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Daniel Loeb Comments on Dow Chemical Company
Posted by: Holly LaFon (IP Logged)
Date: January 22, 2014 01:40PM
Third Point's largest current investment is in The Dow Chemical Company (DOW)("Dow"). Dow shares have woefully underperformed over the last decade, generating a return of 46% (including dividends) compared to a 199% return for the S&P 500 Chemicals Index and a 101% return for the S&P 500.1 Indeed, in April 1999, nearly 15 years ago, an investor could have purchased Dow shares for the same price that they trade at today! These results reflect a poor operational track record across multiple business segments, a history of under-delivering relative to management's guidance and expectations, and the ill-timed acquisition of Rohm & Haas. The company's weak performance is even more surprising given that the North American shale gas revolution has been a powerful tailwind for Dow's largest business exposure – petrochemicals.
We believe that Dow would be st serve shareholders' interests by engaging outside advisors to conduct a formal assessment of whether the current petrochemical operational strategy maximizes profits and if these businesses align with Dow's goal of transforming into a "specialty" chemic als company. The review should explicitly explore whether separating Dow's petrochemical businesses via a spin - off would drive greater stakeholder value.
Dow's petrochemical operational strategy has been to migrate downstream , supposedly to earn higher m argins, to become more "specialty," and to increase the number of customer - facing products. Over the past five years, the shale revolution in North America has led to a boom in natural gas liquids production which has dramatically reduced raw material cos ts, while China and other emerging market economies have aggressively grown downstream derivatives capacity. This combination has led to significant upstream margin expansion in North America, where Dow is the largest ethylene producer, and a commoditizat ion of numerous downstream derivatives margins. Dow's current petrochemical strategy seems misaligned with the changed landscape.
Perhaps unsurprisingly, our analysis suggests that Dow's downstream migration strategy within petrochemicals has not yielded material benefits so far and instead may be a significant drag on profitability. We have examined Dow's aggregate petrochemical cap acities (and associated industry product margins) and compared its petrochemical cost base and profitability with pure - play peers. Our work suggests that upside from both cost - cutting and operating optimization could amount to several billion dollars in a nnual EBITDA. We suspect that Dow's push downstream has led the company to use its upstream assets to subsidize certain downstream derivatives either by sac rificing operational efficiency or making poor capital allocation decisions, or both. Poor segment disclosure combined with Dow's opaque and inconsistent transfer pricing methodology for internally sourced raw materials makes it difficult for shareholders (and presumably, the Board of Directors) to ascertain which business units are most challenged. W hat is easily ascertainable is that the magnitude of the aggregate under - earning warrants a c omprehensive strategic review , preferably with the assistance of an objective outside advisor answerable to a special committee of the Board.
We believe Dow shoul d apply the intelligent logic of its recently announced chlor - alkali separation to the entirety of its petrochemical businesses by creating a standalone company housing Dow's commodity petrochemical segments ("Dow Petchem Co . ") . 2 Such a separation would accomplish two important objectives. First, the split would accelerate
Dow's transition to a true "specialty chemicals" company focused on attractive end - markets such as agriculture, food, pharmaceuticals, and electronics. Second, the standalone Dow Petchem Co . could realign its strategy away from largely focusing on downstream migration/integration and towards overall profit maximization.
The optimization of Dow Petchem Co . combined with the significant step - up in earnings from o rganic growth initiatives already put in place by management – the PDH plant, the Sadara JV, and the U.S. Gulf Co ast greenfield ethylene cracker – could translate into future EBITDA well in excess of $9 billion on a stand - alone basis . This would be before any improvement attributable to what management ref ers to as the "ethylene upcycle " . Both the " self - help " and cyclical upside opportunities create a compelling investment case, which is not reflected in Dow's current share price considering the entire co m pany's 2013 EBITDA base is ~$8 billion .
Despite Dow's best efforts to migrate downstream and become a specialty chemicals company, the market remains unconvinced. By creating Dow Petchem Co . , the strategic direction of these businesses would no longer b e dictated by the broader Dow strategy of becoming more specialty - focused. Instead, management could transform these businesses into a best - in - class, low - cost commodity petrochemical company.
The remaining Dow Chemical ("Dow Specialty Co . " ) 3 would be t he specialty chemicals leader that Dow has aspired to become over much of the past decade. Here too , we see meaningful upside over the coming years:
• In Dow's Agricultural Sciences segment, significant investments have been made in R&D which ha ve yet to t ranslate to profits, most notably in the development of Dow's ENLIST trait package. We are optimistic that ENLIST will be successfully adopted in the South American soybean market, where it has a natural first - mover advantage given that the 2,4 - D herbicide is approved for use in Brazil and Argentina. The South American soybean opportunity alone for ENLIST could i ncrease divisional EBITDA by 30 - 40% once fully penetrated.
• In the Electronics & Functional Materials segment, we see niches with strong e nd - market growth and high barriers to entry, leading to above - GDP growth rates and sustainably robust returns on invested capital.
• Finally, the Dow Corning JV represents a valuable call option on solar power adoption as total system costs for solar contin ue to compress and become
increasingly competitive with other fossil - fuel electricity alternatives in much of the world. Dow Specialty Co . should command a premium to Dow's current multiple, and potentially a premium to other specialty chemicals companies given its attractive EBITDA growth prospects. T he market is skeptical of Dow's divisional margin targets given the lack of clarity around how they were derived and the lack of progress toward achieving them. However , even if management fails to attain t heir targets, we still see the potential for Dow Specialty Co . EBITDA to ramp up to the $4 - 5 billion range over the next 3 to 5 years , co mpared to a 2013 base of ~$2.8 billion .
We believe management's main concern about a spin - off of Dow Petchem Co . will likely relate to the integrated nature of Dow's overall portfolio. Importantly, the majority of the integration in Dow's portfolio exists between upstream / downstream petrochemicals and these businesses would remain together in Dow Petchem Co. In additi on , the integration between Dow Petchem Co . and Dow Specialty Co . is limited to commoditized raw material transfers. Having some amount of commoditized raw material integration does not create differentiation in specialty products nor does it materially i ncrease margins (unless the raw material inputs are being subsidized by Dow's petrochemical segments). The s egments within Dow Specialty Co . which primarily consist of legacy Rohm & Haas businesses and Dow's Agricult ural Sciences segment have successfully operated without raw material integration in the past , or have peers that are able to achieve higher margins without any raw material integration.
W e appr eciate this consideration; it is why we have contemplated a scenario in which bot h the upstream and downstream petrochemical businesses are spun - off together into Dow Petchem Co. W e believe the benefits from a spin - off, including financial uplift from operational improvements at Dow Petchem Co . and the potential valuation uplift from increased business focus and disclosure, far outweigh the supposed integration benefits.
Finally, as Dow management looks to further its journey in unlocking value for shareholders, it now ha s the balance sheet flexibility to consider a meaningful share buyback that could more than offset the share issuance from the conversion of the Warren Buffett (Trades, Portfolio)/KIA securities issued in conjunction with the financing of the Rohm & Haas acquisition. 4 Combined with th e Dow Petchem Co . spin - off, Dow c ould pave a path to ward increased disclosure, greater management accountability for individual business segment performances, and enhanced alignment of interests between management and shareholders. With the difficult task of balance sheet de - levering behind it, Dow finally has the opportunity to embark on its next transformational deal during CEO Andrew Liveris' tenure.
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