It really is “All Change” in the chemical sector this year. While in this case Andrew Liveris is not retiring yet, we see this as a first move in a transition which allows Andrew to retire soon. He has been in the hot seat at Dow for a long time and it was inevitable that he would slow down or retire sooner rather than later. Unlike DuPont and Syngenta, Dow is not really sitting in the middle of investor crosshairs and has not closed its doors to outside advice and opportunity in recent years, allowing activists to reshape the board and embarking on a significant divestment program, culminating in the chlorine chain divestment to Olin this month.
The new three man executive group still faces some significant challenges, not least of which is defining what Dow’s strategy looks like and how the shareholders are going to benefit. Under Mr. Liveris’ watch the strategy has flip flopped from a full focus on specialty to a more recent focus on exploiting commodity opportunities. For the last 18 months we have seen greater focus and consistency of message, with the announcements today clearly another good step in the right direction, but we still struggle to see how a large specialty and a large commodity portfolio can be run effectively under one roof. Dow is not the only company struggling with this issue and it best displays itself in an inflated cost position in the commodity segment.
In our view, Dow is quite well positioned today, perhaps better positioned than DuPont, despite DuPont’s more attractive valuation (based on historical norms). However, a new generation of leadership still has to address some major issues:
- What to do with Ag – on the strategy agenda outlined today. As we have discussed on many occasions, we think that Dow shareholders are likely to be winners in any broad Ag consolidation as the company is more likely to be a seller or participate in a value enhancing JV. Dow has a good Ag business and it is undervalued within the broader Dow portfolio.
- What to do about costs. The company remains very people heavy and like DuPont can unlock value though a more aggressive approach to cost reduction. Some of this could happen through an Ag venture which addressed R&D spend, but there is likely an additional layer of costs to work through.
- What is the plan? Commodity or specialty – can you run both well and with the right cost focus.
Those who know Dow well and anyone who went through the chlorine divestment due diligence process appear to agree on one thing – Dow is top of the class from an asset quality, operational and maintenance perspective. In the commodity space Dow has better quality assets than Lyondell, better scale and integration than Lyondell and, at the margin, better products. Yet Lyondell leaves Dow in the dust in terms of operating margin, free cash flow and return on capital. Some of the benefit is the result of the LYB bankruptcy and the streamlining of Lyondell’s capital base, but most is the LYB focus on being the lowest full cost producer (as opposed to lowest variable cost producer – which Dow can almost claim, behind Exxon).
Dow’s underperformance and value destruction over the last decade (first chart below) rests in part on not keeping up on the cost side – something management can address – but also rests on some very poor, or poorly timed strategic decisions, such as the acquisition of Rohm and Haas. These poor decisions have, in our view come from excessive optimism – second chart.
The investments in Saudi and the US Gulf, as well as the restructuring in Kuwait should add meaningfully to cash flows and the team can win by focusing on what Dow has today and operating the business as efficiently as possible.
Aside from Ag, but related, there is one strategic move that makes sense to us and that is a broad combination with DuPont. This would create a world class Ag business, a world class polymers business, commodity and specialty, and a world class specialty chemical company. More value would likely then be created by splitting into three, but this would be a bold and likely very value added move.