Dow Inc. (DOW) Earnings Call Transcript & Summary

Next up, I'm very pleased to introduce Howard Ungerleider, the CFO of Dow Chemical. As many of you know, Dow is one of the largest producers of polyethylene and polyurethanes on the globe and retain some of the best feedstock flexibility within the industry. Despite its recent rally, Dow still retains a dividend yield close to 6%, which we have consistently flagged in our research as sustainable. Today, Howard is going to be kind enough to start off with some brief remarks, but then we'll utilize our time in a fireside chat format. As a friendly reminder, this event is open to the public, and we recommend referring to the cautionary and forward-looking statements in the materials Dow will post. With that, it's my pleasure to turn it over to Howard.

Well, thanks very much for having us, Chris. And that was a nice introduction. Good afternoon, everyone. This quarter, team Dow has continued to deliver through what I would call a range of extraordinary circumstances, a pandemic that we're all dealing with, the flood that was specific to mid-Michigan and now a hurricane on the U.S. Gulf Coast. Now to those who were impacted by the recent storms, because there are a couple of them so far, we hope each of you and your families are safe and healthy. We are immensely grateful that all the members of team Dow thankfully remained safe through Hurricane Laura. Our Dow sites in the U.S. Gulf Coast reported minimal damage. The vast majority of the sites that shut down in preparation for the storm restarted within a week, and Dow has avoided major supply disruptions to our customers. We're still finalizing the financial impact, and it's underway, and we'll have more to share on that on our earnings call. But overall, we've been very pleased with the low level impact the storm has had on our operations. We anticipate the impact financially to be approximately $75 million primarily in lost margin from downtime with what I would say was minimal physical damage costs. Now turning to the quarter. Overall, macro conditions are continuing to progress as we expected. The economic recovery is definitely continuing. It's continuing at various paces across both markets and regions around the world. Demand has definitely improved from the second quarter lows, and we continue to match supply levels accordingly. We have increased our operating rates across the enterprise, and they are now approaching first quarter levels. And market tightness in polyethylene and isocyanates are both supporting price increases, which, together, are driving improved earnings and incremental margin upside. We have continued to capture robust demand for packaging applications, and our year-to-date volumes are exceeding the same period in 2019. You will recall that in the second quarter earnings, we expected both the July and the August PE price increases to be well-supported. And we now expect that the nominated September price increase is also likely to be implemented, supported really by the low level of industry inventories, coupled with the supply disruption from Hurricane Laura. The increased durables demand we expected really led by the improving automotive and construction industries around the world is also benefiting our polyurethanes business. Also coupled with some supply disruptions caused by some unplanned European outages from our peers, the MDI markets have also seen pricing strength perform a little better than expected. Some other markets where Dow participates are also improving, but they are improving at a bit of a more gradual pace. Personal care, for example, has really followed return-to-work activities, with most regions continuing to lag progress that we saw in the second quarter in Asia Pacific. And cleaning products have leveled off a bit from the pandemic-driven demand highs earlier in the year. Now following our second quarter earnings call, Dow's first call consensus EBITDA was just north of $1 billion, and with the improving market conditions, now sits at about $1.1 billion. With the additional upsides I just mentioned, we now expect an additional $150 million EBITDA above the $1.1 billion consensus, which is a $250 million increase over the modeling guidance input we provided at the end of the second quarter. As you would expect, this also will have a favorable impact on our operational tax rate as well. We expect our third quarter tax rate to be in the range of 23% to 27%. Now beyond these near-term improvements, we continue to progress our proactive focus on ensuring a competitive cost structure and delivering on our cost interventions as well as executing on nonoperational cash levers. At our second quarter earnings call, we increased our 2020 operational expense reduction target to $500 million, and we remain on track to deliver these committed savings this year. We also announced plans to initiate a restructuring program, targeting more than $300 million in annualized EBITDA benefit by the end of 2021, which includes a 6% reduction of our global workforce cost as well as strategic actions to exit assets that are less competitive in today's market. And we'll have more details to share on our third quarter earnings call, but for now, I'd like to highlight that in the quarter, we expect to take a charge for the program in the range of approximately $750 million, with a 2-year payback period. The total charge includes estimated cash payments related to severance, asset exit and disposal costs and some contract termination fees in total of approximately $500 million, which will occur over the next several years. Now in addition to our costs and restructuring actions, we continue to focus on broader cash flow generation by progressing our slate of nonoperational cash levers. In fact, this week, we announced plans to divest select marine and terminal infrastructure assets to Vopak Industrial Infrastructure Americas. The transaction is expected to close by the end of this year with more than $600 million in cash proceeds to Dow. This latest announcement builds upon the rail infrastructure asset sale we announced in July, which we now expect will close 3 months earlier than expected at the end of September, resulting in a cash proceeds of more than $300 million. Together, these 2 transactions demonstrate Dow's continued commitment to a best owner mindset, and they will deliver nearly $1 billion in unique to Dow cash tailwinds this year. The noble litigation also continues to progress and we remain confident that awards from this matter could result in additional payments to Dow over time. Continuing to strengthen our financial profile also remains a priority. Dow has already paid down more than $740 million of net debt through the first half of this year, and we recently just completed a debt-neutral bond issuance of $2 billion at historically low interest rates as we continue to proactively manage our liability profile. This debt-neutral issuance further extends our next substantive debt maturity by another year, which is now the second half of 2024. And on Sadara, negotiations are progressing well, and we remain on track to complete Sadara's debt reprofiling by the end of 2020 with the goal of Sadara achieving cash flow self-sufficiency. Now as we move forward through the year and into 2021, we're confident in the competitive advantages that continue to set Dow apart, and I think Chris spoke to that in his introduction, and they will enable us to continue delivering leading results compared to our peers. Our feedstock flexibility allows us to maintain our advantage on the cost curve and drive incremental margins while feedstock costs have been higher than we anticipated entering the quarter. And our 0 naphtha capability enables competitive advantages, especially while co-product demand is expected to continue to be bumpy through this year and into next. Progressing our ESG and sustainability efforts are also already providing positive tangible impacts to both the top and the bottom line in both the medium and the long term by growing market potential, opening new adjacencies and reducing costs. Our ongoing relationship with Unilever, for example, is advancing to the design phase, where we're innovating new ingredients together in the home and personal care markets for more environmentally friendly products to help them achieve their sustainability commitments. On our work to increase our access to sustainable feedstocks, both our partnerships with Fuenix and UPM are advancing. We're in the process of scaling our capabilities with Fuenix to start building a second pyrolysis oil line using recycled plastics. And we're on track to double our product sales containing UPM's recycled material this year as well. In terms of cost avoidance, we have reached the halfway mark on our value and nature sustainability goal to uncover $1 billion in business value over 10 years in nature-based solutions that are good for our business and for natural ecosystems. Just one example of these nature-based solutions resides at our manufacturing facility in Elizabethtown, Kentucky, where instead of constructing dry containment pond for fire and storm water, we created a 5-acre wetland that meets our functional need, reduces downstream flooding and improves groundwater all at the same time. We also view this period as a prime opportunity to accelerate our actions in areas that will drive long-term value creation for Dow, things such as continuing our digital acceleration to drive improved customer experience and a higher revenue. Altogether, our proactive actions and our unique advantages continue to strengthen our ability to capture value and position Dow competitively as the economic recovery gains further traction. Summing up the actions of team Dow so far this year, Chris, before I turn it back to you, we have -- we've lowered our operating expenses, we've liberated significant cash from working capital, we've initiated a restructuring program, we lowered our CapEx spending, we delivered increased free cash flow and cash conversion above 100%, we've extended our debt maturities, we delivered almost $1 billion already of nonoperational cash tailwinds that have another $1 billion left to go this year, we're making really good progress on the SEDAR reprofiling, and I would just say, all of which, position Dow very well for the market recovery as it continues in front of us. And Chris, with that, let me hand it back to you to open the Q&A.

Howard, thank you very much for those remarks. They're incredibly insightful as always. You did hit on the near-term supply demand dynamics in polyethylene. Can you speak to just the process of, let's call it, further normalization on the supply side and -- throughout the balance of the year? And then also if you could potentially hit on the less cost advantage, which will probably be a kind term production in Asia that you and Jim have both spoken about over the last couple of quarters as we head into the next year or 2.

Yes. Look, I think -- Chris, thanks. I think on the polyethylene side, demand has been resilient. And look, that has been our consistent view. And I know some third-party providers have thought in the beginning it was going to go down, then they said, "Well, it's not going down. It's pantry stuffing." And then the pantry stuffing just has continued. And look, I think it just -- it speaks to the benefits of polyolefins, and the demand has been, and I believe, will continue to be resilient. And in fact, the way we're all living right now in a lot of the world where you're not going to as many restaurants, you're not going to sporting events, you're consuming much more from the grocery store, that will only increase the amount of per square inch of packaging or polyolefins that'll be required to serve each of us as consumers. So demand, I think, is going to be there. Look, from a supply standpoint, you're right, when you look at the cost curve, and thankfully, we're typically in the first or the second quartile in almost every region of the world with almost every asset in the world, so that speaks to our advantage. And then the feedstock flexibility that you pointed out also helps. But when you do the math, in an economic down cycle, which we are clearly still in, I mean, we are clearly still in an economic down cycle, old, less-competitive or assets that are not integrated or not in the first or second quartile of the cost curve will typically get rationalized. We saw that in '08, '09. We saw that in '02, '03. In '08, '09, we had 4 million metric tons of capacity come out, 2 of which came out permanently and 2 of which shut down in '08, '09, and then between 2010 and 2012, it started back up. This time, as we look at -- to specifically address your question, as we look at the world today, there's probably about north of 20 million metric tons of ethylene and polyolefin capacity that's at risk either due to age, due to scale or due to the high conversion costs that are being disconnected from the raw material feedstocks or the market. Of that 21 million metric tons, probably about 6 million or 6.5 million of that 21 million is CTO/MTO, which certainly needs -- certainly needs an oil value with at least a Brent -- with at least a [ 5 handle ] on it to kind of be cash flow breakeven. So I mean that kind of sums it up in terms of what we think in terms of both the supply and demand.

Another -- just on this front, it's probably an easy leeway into another question I had. Just given the current environment, how should investors be assessing your non-U.S. P&SP production assets just given your cost outlook as it pertains to your other thoughts on the long-term polyethylene cost curve?

Look, I think it comes down to our geographic breadth, our market application mix and then the depth of customer application. I think -- I put the Dow portfolio and P&SP up against anyone of our peers. The fact that we are geographically -- when you think about our feedstock flexibility in the U.S. Gulf Coast, it's really second to nobody. We have max ethane capability versus anybody. We've got 2 to 3x the propane butane. We've got the ability to go to 0 naphtha. But then as you go around the world, to your point, we've got the Alberta advantage in Canada, which is pretty unique. Only Dow and 1 other player has that advantage. You've got our Argentinian advantage, which is gas based on the Vaca Muerta shale field. And there's plenty of shale in Argentina for us to compete within Mercosur [ duty ] barrier. Then you go to the Middle East, clearly equate -- is all gas, Sadara, mixed feed, so you have the ability to switch feedstocks to some degree. And then, of course, in Europe, we have a sizable position in Europe. And because of our investments over the last several decades, we have the capability to crack 65% today LPG. And so we can go naphtha if we want to, but we can go as much as 65% LPG if the market is favorable. And then you've got our Thai assets in Asia as well. So I really think the Dow portfolio is very well-positioned in terms of feedstock flexibility, location, and then obviously, the markets and the applications. So you think about P&SP, we have our polyethylene franchise around the world, but we also have about 20%, 25% of our portfolio is in what we call functional polymers, right? So these are -- these go into high -- typically higher-margin, more durable goods. Think pipes, think food packaging, think wire and cable compounds, and so these things will generate higher margins and tend to be more resilient over an economic cycle. That part of the portfolio definitely got hit harder because of the COVID pandemic and a lot of it goes into automotive and transportation more broadly and more durable goods. So that took a step back here in the second quarter, but as the economy recovers, that will be a nice tailwind for us over the next several years.

And just while we're just speaking on the cost curve, let's shift back to the lower end and just talk about U.S. ethane for a moment. Over the last 2 years, actually, Jim 2 years ago, at the time, I think it was at around $0.60. We reached a low around $0.10. Now we're on $0.19. Just when your team is analyzing everything that's going on in the global energy markets and effects on the U.S. GC, just how should we think about your own cost position over the next, let's say, 12 to 24 months?

Yes. I mean -- so look, if your question is, is there enough ethane out there? I mean, my short answer is yes. There is plenty of ethane out there. I know there's a debate going on in the investment community right now. But look, oil and gas producers are guiding to flat production through the remainder of the year. And I would say the abundance of wells drilled, but not completed, will allow producers to bring gas and oil to the market before the actual rig counts recover. So I think some people are looking at rig counts and coming to different kind of conclusion. There's significant ethane rejection today, and it's expected to be in the future, even with the additional gas demand. And I would say, look, while oil demand is in a low right now because of the economic environment, is that the rate of global recovery will determine demand for oil. And I would say that will also then drive more -- even more gas as well. Depending on the third-party analysts that you read out there that covers the oil and gas industry, I would say most folks believe that we'll be back close to 100 million barrels a day of demand at some point in 2021. So that's -- within the next 12 months, you're likely to get back to kind of 2019 oil demand levels. And that speaks well to the overall pricing, which naphtha -- most of the world cracks naphtha. So naphtha will trade-off of oil. And so that will put pressure on naphtha over the next couple of years to move up. And then our view on ethane says that your shale advantage will continue to improve and not go away as some people have predicted, I think, as the crisis of COVID and the oil drop first indicated. I just don't think that that's likely to happen for the reasons that I talked about.

Howard, one of the key debates in the marketplace right now is there is there's this whole debate, I'd say, beginning in July and even into early August, about the sustainability of the polyethylene, the price increases. A lot of people are expecting, I'd say, pennies, and you are on your way to getting dimes. When we think about that, you've got this near-term dynamic and then the intermediate to long-term dynamic, which still isn't a huge focus, but where do you really assess yourself in terms of mid-cycle earnings and why just given all the factors we're discussing?

Look, I would say -- let me step back from polyethylene just for a second. I can circle back to that if this doesn't answer your question. But if you think about the enterprise, right, I mean -- and you take consensus today, consensus for Dow for this year is around $4.7 billion -- in that $4.7 billion to $5 billion range depending on which analysts you want to look at. Mid-cycle earnings for Dow is probably in the -- as we did all of the analysis, all of the Monte Carlo simulations with this portfolio, mid-cycle is in the $8 billion to $9 billion range. And cycle peak is in the $11 billion or $12 billion range with taking reasonable margin forecast and economic upcycle. So we are clearly still in an economic and a petrochemical trough. And there's a mid-cycle in front of us. How long it will take to get there is an open question. Part of that will depend on how quickly the world recovers from the pandemic. And then there'll be a -- it's like earnings cyclical peak in front of that. When you think about polyethylene, you've got good demand drivers. You still have a growing population, and there, over time, it has grown more than 1x GP. For the last 30 years, it's grown about 1.4, 1.5x GP. Now, one, because of the law of large numbers, that number likely -- ratio likely starts to go down. And then you've got the whole recycling sustainability point, which will also probably reduce it. But even if it starts trending down to one, you're still talking about a significant amount of growth over the next 7 to 10 years that you have in front of us. And I think what the pandemic just proved once again is that polyolefins win because they are the most sustainable. And they do provide the least amount of greenhouse gas emissions, the lowest carbon footprint of any other material. They Keep food safe. They keep medical supplies clean. They make cars lighter, more fuel-efficient and have better safety performance. So I mean, no matter what your application is, polyolefins have really proven their value to society over many, many, many decades, and I just personally don't see that changing.

I want to jump to add to a question I had at the end, but I think this is a good time to bring it in. You're mentioning that trip we had together in London a few years ago. And we had a discussion at -- I believe it was lunch about just ESG and recycling. And it's naturally been a very important and integral topic of this conference among your peers and everyone else. And can you just remind -- there seems to be a lot for Dow about plastics. You just mentioned 2 so no need to rehash those in terms of food spoilage and lightweighting and so on and so forth. But can you just remind the investment community on where you stand, all the various initiatives you're involved in? Because if I recall, I received an e-mail from your IR team with about 20 things you were actually doing behind the scenes. So I'd like to give you the opportunity to convey those to the audience and point us to the 2 or 3 we should really be honing in on.

Yes. So look, I mean thanks, Chris. And that lunch in London -- I was joking before we got on. It seems like just yesterday, and it seems like 20 years ago. It was about 18 months ago. But so I remember it finally. Look, on the environmental side, we're doing a lot, right? I mean, we've been a leader in the sustainability space for our 125-year history. We've had stated 10-year sustainability goals for now 40 decades. We just announced some significant goals around getting to carbon neutrality by 2050, making sure all of our polymers are 100% recyclable and a few other things. I mean, we're doing a lot. So a couple of things I touched on, I think, in my prepared remarks, are really around feedstock recycling and percent recycled content. So the partnership that we have with Fuenix and UPM around fossil fuel replacements as well as plastic road offerings, so on plastic roads today, we have now -- not Dow specifically, but we've contributed. There's now over 150 kilometers of plastic -- recycled plastic modified roads in 10 different countries around the world, and we've helped make that happen. We've launched our AGILITY CE series last year, which utilizes 70% post-consumer content. We're working with UPM to use their wood-derived renewable naphtha into our slate of raw materials for the production of bio-based polyethylene in Europe. On the overall carbon side, we're also doing, I would say, 3 different sets of things. We're working on optimizing our current assets. We're working on implementing transitional technologies and then we're really innovating for next-generation technologies. And I could talk about this for several hours, but let me just give you a couple of examples in each of those buckets. So optimizing current assets. We're already the #1 user of clean energy in our industry, and we're 1 of the top 25 in terms of global corporations utilizing clean energy. And we just ratcheted up several hundred megawatts increase in terms of what we have under contract. On implementing transitional technologies. We've worked with -- well, we've worked with FCDh. So we're piloting FCDh in Louisiana to produce propylene with much lower energy and much lower carbon emissions. And then we're working on taking the learnings from that technology and transitioning into what we call EDH technology for ethylene. And if we're able to get that done, that has the potential to reduce our emissions by 40% to 50% by significantly reducing our energy usage. And then when it comes to innovating next-generation technologies, one of the things that we announced earlier this year was a joint development agreement with Shell to accelerate technology to electrify ethylene steam crackers. And that's clearly early development. But if we can do that, that allows you to potentially completely decarbonize when you think about it from that perspective. So we're working on things in all 3 of those buckets. In addition to what I talked about in my prepared comments upfront with customers, whether it's with Unilever that I talked about or what I've talked about in the past with our partnership with Kellogg or other brand owners or other retailers, we're working with every one of our customers to really try and accelerate the sustainability of our products and their products.

Let's switch over another very interesting topic and integral topics at this conference, given we have had some of your competitors. Is this the recovery in polyurethanes? You've seen -- you already mentioned the near-term action into it. Just one of the things I just want to hit on very quickly, just again, the view of the sustainability of the demand equation is naturally, you see the demand improvement, you're seeing spread improvement. How should we be thinking about auto construction? It seems like durable goods has seen a nice pick up. How should we be thinking about that for next year? And also just on the spread front, what would be your latest views?

Yes. Look, I mean, when you think about urethanes, isocyanates, MDI specifically, that product line clearly has suffered the most since COVID because of its tilt or downstream durable end markets. Think automotive, think construction, think furniture, think appliances. And so even before COVID, I would say, we were at historical trough level margins. So there was just no -- the fourth quartile producer was negative cash even before COVID. And when you think about where we were because of COVID, when you think about Dow, our polyurethanes franchise probably dipped below -- the bottom operating rate was in the 50s in the second quarter. So you're clearly not making any money when you're at that kind of level. Now before -- even before COVID, we started to see project cancellations and announcements of rationalization of older, smaller capacity, just like what we talked about in the ethylene chain. And now what you see since we've bottomed, you've seen a lot of the durable good markets start to reengage, right? So if you think about all the big automotive production facilities in North America and Europe, they were basically all closed for the bulk of the second quarter. And so since we've seen the third quarter, there's clearly been a decent ramp in automotive production, probably even better certainly than we saw -- or we thought on our second quarter earnings call, and that's part of the reason why we increased our guidance today. And the same is true in the construction space. Those markets have come up. So you have a combination. I think what's happening is there was 0 margin before COVID. COVID dropped that into really cash losing if you're in the third or the fourth quartile of the cost curve, then now you have a ramp back of demand and then what that -- what typically happens is everybody tries to run hard to meet the demand and then these assets are old and several of the assets have had production issues, because you haven't been maintaining them for reliability, you've been maintaining them for license to operate and for safety, but not necessarily to maximize the reliability. And so these assets have -- several of the assets around the world have had production issues, and that's allowed us not only to get some incremental margin back just because of the operating rate improvement. But now you're seeing pricing in Asia, pricing in Europe and now pricing in North America start to move up. Because you have more demand than you have supply, so you just typically get that commodity response in the isocyanates chain, and that's what we're seeing. But I would still say, you're far away from mid-cycle, and you're really far away from where we were during the fly up in 2017. So I would say, for all 3 of those reasons, that's why over the next several years, as demand normalizes, and then we start to get back onto a GDP growth path for the world, that will deliver more earnings and more incremental margin to the bottom line for Dow.

That's actually my next question, but you've already answered it. So in terms of the approach back to mid-cycle earnings and even potentially above depending on demand, just in the context, you did mention 3 delayed/canceled deferrals. When we think about the industry over the next several years and we think about mid-cycle, and as I said, potentially above just over the longer time frame, what type of pricing do you think we would actually even need to see at this juncture to even consider the 2 cancellations from the Europeans and the 1 in Asia -- or for Asian competitor?