The Dow Chemical Company Flaunts Its Blue Chip Status, Grows Earnings 44%

Make that four consecutive quarters now that The Dow Chemical Company (DOW) has beaten Wall Street expectations. More important for investors, the company has now posted eight straight quarters of year-over-year growth in adjusted earnings per share, EBITDA, and profit margin. The growth may continue for the foreseeable future, as management announced plans to cut fixed expenses by $1 billion in the next three years. But is the growth sustainable and are the goals realistic? Here's what you need to know.

By the numbers

The Dow Chemical Company grew handsomely compared to the year-ago period. While revenue grew a respectable 5%, net income and adjusted EPS grew 43% and 44%, respectively. How did the company manage to do that? A strict focus on operational efficiency and prudent management of cash spending in recent quarters continues to pay off. Meanwhile, favorable market conditions and improving manufacturing performance are providing boosts as well.

Source: Dow Chemical press release.

The numbers are great, but not all revenue and income growth is created equally. Remember, Dow Chemical has five major business segments, each with unique challenges and opportunities, contributing to the top and bottom lines. What were the key drivers of success?

Shining stars

Three segments significantly outperformed the year-ago period.

Source: Dow Chemical presentation.

Electronic & Functional Materials was largely driven by gains in functional materials for energy and pharmaceutical applications. For instance, the company's broad portfolio of microbial control products has found an important niche in America's energy boom. The average shale gas well requires roughly 2 million to 5 million gallons of water, so it's easy to see why drillers would attempt to recycle as much water as possible. However, reusing water that contains high concentrations of microbial cells can lead to inefficient processes, broken pumps, and costly downtime. By actively managing the buildup of bacteria and fungi cells in recycled water with Dow Microbial Control products, drillers can cut costs and downtime. 

Performance Materials was driven in part by double-digit growth in specialty chemicals (thanks again to America's shale energy boom) and novel automotive adhesive technologies that allow automakers to slash curb weight without sacrificing performance or functionality. However, much of the segment's gains were derived from productivity improvements in polyurethane and propylene derivatives. Both enjoyed boosts from seasonal trends: the former from bedding and furniture sales and the latter from inventory buildup of aircraft deicing fluids.

Performance Plastics capitalized on the world's growing middle class, which has resulted in a steady stream of momentum in personal-care packaging and consumer product applications. Pricing power and support -- driven by increased demand, more certain supply chains for raw materials in the Gulf Coast, and scheduled downtime at manufacturing facilities -- were major factors in the segment's growth during the quarter. While not every contributing factor is permanent, Dow Chemical should be able to enjoy growth as middle classes swell and less volatility as chemical producers gobble up excess raw materials.

Propylene glycol-based deicing fluids are among the most common used at airports. Image source: Alex Pereslavtsev/ Wikimedia Commons.

The remaining two segments, Coatings & Infrastructure and Agricultural Sciences, were the laggards of the group. The former only barely managed to grow revenue for the seventh consecutive quarter, although efficiency gains led to stronger gains of 2% in EBITDA compared to the year-ago period. Meanwhile, Dow AgroSciences reported record year-to-date revenue, but challenging market conditions and a loss of pricing power sank EBITDA 72%. Investors do get to look forward to the launch of the recently approved Enlist Weed Control System, which stacks two herbicide traits to provide farmers with more robust tools.

Is the growth sustainable?

The answer to this question depends largely on whether or not North America's petrochemical pricing power is permanent, or how long it remains. Falling oil prices will probably help lessen the pressure to export petroleum, which will result in a higher domestic supply of raw materials for chemical manufacturers such as Dow Chemical to tap into. A large focus on monetizing the chemical building blocks found in natural gas, such as ethane and propane, by converting them into higher-value products, such as ethylene and propylene, will also begin to enable significant cost reductions, vertical integrations, and pricing power for chemical manufacturers near shale energy plays.

Investors should also not forget the long-term value creation that will be enabled when Sadara, the joint venture formed with Saudi Arabian Oil Company in 2011, begins producing in the second half of 2015. Dow Chemical stands to earn roughly $500 million in annual equity earnings through 2026 and realize cash flow positive operations by 2020.

The bottom line on Dow Chemical's third quarter

At this time there's nothing to suggest that Dow Chemical will struggle to keep the momentum going. A new focus on efficiency will continue to boost profit margin and income over the next several years, even if specific business segments fail to impress in a quarter here or there. Efficiency will also help the company respond to or weather a period of slower-than-expected economic growth or volatile commodity prices. While some variables are out of the company's control, management appears to be executing on the things it can control -- which will help Dow Chemical retain its status as a blue chip stock.