[DWDP – DowDuPont] Rack & Break; Part 1
Part 1 is about the past. It will give you an overview of what Dow and DuPont were before their 2017 merger. Part 2 is about the future. It gets into the profit potential and valuation of DWDP’s constituent parts.
Salient experiences create salient stocks. We zone out to Netflix on our iPhones, order more of everything on Amazon, enrage ourselves on Twitter and Facebook. The consideration that large cap tech companies get from us as investors mirrors the attention their services demand from us as consumers. But unless you are living in a cave, I assure you that products from DowDupont touch many more aspects of your everyday life. But quietly, in the background, without clamoring for every unoccupied cranny of consciousness.
In one way or another, they give rise to: the foam in your bed and in your car seat, the paint markers on the road, the dye in your clothes, the detergent you use to wash your clothes, the shampoo you smoosh into your hair, the plastic container from which you poured the shampoo, the paint on your walls, the insulation encased by those walls, the adhesive that keeps the windows in your office from blowing off during violent storms. These are the culmination of a process that converts upstream feedstocks, namely crude oil and natural gas into ever finer gradations of intermediary components…for instance, natural gas is used to make ammonia, which can be converted into the hydrogen cyanide that is used to manufacture monomers that are strung together to create a certain variant of plastic. Large, diversified players like Dow and DuPont integrate production to varying degrees, carrying some intermediates into high margin “specialty” chemicals and offloading others to the merchant market. Here is a breakdown of the value chain, from feedstock to application:
The capital required to stand up a globally distributed constellation of plants, electrical equipment, pumps, storage tanks, etc.; the R&D resources needed to continuously refresh product pipelines; the expertise involved in scaling lab discoveries to global production and sale; the time dedicated to mastering process technologies and earning the trust of multi-national customers forbid frivolous entry, and the drive to capture scale economies has resulted in decades of consolidation in the western world.
But this has been offset by capacity coming online in Asia and emerging economies, turning what were once specialty chemicals with healthy unit economies supporting custom formulations into commodities that increasingly differentiate on price. And it seems that, with the help of activist pressure, the proud engineering cultures of Dow Chemical and DuPont are reluctantly coming to terms with the fact that the R&D dollar perhaps does not go as far as it used to and that future value creation will come as much from cost discipline and operating efficiency as it does from innovation.
Years prior to considering a merger with DuPont, Dow was a perennial restructurer. From 2006 to 2013, as part of two separate Board reviews that explored avenues to becoming a “consistent earnings growth company”, management shifted its portfolio towards higher margin, faster growing business lines like acrylics, plastics, and electronic materials while it divested cyclical, low return commodity intermediates like polypropylene and chlorine. In 2015, the company bought the part of the Dow Corning silicon JV that it didn’t already own and was actively shopping its etiolated agricultural sciences business to several big ag sciences players who were themselves entangled in various acquisition, divestiture, and JV discussions. But none of these machinations changed the fact that Dow Chemical was still a sprawling conglomerate with mediocre returns on capital. When you see a laundry list of “one time” add backs in year 7 year of a transformation process, you start to wonder whether the restructuring process itself needs restructuring.
Perhaps Third Point wondered the same thing in 2013 when it first disclosed a position in Dow. The hedge fund clamored for Board seats, which they got, and a separation of Dow’s Agriculture and Specialty Chemicals businesses, which has been put into motion. Dow also announced a $5bn share buyback program and an incremental $1bn in cost saves over 3 years, likely spurred by Third Point’s involvement. Here is Dow’s revenue and earnings mix in 2006, the year it formally embarked on its portfolio restructuring, compared to 2016, its last full year before merging with DuPont:
In the early/mid-2000s, feedstock cost inflation was relentless, with oil and naptha hitting record levels. By July 2006, Dow had seen 16 straight quarters of y/y feedstock inflation, and could not raise prices fast enough or high enough to fully recoup the hit. The upstream, capital intensive “Basics” businesses that loomed large in 2006 were no longer classified in 2016. The Chlorine value chain (chlor-alkali and its downstream derivatives) that comprised most of Basic Chemicals was sold to Olin Corp in 2015 for $7bn, while polyethylene, which made up most of Basic Plastics, was reclassified into Performance Plastics, rendering the distinction between performance and basic products somewhat fuzzy1.
Anyways, in 2008, waning global demand and escalating feedstock costs were exacerbated by two hurricanes that idled 80% of Dow’s North American capacity in September, just as input costs descended. Moreover, in December of that year, the Kuwaiti government unexpectedly nixed a joint venture partnership that would have supplied Dow with $9bn for its recently announced $18bn cash acquisition of specialty chem player Rohm and Haas. Dow tried to renegotiate the deal. Rohm sued, forcing Dow to issue some expensive preferred stock yielding 15% – supplementing the dilutive 8.5% convertible preferreds that it had already agreed to issue to Berkshire Hathaway and the Kuwaiti Investment Authority – to consummate the transaction without compromising its investment grade credit rating. Dow was forced to take write-offs on the acquisition almost immediately upon closing in early 2009, and while it’s hard to really say how Rohm & Haas performed in the years that followed – most of Rohm was split between “Electronic and Specialty Materials” and “Coatings and Infrastructure” before being buried across “Infrastructure Solutions” and “Consumer Solutions” when business line reporting was changed a few years later – it’s probably fair to say that paying over 6x post-synergy “peak” EBITDA was a mistake2.
But then, some relief. Starting in the mid-2000s, companies started fracking the hell out of shale rock and the US was suddenly drenched in cheap natural gas years later, rejuvenating a US petrochemical industry that relied on hydrocarbon based feedstocks. [Ethane is extracted from natural gas and “cracked” into monomers like ethylene, which is converted into polyethylene. Polyethylene, along with polypropylene, whose production also ties back to natural gas via propylene, are the two most common types of commodity plastics, found in food containers, ropes, medical equipment, lab devices, clothing…a whole bunch of stuff. And plastics is by far legacy Dow’s biggest business, accounting for nearly half its EBITDA.] Suppliers like Chesapeake and Enterprise Products announced ambitious projects to produce and deliver natural gas liquids to the US Gulf Coast, into the cracking infrastructure laid by petrochemical companies. To reduce its dependence on purchased ethylene and propylene, and attenuate feedstock cost volatility, Dow expanded cracker capacity in the Gulf, which included building the world’s largest ethylene asset in Freeport, TX. As the lowest cost olefin plant in America, Freeport went into production in 3Q17 and presents a major source of incremental profits in the coming years. Moreover, Dow’s “flexi-crackers” could alternate between cracking propane and ethane, so not only did Dow benefit from depressed natural gas prices, but it could pick and choose between the cheaper of the latter’s derivatives when making ethylene.