infastructure Solutions 8% Materials and Chemicals Performance Plastics 14% Agricultural Science is comprised of two sub segments: crop protection and seeds. Crop protection s key product lines involve insecticides, fungicides and herbicides. Crop protection makes up the majority of the sales around 75% with seeds comprising of the other 25%. Sales by geographic region include North America with the majority of sales around 40%. The rest of sales comes from EMEAI, Asia Pacific and Latin America. Due to seasonality, Agricultural Sciences is susceptible to volatility in volume as a result from weather conditions, planting seasons, and type of crops planted. Sales and EBITDA have shown past trends of strong first half of the year numbers because of the planting season in North America. Even with global population growth rates slowing, the demand for scientific protection of crops continues to experience growth, mainly from developing nations. Further scientific discoveries within this segment and continued innovation from Dow will allow for further growth among this segment. Consumer Solutions Consumer Solutions segment makes up around 8% of Dow s total sales and operates with three sub segments; Consumer Care, Dow Automotive Systems and Dow Electronic Materials. Dow s Consumer Care sub segment provides products to the everyday consumer with normal household products. Products in this category range from personal and home care products to food and nutrition. Dow collaborates biology and chemistry together with the use of surfactants and solvents to produce performance-enhancing solutions to consumers all over the world. Dow Automotive Systems within Consumer Solutions creates products that provide for the well-being of drivers and passengers around the world. This segment produces plastics, automotive fluids, adhesives and other necessities needed for vehicles to perform optimally and align with safety regulations. Dow is also a global supplier of products that support electronics. This market supports materials used in everyday consumer products such as smartphones, LED television screens, computers and laptops. Dow creates chemicals that are used in the productions of display materials and flat panel displays. Acrylic resins and silicone resins are just a portion of the chemicals that Dow supplies to manufacture everyday electronic consumer goods. Infrastructure Solutions: Infrastructure Solutions is made up of four sub segments: Dow Building and Construction, Coating Materials, Energy and Water Solutions, and Performance Monomers. The Infrastructure Solutions segment is responsible for around 14% of Dow Chemical s total sales. Each sub segment within Infrastructure Solutions makes up approximately a quarter of sales mainly from North America and Latin America. Dow s Building and Construction segment continues to see growth as trends of urbanization have become increasingly steady. Products range from insolation, thermal performance materials, air sealants, and coating materials that resist weatherizing. Dow Chemical s Infrastructure Solutions segment has a joint venture partnership with Corning Inc. in Dow Corning. Dow Corning supplies raw silicone and silicone-based products to both Dow as intermediate goods and to the global market. Silicone sealants provide Dow Building and Construction UOIG 3

4 Figure 5: Consumer Solutions Revenue (USD in Billions) Figure 6: Infrastructure Solutions Revenue (USD in Billions) Figure 7: Performance Materials/Chemicals Revenue (USD in Billions) with superior sealant technology that solve structural glazing while increasing energy efficiency within buildings. Performance Materials and Chemicals Performance Materials and Chemicals consist of chlor-alkali, chlorinated organics, epoxy, industrial solutions and polyurethanes, all representing around 26% of Dow s total revenue in Performance Materials and Chemicals has experienced lower EBITDA margins than Dow s other segments. Typically materials and chemicals produced in this segment are back-integrated as feedstocks into the production of further finished goods, working to create a low cost production base with a reliable steady supply. Materials and Plastics has a global consumer market and has experienced heavy decline in year to year sales. This is a result of the past year s strengthening of the USD and the global economy slowing. Dow s Chlor-Alkali and Vinyl business manufactures chlorine for the integration and alignment for the production of further products downstream. 90% of total chlorine and chlor-alkali produced is consumed in downstream production within materials and chemicals. Dow is moving away from its oldest business and divesting close to $5 billion in assets relating to the chorine business. This is partially due to a strategic shift to move out of lower margin performance materials and chemical products and to move into higher margin specialty chemicals and plastics. Dow Chemical will continue to plan on manufacturing feedstocks that it will utilize in production. However, Dow will focus on producing feedstocks that are inputs to higher margin products with their goal of increasing Performance Materials and Chemicals overall EBITDA margins. Performance Plastics Performance Plastics is responsible for Dow Chemical s highest percentage of revenue around 39% with sales over $21 billion in Dow s plastics business, which involves packaging plastics, specialty plastics, and hydrocarbons, has a broad geographic reach of over 100 countries. These three plastics businesses work collectively to provide higher value to Dow customers all over the world, which show great potential for long-term growth. Market growth for performance plastics is seen to come from socioeconomic improvements within emerging countries. Dow s plastics facilities are placed in strategic areas that provide Dow easy access to developing countries that heavily rely on the use of packaging material. Ethylene and propylene are key and crucial feedstocks produced by Dow s hydrocarbons business that are back integrated into Performance Plastic s finished products. The production of ethylene is derived as a by-product of natural gas or crude oil. Ethylene is used in everyday plastic products and is a high volume production ingredient to finished products within Dow s plastic business. Dow Chemical s Hydrocarbons business is essential to the production of finished goods in Performance Plastics segment. In order for Dow to take advantage of the cost savings from manufacturing ethylene and propylene, it has strategically placed its ethylene and propylene facilities within close proximity to further integrate both products collectively and drive costs down. Since Performance Plastics is a key revenue driver, the company continues to shift out of low margin basic plastic products and into higher margin specialty plastics. New investments intended to take advantage of cheap shale and natural UOIG 4

5 Figure 8: Performance Plastics (USD in Billions) gas reserves are in line with Dow s strategy to lower costs. Back integrating ethylene and propylene as intermediate products, Dow is able to continue to lower its overall cost of goods sold within both Performance Plastics and Materials and Chemicals operating segments. Industry Figure 9: Ethylene Cracker Overview Dow Chemical is the largest U.S. chemical producer of basic feedstocks, materials and plastics and is classified in the industry of major diversified chemicals. The U.S. industry of major diversified chemicals is massive with over $680 billion in annual sales and includes around 10,000 different firms that collectively produce over 70,000 products. The U.S chemical industry is one of the most important industries as its production of chemicals and materials are used as intermediate products that are essential in the production of finished goods all over the world. Products manufactured in the chemical industry are an important part of the growing economic process. Many different industries, both in the U.S. and globally, rely on the production of basic chemicals and materials. The U.S. chemical industry is linked to around 10% of total US exports. Sub sectors within the U.S. major diversified chemicals industry further consist of basic materials, specialty chemicals, agricultural chemicals, pharmaceuticals and consumer products. All chemical sub sector s production of products are very important as they serve to roughly 96% of further downstream goods. Industry Characteristics Source: Biz journal The domestic chemical industry is vastly mature with some advances and opportunities for continued growth. Most growth within the chemical industry is seen in emerging markets and has led domestic U.S. based firms to expand globally. With most of the industries projected growth in emerging countries, large chemical companies with available investable capital are expanding into regions to provide accessible access to new regions. This will provide accessibility to new markets that rely so heavily on basic chemicals for the production of cheap goods. Capital Intensive Industry Figure 10: Capex of U.S Chemical Companies (USD in Millions) Source: Statista Most if not all of the major diversified chemical companies are considered highly capital intensive. This is due to the large investment of capital expenditures needed in order to produce materials and chemicals at a high volume that makes it worthwhile on low margins. With such large startup costs in this industry, the few larger companies seem to dominate with global expansion to capitalize on new growth opportunities. Since this industry is heavily reliant of GDP growth and overall economic health, operating margins in this industry can see volatile movements as a consequence of the demand swinging with the upward or downward momentum of the economy. With the chemical industry linked to economic growth, certain companies have seen it worthwhile to expand globally to further diversify their earnings. Companies within this industry tend to maximize growth through high volume output of materials. In order for companies within this industry to experience higher net income, they must consume large volumes of feedstocks, back integrate them UOIG 5

6 Figure 11: USD/BRL 2015 Source: Yahoo Finance into their end products, further allowing for reduction on input costs. Input costs are a major driver of EBITDA margins and lowering high volume feedstock costs by a few percentage points can drastically increase or decrease margins. Macro factors Most U.S chemical companies that are classified in the major diversified chemicals industry do not rely solemnly on domestic sales but rather partake in foreign transactions. Companies can engage in foreign transactions in multiple forms, such as sales to foreign customers, investing in capital expenditures and or creating new projects in other countries. Having an international presence allows companies to reap benefits of diversification but also arises certain exposures to headwinds. Headwinds that can erode away profits include instability in certain markets, foreign currency exchange rates, and changes in feedstock prices. Economic Stability The stability of an economy is key to the chemical industry s revenue as mentioned above. Many raw materials produced from chemical companies make up additional inputs used in the majority of finished products sold throughout the economy. New investments that involve high upfront capital expenditures may take place in certain regions of the world that are still considered developing or unstable. This can lead to uncertainties about the plants ability to operate effectively without disturbances from foreign governments or the nation s citizens. New chemical investments in properties, plants, and equipment within emerging markets become riskier the longer they take to complete as growth in emerging markets is highly unpredictable. Strengthening of the U.S Dollar Figure 12: Oil ETF Aug 2014 Nov 2015 Source: Yahoo Finance Foreign exchange rates play a very important role in the revenue that is realized by domestic firms that are engaging in sales outside of their county. Most major chemical companies within the U.S chemical industry have suffered with the appreciation of the USD. Over the past year, most U.S firms realized a decrease in revenue due to the strengthening of the USD relative to other major currencies of transaction. With the strengthening of the USD, the U.S economy as a whole has increased imports of foreign goods as a result of becoming relatively cheaper. Exports however, have decreased due to domestic products becoming relatively more expensive. Drop in Oil Prices The recent drop in oil prices over the past year has decreased the cost spread between ethylene and naphtha within the chemical industry. Ethane and naphtha are both widely used feedstocks and raw materials in the chemical industry. Ethylene is a feedstock that is derived from ethane or naphtha. Companies that rely heavily on naphtha have enjoyed reduced costs from the decline of recent oil prices, which has become more cost competitive with companies who rely on ethane in the production process. The recent drop in crude oil prices means lower input costs to chemical companies manufacturing products that use naphtha as a feedstock. The drop in oil prices can lower the overall finished products cost of goods sold if the product is a derivative from oil. The price of global plastic products is priced by the production of ethylene through naphtha. A decrease in oil prices has also decreased the price of many plastic products. The recent decline in oil prices has eroded some of the cost advantage of ethane UOIG 6

7 over naphtha but not completely as it is still cheaper to refine ethylene from ethane. Oil and Natural Gas Figure 13: UNG ETF August 2014 November 2015 The Chemical industry is heavily reliant and dependent on oil and natural gas. Global companies that compete for continued growth look for market growth in emerging markets such as China, India and Brazil but also need to find high supplies of feedstock s that are used in production. Competitors in the chemical industry seek to gain from not just owning massive supplies of feedstocks but also from accessibility to both crude oil and natural gas. Buying and owning flexible ethylene production sites in multiple areas around the world allows companies to increase or decrease the production of ethylene based on current prices. Ethylene is an essential building block such as polyethylene and polystyrene used in many downstream products for chemical companies. Ethylene 5 0 Source: Yahoo Finance Figure 14: Ethylene Margins The manufacturing of ethylene involves a steam cracking process that refines either ethane from natural gas or naphtha from crude oil. Strategically placing flexible ethylene production crackers around the world in high supply destinations allows companies to take advantage of the oil to gas spread. If oil prices decrease relative to natural gas like they have over the past year, this results in a feedstock disadvantage to those refining ethane. With most of the world heavily reliant on crude oil, products produced from ethylene are sold into global markets with an oil price tag. Having the ability to steam crack natural gas and make ethylene, companies are able to sell ethylene products into an oil priced market further capturing higher margins. The ability to have access to ample supplies of both ethane and crude oil allows for greater control over lower end product costs. The ability to succeed in the global chemical industries relies on the accessibility to both crude and natural gas to adjust volume based on price changes. Having a global production and distribution method worldwide is also important to the success of chemical companies being able to capitalize on high growth among developing nations. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Ethane/Naphtha Spread Ethylene/Naphtha Margin PE/Ethylene Margin Source: Dow Earing Slides Competition Dow chemical has faced tough competition historically within the major diversified chemical industry both domestically and in foreign markets. Many firms tend to focus on specializing on one main segment of the market and Dow has been focused on moving into becoming the main supplier of specialty plastics. Domestic Competitors Dow is just one of the 10,000 firms within the United States that competes for market share in the chemical business. Dow is the largest chemical company in the U.S and having a long history in the industry enables them the ability to maintain customer relations and find growth within its share of the market. Companies that Dow competes with directly involve the comparable companies selected, including Eastman Chemical, Ashland Inc, Celanese Corp, DuPont and many more. These chemical companies compete with Dow both domestically and also in global markets. Eastman Chemical competes directly with Dow Chemical within the specialty plastics business. Dow is looking to enter into further direct competition with Eastman Chemical as specialty plastics provide higher margins on average over other plastic products. DuPont is also a direct UOIG 7

8 competitor to Dow as they compete in all the segments especially with its Agricultural Sciences department. With the increase of acceptance of the use of herbicides, pesticides and modified seeds this market is expected to rapidly grow in the next decade. This will allow for a further chance for increase market share for companies that provide a superior product at a competitive price. Figure 15: Chemical Companies 2015 Revenue (USD in Billions) LyondellBasell Saudi Basic Bayer Global competitors Global companies that compete in the chemical industry involve BASF, Shin- Etsu and SABIC. BASF is the largest chemical producer by sales in the world and has a global span of South America, Europe, Africa and Asia Pacific. BASF competes most directly with Dow on a global sense and offers similar products. Most of these chemical companies have well-established roots in their saturated domestic markets and look to expand overseas in emerging markets. Dow 58.2 Strategic Positioning BASF Source: Statista 89.9 Dow Chemical works to further combine science and technology in order to further human progress. According to Dow Chemical, many of the world s concerns can be solved through the innovation from biotechnology, physical and chemical advances. Dow delivers technological advanced products from agricultural sciences to industrial sealants, bringing value to customers and business around the world in over 180 countries. Dow seeks to combine high quality raw feedstocks at a low cost input in order to bring higher value to global customers. Figure 16: Global Chemicals Investment Focused in Three Regions with Varying Strategies Dow s strategy is to invest in market portfolios that use technology enabled businesses that work to create higher value to shareholders and to customers (Dow). Dow is in the process of a slow transition with a new focus on higher margin plastics and materials that are mainly manufactured with ethylene. Another strategy that they are currently pursuing is having an abundant supply of cheap ethylene with their new investments in Sadara and in the Gulf Coast. Dow plans to further focus on divesting its Chlor-Alkali and Chlorine businesses in order to specialize in performance plastics. This shift will allow Dow Chemical to achieve its $10 billion EBITDA goal and by one of the leading producers of ethylene worldwide. Investments Dow Chemical has ongoing investments in both the U.S Gulf Coast and in Saudi Arabia. These investments will provide Dow with cheap feedstocks while its investment in Saudi Arabia will allow further penetration into the market for plastics in the Middle East and Asia Pacific. Dow s strategic placement of operating plants around the world allows it to reach and increase supply within fast growing emerging markets. Sadara Source: IHS Chemical Sadara Chemical Company is a joint venture between Dow Chemical and Saudi Aramco that consists of 26 manufacturing units. Dow Chemical holds a 35% interest in Sadara and it is the world s largest chemical plant built in one single phase. Sadara is nearing completion and is set to come online in Sadara will use flexible cracking capabilities allowing it to produce ethylene from either naphtha or ethane, lowering its dependence on a single feedstock. Sadara Chemical will effectively produce 3 million metric tons of value end plastic and UOIG 8

9 chemical goods mainly to Asia Pacific s fast growing regions. 100% of the initial startup production has already been pre-sold. Total investment cost totaled around $20 billion in USD and Sadara is expected to generate $10 billion in annual revenues once fully operational. Figure 17: Ethylene Capacity 2019 Expectations Dow US Gulf Coast The recent discovery of an abundance of shale and natural gas opportunities has brought forth an investment in the U.S Gulf Coast in order to continue to gain access to low cost feedstocks. The investment in the Gulf Coast will allow Dow to further its supply of important raw materials used in production and the ability to satisfy growing global demand. SABIC Exxon Mobil Dow Chemical plans to further capitalizing on the shale boom and the low cost of natural gas in the US Gulf Coast. Dow Chemical is investing around $4 billion in its investments involving improvements to current ethylene facilities. They will also be constructing a new world class ethylene cracker facility set to come on line in Dow s investments will take advantage of the ethane to oil spread by adding around 20%-30% capacity to the current cracking capacity. Source: Dow Dow Chemical s recent investments in both the USGC and Saudi Arabia will help achieve their goal of $10 billion EBITDA within the near future Business Growth Strategies Malaysia India Philippines Figure 18: GDP Growth in Emerging Asia 5.50% 5.60% 5.90% The global major diversified chemical industry will see growth within emerging markets. Global chemical companies will capitalize on this growth by finding access to feedstock supplies within close proximity to these high growth markets. Establishing feedstock supplies close to emerging markets allows for the complete production of products from raw material to end products. Most of end products for the chemical industry are further used downstream as intermediate products of companies in the emerging markets. Dow Chemical has been actively investing, acquiring and divesting companies that work to further support Dow s long-term strategy. Dow Chemical will remain competitive on a global basis by securing its access to low cost feedstocks with close proximity to emerging markets. Management and Employee Relations Andrew Liveris Chairman of the Board, Chief Executive Officer and President Indonesia China Source: Money and Markets 6.20% 7.00% Andrew Liveris has been with Dow Chemical for 39 years as of Liveris s career started with Dow in 1976 where he first started working in Melbourne, Australia. Liveris was appointed CEO in 2004 with a new plan on how to transform the well-known commodity producing Dow Chemical into a higher margin specialty producer. Liveris started Dow s transformation with the acquisition of Rohm and Hass for $16.2 billion. This acquisition was Dow s first strategic move into the specialty chemical business. UOIG 9

10 James R. Fitterling Vice Chairman and Chief Operating Officer Figure 19: Net Income (USD in Millions) Fitterling has fulfilled a key role at Dow Chemical executing Dow s strategy to shift their market-driven portfolio in order to bring additional value to shareholders and customers around the world. Fitterling joined Dow in 1984 and started working in sales, marketing and supply before moving up as Commercial Director of liquid separations. Fitterling was named CEO of Optimal Group, and then senior vice president of corporate development in Howard I. Ungerleider Vice Chairman and Chief Financial Officer Ungerleider joined Dow in 1990 where he started working in commercial business while fulfilling enterprise-level leadership roles. He managed Dow s specialty polyolefin brands at Dow s European headquarters in Switzerland. Ungerleider served as Vice President of investor relations where he dealt with and investor outreach program during the mid-2000s global economic crisis Joseph E. Harlan Vice Chairman and Chief Commercial Officer Joseph Harlan joined Dow Chemical in 2011 bringing along with him geographic business and customer experience backgrounds from 3M Corporation. Before working for Dow, Harlan spent 20 years with General Electric Company within their Plastic Appliance Department. While at GE, Harlan fulfilled operational and finance positions before he served as CFO of GE lighting. Executive Compensation Figure 20: Dividend Yield 3.40% 3.60% The board of director s compensation and leadership development committee decides compensation, pay and stock options. Dow Chemical requires executives of the company to own company stock as an incentive to increase the stock price. Compensation fluctuates year to year determined by either surpassing company goals or falling short of expectations. 2.50% 1.70% Management Guidance Dow Chemical is committed to delivering value to its shareholders by staying focused on its long-term goals. Dow s commitments in focused on productivity programs, completing mergers and acquisitions, investing in new innovative production facilities, and returning cash to owners. DD CE BASF Dow Source: Dow Upper management within Dow has completed a $1.75 billion productivity program set in 2013 and has completed $208 million of its $1 billion productivity program goal. Dow set out to see mergers and acquisitions proceeds of $7-8.5 billion and has realized $12 billion in total pre-tax considerations. Management is set on returning value to the shareholders by the distribution of cash. Dow plans to earn 10% growth with a 45% payout ratio along with a $9.5 UOIG 10

11 58.86 Figure 21: Executive Compensation (USD in Millions) billion share buyback by Dow has exceeded its 45% payout ratio over the past 5 years. A total of $6.5 billion in share buyback has been completed with another $3 billion still in the works. Total dividends paid since YE 2012 equaled to $4.3 billion. During the most recent earnings call, Dow Chemical s management has expanded upon its near term goals and completion methods. Dow will continue to expand cash flow and grow earnings within the next three years by the implementation of Dow Dow 10.0 will realize a $1 billion in reduction of costs over the next three years. Management has also expanded upon the completion of assets in USGC and Saudi Arabia in order to achieve a $2.5 billion per year EBITDA from USGC and $500 million per year equity income from Dow s 35% interest in Sadara Source: Morningstar Portfolio Strategy Dow Chemical (DOW) is currently held within the Tall Firs portfolio. Dow Chemical was purchased at $43.76 at a quantity of 400 shares. The approximate realized return excluding dividends paid is 16.5%. Current holdings of Dow Chemical reflect the strategy of the Tall Firs portfolio. The Tall Firs portfolio consists of five sectors, with Dow Chemical invested in the Industrials/Materials/Energy (IME) sector. Recent News Dow Chairman and CEO Andrew Liveris Receives the 2015 Kavaler Award ICIS, October Figure 22: Tall Firs Portfolio Holdings by Sector Dow chemical s CEO Andrew Liveris was awarded the ICIS Kavaler award on October 27th. The Kavaler award is presented to recognize executive management for outstanding leadership and achievements. Liveris is granted the Kavaler award in regards to his divestment of low margin chlorine, chloralkali business. Liveris is also being recognized for the investments in low feedstock supplies in the USGC and in Saudi Arabia that align with Dow s longterm strategy. Dow Q3 Earnings: Higher Margins Drive Growth In Low Oil Price Environment Trefis, October 27 th 2015 Dow Chemical released their Q earnings on October 22 nd. Operating EBITDA was $2.4 billion, up $70 million year over year. Despite price declines in commodities and in oil prices, Dow Chemical was able to achieve its 12 th consecutive quarter of year over year EBITDA margin expansion. This indicates that Dow has been making progress from exiting the low margin commoditized business and into higher valued specialty products. Source: UOIG Tall Firs Portfolio UOIG 11

12 Catalysts Figure 23: Dow Chemical EBITDA Margin Upside 14% 12% 9% 11% 11% New investments provide Dow with high accessibility to low cost feedstocks such as the production of ethylene. Dow works to take advantage of the naphtha ethane cost spread by changing production volume depending on how costs change Divestment of low margin chlor-alkali business allows for strategic shift into further pursuing higher margin payouts from specialty plastic products Favorable natural gas to oil spreads allowing Dow to receive higher margins from the production of ethylene from ethane Figure x: UOIG Spreads Figure 24: EBIT Margin by Company 14% 23% Downside Exposure to macro factors such as oil-pricing and exchange rate fluctuations Dow Chemical may be exposed to certain litigation lawsuits from normal business operations Certain restrictions from the EPA imposed on the chemical industry could have future cost implications The changing of management, such as the resignation of Dow s long time CEO Andrew Liveris may develop uncertainties of the direction of the company Disappointing news about the future investments of either The U.S Gulf Coast ethylene production facilities or the Sadara investment in Saudi Arabia 20% 28% Comparable Analysis 15% Dow Eastman Ashland Celanese DuPont Figure 25: Eastman Chemical Source: Google Images Comparable companies were selected on certain similar metrics such as growth rates, size and similar operating margins. Similarities in production of substitute products within similar operating segments were also taken into account when screening for comparable companies. Eastman Chemical (35%) Eastman Chemical is a global competitor within the specialty chemical segment. This company produces a wide range of specialty chemicals along with advanced materials. Eastman Chemical operates its business into five focused segments. Its segments are Additive and Functional Products, Adhesives and Plasticizers, Fibers, Specialty Fluids, and Advanced Materials. Eastman Chemical was selected as a comparable company that closely represented Dow Chemical because of Dow s shift into the Specialty Plastic segment. Eastman Chemical s specialty plastics consist around 54% of its total revenue in Dow is seeking to benefit from higher margins by further shifting into the Specialty Plastics segment. Eastman serves customers in over 100 countries from Asia pacific, and EMEIA. UOIG 12

13 Ashland Inc. (25%) Figure 26: Ashland Inc. Source: Google Images Ashland Inc. is a leading specialty chemical company that provides products and services in North America as well as Asia Pacific, Europe and Latin America. Ashland segments its production into three main reportable segments, Specialty Ingredients, Performance Materials, and Valvoline. Ashland has gone through a transition into becoming a global specialty chemical company through its acquisitions and divestments. Ashland has initiated a cost reduction program similar to Dow 10.0 with its restructuring program that will work to improve operational performance. Ashland s restructuring will effectively work to reduce $200 million in cost savings. Ashland Inc. was selected based on similar business operations in specialty plastics and with similar EBITDA margins to Dow Chemical. Celanese Corp (20%) Figure 27: Celanese Corp Source: Google Images Celanese Corp is a global technology company that competes in the chemical industry by offering specialty materials to consumers all over the world. Celanese operates within four operating segments: Advanced Engineered Materials, Consumers Specialties, Industrial Specialties, and Acetyl Intermediates. Acetyl intermediaries are one of Celanese main feedstock used in the production of downstream products such as adhesives, and paint coatings. Celanese Corp competes with Dow Chemical in the Infrastructure Solutions and Performance Materials and Chemicals segments. Celanese Advanced Materials segment offers plastic polymers within the automotive, telecommunication and electronics industry. Celanese was selected as a comparable company based on similar margins and similar risks related to the EPA. E. I. du Pont de Nemours and Company (20%) Figure 28: DuPont DuPont ranked 8 th largest chemical producer in the world by sales in 2014 and competes with Dow chemical on all operating segments. DuPont operates in 7 reportable segments: Agricultural, Electronics and Communications, Nutrition and Health, Industrial Biosciences, Performance Chemicals, and Performance Materials. DuPont operates around the world with 322 sites in North America, EMEA, Asia Pacific and Latin America similar to Dow Chemical. Agricultural represented around 50% of total R&D expenses, while Agricultural revenue makes up around 32% of total sales. DuPont was selected from its similar market exposure and offering similar products in the agricultural market. Multiples Source: Google Images Multiplies were selected based on company and industry relevance and were weighted appropriately. Enterprise Value to EBITDA is a common metric used within the major diversified chemical industry. EV/EBITDA was weighted at 60% due to its relevance in evaluating companies in the chemical industry. Enterprise Value to EBITDA minus Capex was weighted the additional 40%. EV / (EBIDTA-Capex) are often used as a metric for companies in capital UOIG 13

14 intensive industries. The major diversified chemical industry is heavily capital intensive due to expensive startup and investment costs so EV / (EBITDA- Capex) was weighted accordingly. Discounted Cash Flow Analysis Figure 29: EV/EBITDA by Company Revenue Model Revenue was projected individually for each of Dow Chemical s reporting segments. Historical past year over year percentage growths, percentage of overall revenue, future trends and strategic operating shifts were all taken into account when forecasting revenue. Agricultural Sciences Dow Eastman Ashland Celanese DuPont Agricultural Sciences made up around 12.5% of total revenue in Projecting Agricultural Science s revenue into 2024 mainly incorporated steady growth rates in this industry and the global acceptance of the use of herbicides and pesticides. Near term projections are forecasted to experience about 3-4% decrease year over year align with management s projections. Enlist Duo being set to launch along at year end along with 4 more promising patented products within the next five years will further help secure market share in developing markets, such as Brazil. By 2024, Agricultural Sciences is projected to make up 11% of total revenue with a slight increase in growth over Consumer Solutions Figure 30: EV / (EBITD-Capex) by Company Dow Eastman Ashland Celanese DuPont Consumer Solutions have consisted of only around 7% of Dow s total revenue and are projected to stay fairly consistent staying around 8% of total revenue by Forecasting for Consumer Solutions incorporated Dow s further presence within emerging markets, seeing peak years in 2019 and Growth rates of Consumer Solutions are forecasted to taper off after 2020 as emerging markets become saturated with competition. Infrastructure Solutions Infrastructure Solutions is projected to align with global construction projections. Global construction is projected to steadily increase and further recover from housing crisis. Peak growth years are projected to be seen in 2019 and U.S. construction is projected to increase.6% a year going into 2020 while emerging markets should expect to see around 5.6%. One third of Dow s realized revenue in this segment consists of domestic sales and two thirds have come from foreign market. Dow is projected to experience 3.7% segment growth mainly experienced from construction growth in foreign markets in peak construction years 2019 and Performance Materials and Chemicals Performance Materials and Chemicals are projected to experience slight declines in growth rates in the near future with Dow s movement out of the chlorine UOIG 14

15 60% 50% 40% 30% 20% 10% 0% Agricultural Sciences Figure 31: % of Revenue by Segment Consumer Solutions Infrastructure Solutions Materials and Chemicals Performance Plastics Figure 32: Performance Plastics Projected Revenue (USD in Millions) business and 2020 are forecasted to be the peak years for Dow, as a strategic shift into emerging markets will continue. Performance Plastics Performance Plastics currently is Dow s main revenue driver and is forecasted to rise from 36% of total revenue in 2014 to 46% of Dow s total revenue by Dow s strategic shift into the higher margin plastics business and out of the low margin commodity business will increase Performance Plastic s total revenue. Dow will further benefit from economies of scale with its Sadara investment coming online in 2016 and its USGC investments taking advantage of low cost natural gas. Dow s ethylene production will increase by nearly 20-30% when all ethylene polypropylene investments are online and running at near full capacity. Sadara will sell 70% of its initial products to emerging markets in Asia Pacific with another 15% to the Middle East. Dow will start benefiting from an increase in supply of low cost natural gas in through 2019 are forecasted as peak years for Dow Chemical as they further benefit from an increase in low cost feedstocks back integrated into downstream Dow finished products. Dow s strategic placement of ethylene crackers will allow for the distribution of polypropylene to emerging markets. These emerging markets have shown a historical increased reliance on commodity plastics for the production of further finished goods. Beta Figure 33: COGS as a Percent of Revenue Dow Chemical is a large cap company that trades at fairly consistent high volumes. Multiple regressions were ran including 1,3,5 daily and 3,5 weekly were regressed against the S&P 500. A 5 daily regression had a minimum standard error at with a beta of year daily regression offered a standard error at.052 with a beta of I weighted my beta 75% 3 year daily and 25% 5 year daily. This takes into account the minimized standard error while also taking into consideration that Dow Chemical has been strategically shifting its business operations within the past 2-3 years. A 3 year beta effectively captures Dow s exit out of the chlorine business and further into mass producing performance plastics. Operating Expenses Cost of Sales: 80.3% 79.5% 77.6% 72.6% 73.6% Cost of sales represented around 80% of total revenue in 2010 while decreasing to 77.6% in Cost of sales is projected to further decrease due to recent investments that will capitalize on cheap natural gas prices in North America. The USGC increase in ethane production has reduced COGS to around 73% of total revenue for the first three quarters in Future forecasting involves Dow experiencing economies of scale fairly quickly within 2016 with all of its investment ethylene crackers coming online around the same time. Dow will experience a 20-30% increase in the production of ethylene UOIG 15

16 Research and Development R&D is important to Dow Chemical as it provides for innovative products for all of its reporting segments. Dow Chemical s R&D expense was projected based off percent of revenue and has stayed fairly consistent around 3%. Management s guidance of a steady constant future projected R&D expense was taken into account when projecting DCF. Capital Expenditures Figure 34: Dow Capex Capex was mainly projected forward based off of Dow s management s guidance from their recent earnings call. During 2015 capex reached a peak of 7.5% of revenue as a result of Dow Chemical s two major investments in the USGC and in the Middle East. Management foresees no major investments within the next 5 years, so capex is projected to fall to 2% of revenue in Beyond management s 5 year projections, capex is expected to rise in order to maintain current fixed assets such as ethylene cracker facilities in the USGC. Tax Rate The tax rate for Dow Chemical has historically ranged from 17% to 33% within the last four years. Dow Chemical s management guidance was used in projecting a 27% tax rate in the near future. The tax rate is projected to remain close to 27% rising to around 29% in the terminal year as Dow s growth in emerging markets is projected to slow. Recommendation Figure 35: Final Evaluation Method Implied Price Weight Discounted Cash Flow % Forward Comparables % Implied Price Current Price Undervalued 5.73% Dow Chemical faces tough competition within the major diversified chemical industry. Their strategic shift into higher margin plastics will allow Dow to reach their $10 billion EBITDA goal within the near future. Demand for plastics is growing rapidly among emerging countries, and Dow Chemical is strategically invested in order to quickly soak up market share. With Dow s two major new investments coming online within the next year, Dow will further reach economies of scale from the mass production of ethylene. Dow s gross margin will improve in the near future through the continued back integrating of ethylene to downstream products. The UOIG currently holds Dow Chemical in the Tall Firs portfolio. Through research and analysis, Dow Chemical s (DOW) implied price is set at $56.37 currently undervalued by 5.73%. Dow Chemical is a recommended hold for the Tall Firs portfolio. UOIG 16

17 Appendix 1 Relative Valuation Comparables Analysis DOW EMN ASH CE DD Dow Chem Eastman Ashland Celanese ($ in millions) (DOW) Chem(EMN) Inc.(ASH) Corp(CE) DuPont(DD) Stock Characteristics Max Min Median Weight Avg % 25.00% 20.00% 20.00% Current Price $ $53.32 $71.61 $79.84 $53.32 $72.17 $ $71.05 $63.40 Beta Size Short-Term Debt 1, , , Long-Term Debt 17, , , , , , , , , Cash and Cash Equivalent 7, , , , , , Non-Controlling Interest Preferred Stock Diluted Basic Shares 1, , Market Capitalization 62, , , , , , , , , Enterprise Value 74, , , , , , , , , Growth Expectations % Revenue Growth 2015E 3.4% (18.0%) (15.4%) (11.1%) (13.6%) (14.8%) 3.4% (16.0%) (18.0%) % Revenue Growth 2016E 3.5% (8.2%) 1.1% (0.3%) (1.7%) 1.1% 1.1% 3.5% (8.2%) % EBITDA Growth 2015E 12.5% (22.9%) (2.0%) (1.0%) 7.7% 12.5% (0.7%) (3.2%) (22.9%) % EBITDA Growth 2016E 2.4% (2.3%) 2.1% 1.6% (2.3%) 2.4% 2.1% 2.0% (1.0%) % EPS Growth 2015E 59.1% (31.2%) 4.4% (0.6%) 59.1% 2.6% 14.1% 6.2% (31.2%) % EPS Growth 2016E 30.0% 5.7% 7.6% 9.3% 30.0% 5.7% 9.0% 6.3% 18.8% Profitability Margins Gross Margin 35.11% 27.01% 29.62% 29.96% 27.43% 27.27% 31.97% 27.01% 35.11% EBIT Margin 18.39% 14.48% 16.20% 16.36% 18.39% 17.88% 14.48% 17.08% 15.31% EBITDA Margin 26.17% 17.54% 22.39% 22.86% 17.54% 23.79% 21.00% 26.17% 20.27% Net Margin 15.65% 8.68% 10.90% 11.34% 12.15% 11.20% 8.68% 15.65% 10.60% Credit Metrics Interest Expense $ $ $ $ $ $ $ $ $ Debt/EV Leverage Ratio Interest Coverage Ratio Operating Results Revenue $50, $5, $7, $11, $50, $9, $5, $5, $25, Gross Profit $13, $1, $2, $3, $13, $2, $1, $1, $8, EBIT $9, $ $1, $1, $9, $1, $ $ $3, EBITDA $8, $1, $1, $2, $8, $2, $1, $1, $5, Net Income $6, $ $1, $1, $6, $1, $ $ $2, Capital Expenditures $3, $ $ $ $3, $ $ $ $1, Multiples EV/Revenue 2.45x 1.49x 2.07x 2.04x 1.49x 1.81x 1.87x 2.27x 2.45x EV/Gross Profit 8.39x 5.42x 6.80x 6.86x 5.42x 6.62x 5.86x 8.39x 6.98x EV/EBIT 16.01x 8.08x 13.11x 12.63x 8.08x 10.10x 12.95x 13.26x 16.01x EV/EBITDA 12.10x 7.59x 8.79x 9.04x 8.48x 7.59x 8.93x 8.66x 12.10x EV/(EBITDA-Capex) 17.41x 10.75x 12.13x 12.75x 14.86x 10.75x 13.12x 11.14x 17.41x Market Cap/Net Income = P/E 20.62x 9.75x 14.34x 14.10x 10.30x 9.75x 16.65x 12.03x 20.62x Method Implied Price Weight Discounted Cash Flow % Forward Comparables % Implied Price Current Price Undervalued 5.73% UOIG 17