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WIKI ANALYSIS
With a market cap of US $42.2 billion, Dow Chemical (NYSE:DOW) is the world's second largest chemical manufacturer. Its products are used in a wide variety of end industries, from the automotive to toy. Dow Chemical is composed of six operating units: performance plastics, performance chemicals, agricultural sciences, basic plastics, basic chemicals and hydrocarbons & energy. Performance plastics and performance chemicals accounted for nearly half of Dow's revenue in 2006.
Dow is not reliant on any single set of customers--with 37% of its revenue coming from the United States, 36% from Europe and 27% from the rest of the world, the company is instead unusually dependent on the strength of the global economy. Thus, Dow is not prone to wild fluctuations in value--its diversification makes it largely immune to local or even national slumps. For instance, reduced demand for Dow products due to a housing slump in the United States may be offset by an increased demand for Dow products in emerging markets worldwide.
The cyclical nature of the chemical industry can also hurt Dow, as long term economic slowdowns can often last several years. And although demand for Dow products is fairly predictable, the actual cost of productionis prone to swings. This is because the primary chemicals that Dow uses are derived from oil, natural gas, and other petroleum products, making Dow especially vulnerable to the price variations of one of the most unpredictable and financially volatile commodities in the world.
History and Products
Dow Chemical was founded in 1897 by Herbert Henry Dow, who discovered an efficient method of extracting bromine from brine in Midland, Michigan. Dow's headquarters are still located at Midland today. At first Dow sold only bleach and pottasium bromide, but now Dow sells hundreds of different chemicals most notably polyethylene, synthetic rubbers and polystyrene. Dow used to have a product line including Saran wrap and Ziploc bags, however, those lines have been sold to S.C. Johnson & Son.
Products
Dow Chemical is composed of six operating units. Performance plastics (used in automotive and construction industry), performance chemicals (used as starting materials in agrochemicals), agricultural sciences (products used in insecticides and herbicides), basic plastics (found in a vast array of consumer products), basic chemicals (found in paints and some food products) and hydrocarbons & energy (oversees energy management at Dow).
| Revenue $M | ||||||
| 2002 | 2003 | 2004 | 2005 | 2006 | CAGR | |
|---|---|---|---|---|---|---|
| Performance Plastics | 7 926 | 8 694 | 10 449 | 12 405 | 13 944 | 15.2% |
| Performance Chemicals | 4 941 | 5 372 | 6 483 | 7 521 | 7 867 | 12.3% |
| Agricultural Sciences | 2 717 | 3 008 | 3 368 | 3 364 | 3 399 | 5.8% |
| Basic Plastics | 5 894 | 7 028 | 9 284 | 11 007 | 11 833 | 19.0% |
| Basic Chemicals | 3 351 | 4 357 | 5 439 | 5 643 | 5 560 | 13.5% |
| Hydrocarbons & Energy | 2 435 | 3 820 | 4 876 | 6 061 | 6 205 | 26.3% |
The Global Economy and Dow Chemical
More so than most industries, the profitability of the chemical industry is closely correlated with the strength of the global economy. This correlation with the global economy is also the reason that the chemical industry is cyclical in nature. In essence the cycle works like so:
1. Demand for Dow products is sufficiently high such that Dow increases its capacity. This capacity increase is normally very large.
2. Prices drop due to the increased supply of Dow products.
3. Demand continues to increase as the global economy grows, which causes prices to increase and the capacity increase becomes profitable.
4. Once again the demand for Dow products is sufficiently high to increase capacity. So starts the cycle again.
From 1991 to 2006 the value of a Dow Chemical stock was 73% correlated with the percentage growth in world GDP.
Commodity Margins
One of the most important concepts in the chemical industry, is that of the commodity margin. The commodity margin is simply the difference between the price a chemical is being sold for (demand) and the cost of producing that chemical (supply). Factors that can influence the demand for a chemical are:
Recycling
Recently, bills have been passed in California that further encourage the recycling of plastic bags. This is harmful to the chemical industry because 38% of polyethylene resin demand comes from films and bags. About 70% of Dow's capacity in the basic plastics operating unit is polyethylene, so an increase in the rate of recycling of plastic bags can be very harmful to Dow. A Democrat victory in the 2008 presidential election will likely result in an increase in recycling initiatives across the United States, which would have a negative impact on Dow.
Housing and Automotive Slumps
It has become very apparent in the last few quarters that the housing industry and the automotive industry are both suffering. Many of Dow's performance plastics are used as end products in both the automotive and housing industry. Because performance plastics are more value-added than basic plastics, slumps in the housing and automotive industry will have less an effect on commodity margins. However, performance plastics can still display commodity like behavior at times.
Shift in semiconductors toward hafnium
For decades, Silicon has been the main insulator used in semiconductor chips. Recently, IBM, Texas Instruments and Intel announced that they would be producing chips that use a substance called hafnium as an insulator. Dow, through its JV Dow Corning, produces Hi-K precursors, which can be used to produce insulators like hafnium.
Ethanol Production
Since 2001, the production of ethanol in the United States has more than doubled. This is helpful to Dow because Dow chemicals are a large component of the fertilizers used in the growth of corn. As well, herbicides derived from Dow products are used to control weeds in cornfields, which further increases demand for Dow products. Whereas a Democrat victory in the 2008 election hurts Dow in terms of increased recycling, a Democrat victory will help Dow here as the Democrats have historically been more likely to encourage the use of alternative fuels.
Whereas a few variables affect the demand for Dow products, only one really affects the cost of production.
Price of Oil, Natural Gas and Petrochemicals
Most of the primary materials Dow produces are derived from either natural gas or oil. Ethylene and propylene are both derived directly from oil, so an increase the price of oil will decrease ethylene and propylene margins. Acetylene and methanol are derived from natural gas, so an increase in the price of natural gas will decrease margins for these two primary chemicals. The relationship between the price of oil and ethylene margins is shown below.
The price of a barrel of oil and the ethylene margins are 61% correlated.
Partnerships and Acquisitions
Kuwait Petroleum Corp (KPC) was considering Royal Dutch Shell (RDS'A) and Dow Chemical (DOW) as possible partners in a 250,000-300,000 bpd refinery planned as a joint venture with SINOPEC Shangai Petrochemical Company (SHI) in Guangdong. This one is simple, gaining access to the one of the world's largest and fastest growing economy's and deepening a partnership with Kuwait really has virtually no downside. It does look as though Dow is becoming the "partner of choice" for these nations looking to expand their petrochemical complexes.
DOW is currently working with Berkshire Hathaway (BRK) in order to acquire Rohm and Haas Company (ROH). Dow management defended the deal as the company looks to expand its chemical-product line and diversify away from commodities. Dow has struggled lately as soaring oil costs have eaten away at the chemical company’s margins, spurring double-digit price increases in both June and July. Just over 30% of Rohm and Haas revenues come from materials used to make electronic components, a nice complement to Dow’s current line-up, which is heavy on petroleum-based products.
Dow Ag, a division of Dow Chemical (DOW) has reached an agreement to acquire Wisconsin based Diaryland Seed Co., one of the nations largest independent seed companies. By acquiring Dairyland, Dow will boost its soybean and alfalfa breeding program and expand seed sales in the northern Midwest, where the family owned 101-year-old Dairyland is a well-known brand to farmers.
This is Dow's 5th seed-related acquisition in the past year. The seed business Dow has built currently is strong in corn, sunflowers and cotton and now that is being expended into soybeans and alfalfa with the purchase. Coming into 2010 is the introduction of Smartstax, the first 8 trait genetically engineered seed developed in conjunction with Monsanto (MON).
Dow Ag is growing earnings 15% to 20% annually and with recent (and future) acquisitions and perhaps the largest product launch yet on the horizon, that growth looks to be able to grow unimpeded for at least the next several years.
Railcar Loadings and Other Indicators
One of the most important early indicators used in the chemical industry is the number of chemical railcar loadings per week. This is an early indicator of the demand for the products of Dow Chemicals. The usefulness of railcar loadings as an indicator is limited because only 21% of all chemical shipments are by rail (52% by truck, 23% waterborne, 4% pipeline). Ethylene margins is another important indicator because ethylene is the most produced chemical by Dow.
References
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