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Cashing in on the availability of cheap gas

Dow Chemical (NYSE:DOW) strategically chose to invest in the U.S. Gulf Coast to take advantage of the cheap and abundant shale gas. Led by the oil boom, the contribution of shale gas to the total U.S. natural gas production has increased dramatically from 1% in 2000 to 44% currently. Under the expansion program, Dow will be building four new plastic production units, two in Freeport (Texas) and the other two in Plaquemine (Louisiana). The two new facilities in Freeport will manufacture the AFFINITY and ELITE brand polymers that are used in adhesive packaging and food, medical, and industrial packaging. In Plaquemine, Dow will expand its low density polyethylene polymers like AGILITY, which is used in food packaging. The company anticipates the new production facilities to be operational by 2017 and expects this expansion to increase its EBITDA by $2.5 billion. The company will meet the raw material demand from these production facilities with its plan to restart its ethylene cracker in Louisiana and build a propylene production facility as well as a new ethylene unit in Freeport.

Shale gas can be used to produce ethane, which in turn is used to make ethylene. Ethane based ethylene is an almost 50% cheaper raw material than naphtha based ethylene for producing plastics such as polyethylene, or PE. With the expansion on the U.S. Gulf Coast, Dow will increase its capacity by 3 billion pounds of PE. This will help the company make further inroads in the global PE industry, which is expected to grow to $148 billion in 2017 at a compounded annual growth rate, or CAGR, of 3.5%. I expect the company to post similar growth in revenue from its plastics segment, thus providing an upside potential to its earnings. Considering its ongoing expansion, Dow is well positioned to take advantage of the availability of cheap natural gas that will be used as feed-stock for producing plastics.

Another chemical player, BASF (OTCQX:BASFY), is increasing its presence in the U.S. due to the availability of cheap gas. The company is already active in the U.S. through a joint venture with Total Petrochemicals, a subsidiary of Total SA (NYSE:TOT). The joint venture company named BASF Total Petrochemicals started building a 10th ethane cracking furnace at its Port Arthur steam cracker, and it is expected to be completed by the second quarter of 2014. Once completed, the new furnace will increase Port Arthur's existing capacity of 1 million tons of ethylene by an additional 15%.

Since BASF's chemical plants are located in Europe, the company's energy costs are higher than Dow's costs. BASF estimates annual savings of $680 million, if it were to shift its chemical plants to the U.S. However, the company will be spending $4 billion to expand its operations in the U.S. by 2017, which will help reduce its operating expenses.

Why the expansion of the performance plastics segment makes sense

Dow Chemical's expansion will increase its dependence on the performance plastics business over the coming years. Historically, the performance plastic segment has consistently contributed a major part of the company's revenue. Moreover, in last four out of five quarters, the segment's EBITDA margin has been better than the company's overall EBITDA margin.

Parameter

3Q 2012

4Q 2012

1Q 2013

2Q 2013

3Q 2013

Performance plastics revenue as percent of company's total revenue

25.6%

26.4%

24.3%

25.2%

26.3%

Company's EBITDA margin

13.2%

0.9%

15.4%

28.5%

13.3%

Performance plastics EBITDA margin

21%

21.8%

27.2%

27.4%

26.8%

As a result of the segment's impressive performance, Dow is now focusing on divesting unrelated lower margin assets. Last month, the company announced that it will be selling the commodity chemicals business, which represents about $5 billion in annual revenue. Moreover, the company is targeting to raise $3 billion-$4 billion through asset sales in the next two years, which will ensure regular cash inflows to fund its plastics expansion. This will allow the company to focus on segments that are more profitable, such as performance plastics. I expect the company's plastics business to drive its earnings growth in the coming quarters.

A glance at the company's cash flows

Below I have analyzed the company's ability to generate regular cash flows through its capital expenditures, or capex, by calculating the cash flow to capex ratio.

Parameter

2011

2012

9 months 2013

Cash flow from operations (in $ million)

3879

4075

5590

Capex (in $ million)

2830

2614

1418

Cash flow to capex ratio

1.37

1.56

3.94

Dow has successfully increased its cash flow to capex ratio since 2011, displaying improving efficiency. Assuming a similar kind of efficiency, the company will generate positive free cash flows even with the Gulf Coast expansion in the coming years. Moreover, the availability of cheap natural gas will help the company operate at lower operating costs, thereby increasing profitability. In the near future, the company's asset sales will generate cash that will improve its financial flexibility. This will allow the company to fund its expansion projects without raising additional finance. I recommend a buy on this stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Dow Chemical: On The Right Path