Analysis: DWDP LYB

The time has finally arrived. On April 2, DowDuPont (DWDP) will complete its separation of New Dow, or Dow Inc., from the enterprise through a one-for-three spinoff, leaving Corteva Agriscience and New DuPont as the remaining entities within DWDP. This spinoff has been a long time coming, as Dow Chemical and DuPont merged on Sept. 1, 2017, setting forth a path of combination, synergy realization and eventual separation. Throughout this period, we invested in DWDP because we believed shares did not reflect a sum-of-the-parts valuation that was greater than its whole and the breakup would unlock that value. After much patience, the large catalyst event that we expect will force the market's valuation to converge towards the entity's true value has finally arrived.

For those unfamiliar with how spinoffs work, your share count in DWDP will not change from the transaction, however investors should expect DWDP to decrease in price. But fear not, the total value of your investments will not change. As typical with spinoffs, the market value of Dow will come out of DWDP, transferring to a brand new holding in your portfolio on a 1 for 3 share basis. Let's say you own 300 shares of DWDP. After the spinoff occurs, you will maintain ownership of 300 shares in DWDP, but now you will own 100 shares in the New Dow [300 shares * spinoff terms (1 for 3) =100 shares]. Dow Inc. will also replace DowDuPont in the Dow Jones Industrial Average effective the spin.

This transaction qualifies as tax-free, meaning that a percentage of your cost basis in DowDuPont will be allocated to New Dow based on the terms of the spin (again, 1 for 3) and the market values of the child (New Dow) and parent company (DowDuPont). Furthermore, investors will not incur a capital gain/loss from the corporate action until shares are sold, of course. When the transaction is completed, we will help walk you through the steps of how cost-basis changes. For investors looking to get an idea of how cost moves, this website here offers a simple look into the moving parts. We will be using the open price of New Dow as our "fair-market value."

Now before we dive in to New Dow, we want to remind members of how DowDuPont provided a downside update to its first quarter 2019 earnings last Thursday (see our Alert here.) Specific to New Dow, management now expects net sales to be down low-teens percent and operating EBITDA down mid-20s percent, versus previous guidance of down high-single digits percent and down low-20s percent, respectively. This was primarily driven by greater than expected margin compression globally in Packaging and Specialty products. While a disappointment, it was good on management to get the quarterly downside out to the public and into the stock ahead of the spin.

The Portfolio:

Source: Dow Corporate Presentations

What exactly has changed from the Old Dow to the New since the September 1st, 2017 merger date? The new DOW has realigned several businesses, divested some others, and transformed into a focused business portfolio with a more efficient operating base. Previously, the old Dow was spread across 15 businesses and as one could imagine, managing all those different types of businesses could get difficult. The New Dow will be much more streamlined, operating six different businesses in three market verticals.

Source: Dow Corporate Presentations

Dow Inc'.'s three major Segments are: Performance Materials and Coating; industrial Intermediates and Infrastructure; and Packaging and Specialty Products.

The Performance Materials and Coatings business can be broken down into two units: Consumer Solutions and Coatings & Monomers. The Consumer Solutions business is slightly larger in sales and is where Dow's world leading silicone and siloxane businesses comes into play. Its materials go into nearly every household/personal care, cosmetic, and cleaning product used today. Meanwhile, the Coatings and Monomers business is known for its acrylic franchise from Rohm and Haas, but there are intriguing opportunities for growth that are less thought of. For example, autonomous vehicles require coatings that Dow management says, "have to be able to talk to cars", so the increased adoption of driverless vehicles requires more durable coatings on traffic and road markers. Dow Inc. provides these solutions.

The Industrial Intermediates and Infrastructure segment can be broken into two units: Polyurethanes & CAV, and Industrial Solutions. Customers in the polyurethane markets tend to grow at a rate well above GDP, driven by their usage to global challenges. At the New Dow Investor Day last November, Jane Palmieri, DowDuPont's President of Polyurethanes and Head of Asia Pacific, referred to these when she said, "Things like population growth, resource scarcity, energy consumption and as one of the most versatile chemistries, polyurethanes are used at least to some extent in pretty much in any industry you can think of. This translates to robust demand growth for polyurethanes technologies and solutions." At Industrial Solutions, this business produces chemical intermediates and its products have ties to a wide range of markets, including energy, consumer technology, life science, and industrial applications.

Lastly, Packaging and Specialty Plastics is the company's largest segment by EBITDA and can be broken into two units: Packaging & Specialty Plastics and Hydrocarbons & Energy. This business has a global reach, and roughly two thirds of sales come from outside the United States. This business is where Dow Inc. flexes its muscles as the world's largest product of ethylene, polyethylene, specialty resins, and adhesives for packaging. Thanks to its global footprint, Dow can leverage advantaged feedstock (input) occasions, which in turn helps stabilize margins during period of economic downturns.

Volume growth multipliers, historical operating EBITDA margins, and near-term drivers of each segment can be found in the company's slide below. Note that each segment's volume growth compared to global GDP has a >1 multiplier. Furthermore, fourth quarter 2018 operation EBITDA margins in two of the three reporting segments were at the lower bound of company's historical range. This is just one piece of the puzzle, but this information shows that Dow's fourth quarter margin results were near historical lows, which therefore suggests improvements to come in the future as the cycle improves.

Ethylene Cycle:

Source: Dow Corporate Presentations

Dow Inc.'s margins are highly dependent on commodity prices. Despite the pressures that hurt margins in the fourth quarter of 2018 and at the start of 2019, management holds an optimistic view of the supply and demand dynamic, with the latter growing at a rate of about 1.4x global GDP. As one could assume, differences in global growth assumptions can create a debate between the bulls and the bears due to expectations in demand and margins.

On the bull side, analysts at Bernstein expect a global ethylene upcycle to occur in 2020 (see Bernstein's figure above) as demand overcomes challenges related to a global economic slowdown and outpaces new supply despite expected additions in the U.S. They believe the current market condition is tight and will only get tighter over the next two years with the expectation for ~12.4 metric tons per annum (mta) of new ethylene capacity compared to ~14.4 mta of demand growth. Based on their figure, we are currently near a bottom in terms of margins with uplift coming next year, and the large dividend yield at its current price supports that type of thinking.

On the bear side, though, any disruption to global economic growth (whether it be from interest rates, trades wars, etc.) would certainty cause demand trends to grow beneath new supply. If you are bearish on the economic picture, then it is natural to be lukewarm to New Dow and we would not fault you on that. Still, it is worth noting that Dow's fastest growing region is APAC (Asia-Pacific), which also tends to be the regions with the highest levels of economic activity. Plus, Dow's position as the low-cost provider in the market should make them better equipped at handling a downturn compared to peers.

But we also must be mindful of all the different types of plastic bans many cities and companies have pledged to. Dow Inc. wants to be part of the solution towards ending plastic waste, but that would certainly come as slight headwind to margins. Still, Dow Inc.'s commitment to the cause is evidenced through their leading role in the Alliance to End Plastic Waste, which aims to manage plastic waste and promote post-use solutions of plastics.

Operating Structure:

Source: Dow Corporate Presentations

With greater focus comes improved capital discipline, and management expects capex of the New Dow to be less than or equal depreciation and amortization (D&A), unlike the old Dow which had capex greater than D&A. After spending five years with capex exceeding D&A, management has now transitioned its focus to incremental, high-return on invested capital projects. Think brownfield projects over greenfield. Not only do brownfield projects inherently carry lower risk, this type of strategy will also free up capital to be returned to shareholders.

Capital Returns:

Source: Dow Corporate Presentations

We think investors are going to like how friendly of a capital return policy the New Dow will have. Management is targeting an industry leading long-term payout ratio target across the full length of the cycle at about 45% of net income. The figure above shows that Dow's dividend payout ratio is one of highest, if not the highest, payout ratios amongst Chemical peers.

Management plans to increase the dividend appropriately as earnings and free cash flow increase. On buybacks, management is committed to share repurchases as part of an ongoing capital deployment strategy. Their near-term target for repurchases is more than 20% of net income.

From a yield perspective, the most logical one to compare Dow Inc. against is multinational chemical giant LyondellBasell (LYB) , which currently yields about 4.80%. Now the two won't trade exactly apples to apples, but if we extrapolate LYB's ~4.62% yield to new Dow, we get a stock with significant upside from the current when issued line price. In fact, a 4.67% yield puts new Dow around $60.60.

Source: Dow Corporate Presentations

So how much capital will New Dow offer shareholders? Management has already announced that it will initiate a $3 billion share repurchase program after the April 2nd separation date. We cannot expect management to exhaust its entire $3 billion program over the next nine months, however, the appropriate paper work has been completed and the company will have the ability to repurchase stock immediately upon separation through a 105b program, as evidenced by the press release here. This will allow management to take advantage of the intrinsic value of the stock during a window that is frequently closed due to the timing of earnings.

As for the dividend, income-oriented investors will like what the company is offering. Management has announced that annual dividend payment will start at $2.1 billion. But what is that on yield terms? Since New Dow hasn't become public yet, we cannot pinpoint exactly what the dividend yield will be; however, we can take a look at the "When Issued" line for guidance. As of the close on March 29, Dow-When Issued traded at $51.63, implying a yield of about ~5.4%.

According to a March 14th research note from Fermium Research analyst Frank Mitsch, a 5% yield (which he suggests should be an "outright bottom") means DOW trades at $56 and a 4.50% yield puts the stock at about $62."To our way of thinking," Mitsch wrote, "we'd place New Dow initially in the 4.0 - 4.5% range, which translates to a share price range of $62 -$70/sh."

It's also worth noting that at the current price, New Dow will have the largest dividend yield in the Dow Jones Industrial Average by a steep margin. That means it will find appeal to the subscribers of the "Dogs of the Dow" investment strategy, which calls for investing in the 10-highest dividend yields stocks in the Index on the premise that the specific company's business cycle is near bottom, though this strategy is often implemented at the start of the year and not in Q2. Nevertheless, a large yield during a period when the company is working through de-stocking issues is indicative of a bottoming of the business cycle, suggesting that better times are ahead.

Balance Sheet:

Source: Dow Corporate Presentations

How about the balance sheet? The slide above displays the solid degree of financial flexibility and liquidity New Dow will have. By the time of the spin, New Dow will have about $3 billion in cash and $18 billion in financial debt for a net debt total of about $15 billion. But management's operating target calls for financial debt to trend more towards $16 billion, putting its net debt target at about $13 billion. In the longer run, management's target adjusted gross debt to EBTIDA ratio across the cycle is 2.5x to 3x. With an improved EBITDA to CFFO conversation target compared to the old Dow and a manageable debt maturity profile, management should be able to maintain a strong investment grade credit rating across the cycle.

Peer Comparisons:

Source: Dow Corporate Presentations

From an investment thesis compared to peers perspective, Dow Inc. management presents a compelling argument. Management plans to work down corporate costs over time, reducing it from the $325 million they have modeled in 2019 to "closer to $200 million over the first year-time period," as CEO Jim Fitterling previously stated at the New Dow Investor Day. Between remaining cost synergy savings and strand cost removals, management believes there is about ~$800 million yet to be delivered. Of that total, 75% is expected to be realized in 2019. As for incremental growth investments, this comes from management's brownfield approach and their favoring projects with quicker payback periods, low execution risk, and fundamentally higher return on invested capital. Dow has already invested in a "Wave 1" series of projects that will provide additional capacity to the Gulf Coast and is expected to deliver $200 million to $350 million of operating EBITDA this year (depending on margins) with no execution risk. But that's not the only project at the company. Management has another growth investment initiative, called "Wave 2," and investors will begin to see this earnings tailwind in the first quarter of 2020.

On the stability front, management believes the New Dow portfolio offers both diversity and cross-cycle resilience thanks to its global scale, improvements to cost structure, a favorable debt maturity schedule, and the flexibility to move in and out of low-end businesses that may not be profitable in a downturn. Lastly, we know from the above that the capital return framework is extremely favorable to investors.

Additional Considerations:

We hold a positive long-term view on the undervalued yield story that is New Dow, however, we do want members to be well aware of the general types of technical pressures that come with significant corporate action. We expect there will be some volatility at first as the company solidifies its investor base and the old DWDP investors officially decide whether to remain in the name for the longer term, though we see little reason why those investors who bought in to the breakup on the premise of value creation would succumb to an early departure.

Analysts from Bernstein presented this case when they initiated coverage on DOW with a $74 12-month price target last Tuesday. "We see downside to ~$40-$45/share immediately following the spin as many DowDuPont holders jettison Dow in favor of the DuPont/Corteva RemainCo," they wrote in a research note. "There will also be technical selling pressure as we do not expect Dow to be immediately included in the S&P500, causing outflows from index funds that will continue to hold DWDP. All told, we see downside of ~10-20% based on other recent spins, but the exact nature or duration of the decline is difficult to predict given the idiosyncratic nature of spinoffs." Keep in mind that this fraught initial expectation comes from the research team who project a bullish upcycle in 2020.

Now, since Bernstein's post we have learned that Dow will indeed be added to the S&P 500 at the open April 2nd, so the outflows as predicted by Bernstein should not be as robust. However, if we do see some type of indiscriminate selling at Dow Inc.'s inception, don't write the stock off in a panic. Stocks tend to be volatile around the completion of large corporate actions. Recall that we saw Disney go through heavy selling pressure when it closed on Fox acquisition, but that selloff has turned into a solid buying opportunity.

Just as importantly, because this transactions strips out about one third of the value for DWDP into this new position, our small weighting in the name will provide us the luxury to scale into a larger position at a measured pace, allowing ourselves time to get comfortable with how it trades.

But what does Bernstein think long-term? "Dow shares recover and stabilize at ~$60 as the investor base resets and commodity margins remain resilient over the course of 2019," they added. "Built into this belief is the assumption that the market will value Dow on EV/EBITDA at a slight premium to LYB, and that pension liabilities will generally be excluded from enterprise value calculations."

How about after that? "Shares to $74+ as market begins to discount ethylene upcycle margins of ~$1200/tonne. While we do not expect the market to apply a ~6x multiple to upcycle earnings (which would yield a share price of ~$100)," Bernstein explained, "we do expect Dow to move up with ethylene margins as has happened with ethylene peers in the past, not to mention other commodity producers."

Now this is just one opinion from the sell-side, but it is illustrative of how stocks can be volatile after major corporate actions with it having nothing to do with the company's business prospects. Should the stock get hit on a changing investor base, even though it will likely create an opportunity in the long-run, we still must be sensitive to both timing and price. Having said that, New Dow will have the benefit of a large dividend yield, and we would expect income hunters to stabilize the stock should the yield balloon in size.

Bottom Line, Price Target, Rating

Over the past year and half, Dow has gone through a portfolio and operating structure transformation which has created a more focused and capital efficient entity. In the near-term, shareholders stand to gain from a robust capital return program via dividends and buybacks. In the more immediate term, if management's expectations hold and there is an ethylene upcycle in 2020 like what Bernstein projects, the company will enjoy a period of significant earnings expansion. However, with the separation catalyst here, we must also be more critical now than before on expectations of global growth, and act should economic activity appear to deteriorate. But with the Fed pausing its interest rate hike glidepath and a more amicable trade rhetoric driving markets again, a global GDP growth rate near 3% may be achievable.

Tomorrow, we will be initiating Dow with a $62 price target to start, reflecting roughly 12x consensus 2019 earnings per share. Although we are watching the trading in the name initially, we will rate the stock a ONE given the de-risked nature of last week's preannouncement and the stock's attractiveness to income-oriented investors. We note that our upside target of $62 price would have a dividend yield of approximately 4.50%.