Dow Vs Lyondell – Bet On The Company With More Levers To Pull – DOW

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 29th, 2014

Dow Vs Lyondell – Bet On The Company With More Levers To Pull – DOW

  • Q1 numbers from Dow showed an upside surprise despite a substantial feedstock headwind, mostly in the US. Dow was able to offset the increase with improvements in its specialty businesses (including Ag) and some belt tightening.
  • LYB on the other hand missed expectations slightly, as improvements in Europe and in refining were unable to offset maintenance and cold weather related outages and margin compression as NGL prices rose.
  • LYB is very dependent from here on the spread between natural gas and crude oil as, while the company has some capacity expansion this year and next, the ethylene margin is the only real game in town. LYB is lean and has very little else it can do to boost earnings other than buying back stock with free cash.
  • DOW on the other hand has all of the same commodity leverage as LYB. However it has much higher costs, which could be reduced, unlockable value in assets that should be worth more to others than they are to Dow, and lots of additional capacity to exploit lower cost feedstocks.
  • Both companies face the same risks – a reduction in the US natural gas/Brent crude spread, and a change in strategy with regard to M&A. Dow is cheaper on our normalized framework measure and for LYB we are using the new leaner cost structure to drive normal earnings, while DOW is based on 40 years of history, with costs growing.
  • The commodity portion of Dow’s portfolio could continue to cut costs to the tune of more than $2.0bn in our view, which would drive up both earnings and valuation. $2.0bn would add as much as $1.10 to fully diluted earnings per share and $15-17 per share to value.
  • We believe that selling/spinning the Ag business is a good thing, but do not see the value in waiting – the business may be worth more in absolute terms in the future, but relative to the remainder of Dow it may not be.
  • DOW should outperform LYB if we see more of what we have seen from DOW in the last two quarters going forward. Risks aside (market, energy, economic) we see 24 month upside to DOW to $75 – so more than 50%, while we struggle to see more than 20% in LYB on the same basis.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Our position on LYB has been that the company has done a great job of lowering costs and maximizing the benefit of its exposure to the US natural gas opportunity. We remain convinced that this is more than priced into the stock today, and that upside will only come from consistent dividend increases and buybacks like the ones announced last week. The stock has been rewarded for great execution and a great footprint relative to the US shale gas opportunity. There is still upside if the natural gas/crude spread remains at recent levels, given capacity additions that will come on line over the next 2 years.

Our view of Dow has been that the company is too complex and is pursuing divergent strategies – big, low cost, commodity on then one hand, and R&D intense specialty on the other – and concerns that these cannot operate well under the same roof. At the same time, we think that Dow is spending too much money and has many opportunities to cut costs. This has constrained margins and earnings, and while the company had a good 2013 from a stock perspective, it has underperformed LYB significantly on a 3 year basis, Exhibit 1.

The premise behind this report is that Dow appears to have gained a sharper focus on the opportunity – perhaps it has been there for a while and has taken time to bubble to the service, or perhaps it has been brought into focus by the recent activist interest in the stock. Frankly, it does not matter what the reason is – the opportunity is significant, and we saw signs of that in fourth and first quarter earnings. LYB has turned itself into a lean, focused, cash machine: the opportunity for DOW is to turn itself into a leaner, more focused, cash machine and that is not yet priced into the stock.

LYB is today earnings around 75% above what we would consider “normal”, based on historic mid-cycle US basic chemical margins. DOW is only earnings around 35% above normal. DOW is a more complex business and less levered on a per share basis to the US shale opportunity, but the LYB model is based on LYB’s cost position post-bankruptcy, which is so much lower than DOW on a per pound of product or per dollar of sales basis.

As we suggested in prior research we think DOW can take as much as $1bn of costs out of its business just on headcount. With more than the same amount available from rationalizing and optimizing operations so that the commodity business generates similar margins to LYB. While we do not believe that the company sees as much of an opportunity, even if they get half way there it will have a material impact on earnings. We would need to see:

  • More focus on re-working R&D such that the attention is on real returns on investment and prioritizing the big likely winners – we have seen some of this in Q1, but believe that the company can do more.
  • Further asset rationalization – the company is doing a good job here, particularly in Europe where the market has changed dramatically and where DOW can likely supply many of its customers more cost effectively from the US.
  • More buyback and another dividend increase
  • A cut in capital spending – or perhaps some further partnerships to reduce the capital cost and risk to DOW. See MLP comment below.
  • We would still like to see some ethylene capacity included in the chlorine spin off as we believe that the spin-off company will be strategically impaired without it.
  • Some further thought on the Ag business. Waiting may not be the right move – what matters in the relative multiple difference between DOW today and how the Ag business would be valued. If the company could buyback or reduce the share-count by 20% today and the expectation is that 3 years from now the Ag business may be worth more, but so would legacy DOW and it would still be 20%, DOW should be indifferent on timing.

In our view, DOW has far more levers to pull than LYB and consequently, with the right focus (which is key), can drive earnings growth far more quickly than LYB for the next three to four years. The risk is the same as it always been – transaction – but it applies to both companies.

Dow could add as much as $1.10 to earnings through cost initiatives and another similar number through the low-cost capacity it is adding. If the Ag business can be divested accretively, which should not be hard, the stock would have further upside. Adding $2.00 to our view of normal earnings ($1.00 from cost initiatives and $1.00 from new capacity/divestments), we calculate a fair value of $75 per share. If we give the company half of this earnings benefit but assume that it continues to trade above “normal value” because of the US shale advantage we arrive at a similar value – $70 per share.

The Cost Opportunity at DOW – Relative to LYB – Is High

Here we repeat the section that we wrote comparing Dow’s basics business with Lyondell in the research we wrote in February. We created pro-forma commodity chemical simplified financials for both companies by stripping the refining business out of LYB and the Ag and Electronics and Functional Materials business out of Dow. In both cases we have stripped out equity income so that we can arrive at a fair EBITDA margin for the wholly owned businesses. We look at the last three years of data.

As we think about the comparison:

  • DOW and LYB have similar levels of revenue per pound of ethylene capacity – around $2.25.
  • Both companies have assets outside the US with DOW slightly more exposed to Europe than LYB and also more exposed to the rest of the world. LYB’s Chemical business has around 55-60% of its sales outside the US – for DOW the share is higher at around 65% of sales.
  • Major products for both include: ethylene, polyethylene and propylene oxide and polyurethane intermediates. LYB has a big polypropylene business – DOW divested its polypropylene business in 2011.
  • LYB has a meaningful methanol and acetic acid business. Dow has acrylates, amines, chlor-alkali and chlorine derivatives, specialty polymers and rubbers, polyurethanes, epoxy resins, and acrylics, as well as many related and derivative products.

On the surface, Dow looks like it has the much higher value added portfolio, but is making less money – Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

The obvious first step in any plan here would be to get to the EBITDA margins that Lyondell enjoys. A reasonable secondary goal would be to get to higher margins given the business mix.

The last two quarters have shown us that Dow can squeeze a lot more out of its portfolio when the focus is there. In the past we have seen short spurts of operational and cost control brilliance from DOW, highlighting want can be done – what we have also seen in the past is the focus drift, where a good cost control program gets derailed by a change in strategy or by a deal or by a proposed deal. If DOW management can keep its focus we could see steady improvements in costs and product mix, leading to better earnings and more surprises relative to what the energy market would suggest possible.

MLP – What works for WLK, could work for a large part of DOW

The market has reacted very well to the WLK announcement that it is placing assets in an MLP. This comes back to what we have written about several times already: neither LYB nor WLK looks expensive if you are sure that the cash is going to be returned to you as a shareholder. By forming an MLP, you provide much more certainty about the return of cash. In its conference call today LYB management suggested that its tax structure might make such a move less interesting.

DOW might consider a large MLP in the US – encompassing its existing basic chemicals (NGL derived) and infrastructure assets – AND – the large projects for ethylene and propylene, funding these projects through a capital raise (share issuance) from the MLP, thereby taking some of the risk away from the parent. DOW could retain the majority ownership and most of the cash flow.

Take a reasonable offer for the Ag business – but don’t wait

There is an element of trying to be too clever in DOW’s hinted at strategy with regard to the Ag business. The business is on a great trajectory today, and all things being equal, the company (and we) can see how it could be more valuable in the future. But all things are never equal. Today’s Ag businesses command a premium multiple to diversified or commodity chemical businesses and there is a positive arbitrage in a stock swap or spin, in that the legacy DOW would likely end up with a proportionally lower share count and higher pro-forma EPS.

  • This relationship may not exist in two or three years – we are not sure we can come up with a robust argument as to why it might not exist, but a global backlash on GMO’s and the use of chemicals in farming might be one possible reason.
  • If DOW believes its own rhetoric about the innovation upgrade of its broad portfolio, it should buy into the idea that, while the Ag business may be worth more in 2-3 years, legacy DOW should be worth more also. If the company is looking at a spin or stock swap (a straight sale has some pretty awful tax consequences) it is the relative value of the Ag business versus the legacy business that matters, not the absolute value. That relative value could be at a peak today.

Risks – Some Common – Some Specific

The common external risks are the spread between oil and natural gas, European competitiveness and the general state of the global and regional economies. We think that the companies will move in tandem with all of these risks from a valuation multiple perspective, and would not highlight one as being any more vulnerable than the other at this point.

The other common risk, which could apply to one company or the other or both, would be acquisitions. Both are telling a story of capital discipline, targeted investments, focus on costs and return of free cash to shareholders. If either were to make a significant acquisition we think that shareholders would be disappointed and the stocks would underperform. Both companies appear convinced that ethane will be in

abundance in the US going forward, and consequently are probably not interested in back integrating into E&P. However, if export terminals for ethane get built and if there is sufficient export demand to fully load the facilities, this might raise concerns and could encourage either company to think about committing capital to secure access to NGLs.

Specifically to DOW, the risk is that the cost focus is temporary and stops at simply scratching the surface of the opportunity. DOW should have LYBs commodity EBITDA margin as a goal and continue to focus on driving its costs down to a level to achieve that margin. DOW is also at risk from rising construction costs in the US Gulf – discussed by LYB on their conference call today. DOW could see meaningful increases in the costs of its US Gulf projects, which would reduce the returns on these facilities.

The relative upside to LYB would come from a much better refining environment in the US as this would be a benefit that DOW would not enjoy.

©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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