Dow: Question The Dividend

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About: Dow Inc. (DOW), DWDP
by: JP Research
Summary

DowDuPont Inc. spun off its material science division, Dow Inc. in line with its plan to break up the company into three independent public companies; agricultural division Corteva.

DOW is an advantaged global petrochemical player that generates sizable EBITDA levels (~$9 billion in FY 2018) with the potential to reduce its cost structure from the previous years’ initiatives.

Due to oversupply issues and lethargic global economic growth, we forecast lower revenues i.e., decline of 5% year-on-year. Accordingly, EBITDA margin contraction is likewise expected.

In our view, DOW premium valuation stems from its hefty dividend payment; albeit seems not sustainable in the long-run with several headwinds in the horizon.

Investment Summary

In April 2019, DowDupont Inc. (DWDP) finalized the spin-off of its material science division, Dow Inc. (DOW) through share distribution of 1 DOW share for every 3 DWDP shares. As a stand-alone company, DOW is an advantaged global petrochemical company with sizable capacity & operations, with considerable EBITDA of $9 billion. Majority of its EBITDA is being utilized on dividend distribution of ~$2 billion, which consequently, results in its current premium valuation over closest peers. In our view, there is a question of the sustainability of its generous dividend in the coming years due to uncertainties surrounding the petrochemical markets. Hence, a lower valuation seems warranted in the near term, with a price target of $49 per share - an 18% decline from current share price levels.

Breaking Up Is Not Hard to Do…

On the 1st of April 2019, DowDuPont Inc. disclosed that it has finalized the spin-off of its material science division, Dow Inc., through share distribution of one (1) DOW share for every three (3) DWDP shares held as of 21st March 2019. Further, DWDP shareholders receive cash in lieu of fractional shares of DOW common stock.

The transaction is the first phase towards management's plan for the formation of three independent public companies - with DWDP planning to further distribute all of the common stock of its wholly owned agricultural subsidiary, Corteva Inc. on 1st June 2019. Upon completion of this spin-off, there will be three independent public companies: Dow (Materials Science), Corteva (Agricultural), and DuPont (Specialty Products).

DWDP CEO Ed Breen said that breaking up the business into three independent companies would improve service to their customers better and focus on their innovative priorities, leading to market leadership in their respective fields.

DOW Overview

Following the spin-off, Dow's business consists of the commodity business and legacy DuPont's ethylene copolymers. The company is an integrated and diversified global producer of commodity chemicals and the world's largest producer of ethylene with nearly 28 billion pounds of ethylene capacity globally: about 14.5 billion in the US and 13 billion pounds offshore.

It operates in 32 countries with assets concentrated in low-cost regions (US Gulf Coast, Canada, Argentina, and the Middle East) serving c. 23,000 customers in more than 150 countries. According to 2018 revenues, US & Canada account for 36% of its sales, 19% in the Asia Pacific, 35% in Europe, MENA and India, and remaining 10% in Latin America.

First, let me show you the goods…

Positive #1: Advantaged Global Petrochemical Player. As discussed, Dow is the largest ethylene and polyethylene producer in the world with the majority of its capacity in North America (~14.5 billion pounds). North American production is advantaged since natural gas liquids are primary feedstocks, which structurally have a cost advantage over oil-based raw materials utilized in Asia, Europe, and South America due to its operational scale.

Positive #2: Opportunities to Further Improve Cost Structure. Our projections reveal that the company will be able to rid of $600 million in 2019 from its cost structure and another $200 million in 2020, mainly due to cost reduction efforts that began efforts that started in 2017 upon the merger of the Dow and DuPont. Additionally, DOW now has streamlined its business structure and upgraded its information technology systems. However, we estimate that there is an upfront cash outlay of c. $1.1 billion in 2019 to accomplish these cost reduction initiatives, which would dampen their free cash flow generation in the short run; albeit warranted since it provides a better cost reduction flexibility in the future.

…But Positives Are Negated by Prevailing Headwinds

DOW is subject to volatile swings in profit generation due to its production scale and margin sensitivity to change in raw material prices. We estimate that each penny per pound in integrated ethylene to polyethylene or other chemicals margin yields a $250 million change in EBITDA. On the other hand, the change in margins appears to be a function of oil price - higher oil price means EBITDA expansion, and conversely, lower oil price means lower EBITDA.

In our view, the direction of the ethylene margins in 2019 throughout 2020 points lower. This is mainly due to various factors including lethargic global growth, global trade issues, and oversupply conditions. Consequently, it would be difficult to see a scenario of EBITDA expansion for the next 2 years under these circumstances.

Financial/Strategic Outlook

We estimate DOW to register lower revenues of $47 billion in 2019, a 5% year-on-year reduction from FY 2018 levels of $50 billion, based on our expectations of pricing pressures in the polyethylene from reduced oil prices, slower global demand and continued oversupply conditions. Further, we expect an EBITDA contraction to $8 billion for the same year, 10% year-on-year drop; derived from lower polyethylene margins which offset the cost synergies discussed above.

Subsequently, we model our forecast to show recovery in FY 2020 and FY 2021 with revenues of $49 billion and $51 billion, respectively i.e. exceeding the "2018 revenue levels" due to the gradual improvement in the global demand and pricing recovery. Consequently, EBITDA will reach $10 billion in FY 2021, along with an uptick in EBITDA margins to 19%, which would likewise surpass the historical margin levels of 17% to 18%. Our assumptions are partly driven by the cost initiatives in the previous years.

Premium Valuation Could Be Challenged

DOW trades at 8.1X FY 2019 EBITDA, higher than its closest peers; LyondellBasell Industries (LYB) trading at 6.4X, while Westlake Chemical Corp. (WLK) is valued at 5.4X. Investors are attracted to the hefty dividends that DOW distributes - a dividend of $2.80 per share or 4.7% dividend yield, basically higher than LYB's dividend yield of 4.3% and WLK 1.3%. However, the possibility of continued generous dividends seems threatened due to what we expect will be muted revenue & EBITDA figures in the upcoming years due to uncertainties surrounding the petrochemical markets.

Accordingly, we settle for a reduced EV/EBITDA multiple of 7.2X (based on normalized EBITDA multiples for large North American petrochemical companies) which would imply a share price of $49, an 18% decline from the share price of $59.71 as of 4th April 2019 close. Our upside scenario points to a higher share price if investors feel more confident in DOW's ability to sustain its large dividend payout over a long period of time.

Conclusion

Due to continued lackluster global economic growth and capacity additions leading to oversupply issues, we assume that further EBITDA growth is unlikely in the upcoming year. As such, we also believe that the high dividend distribution is not sustainable and hence, DOW's premium valuation will not hold in the near term.

Disclosure: I/we 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.