Dow Inc. (DOW), the chemical industry titan, has just posted lackluster Q2 results, which were pummeled by pronounced softness in the global economy precipitated by the coronavirus pandemic. The company topped analysts’ revenue estimates but failed to live up to the expectations on loss per share, even considering the bar had been lowered a few times. As of writing this article, the stock price was down in low-single-digits, as the market was disappointed by the deeper losses and ignored the broader picture, e.g., signs of a nascent recovery in a few of its end-markets, robust cash flow (even propped up by a few one-off items), and ambitious cost-cutting plan.
This July I have already written a bullish note on Dow, citing its recovery potential, high dividend yield, and free cash flows despite depressed sales. After analyzing its available H1 and Q2 cash flow data, I would like to conclude that the dividend remains relatively secure, and the dividend investment thesis I created two weeks ago is valid. Now let’s delve deeper and discuss the essential things that deserve investor attention.
The top line
In my previous piece, I said that the second quarter would likely be the toughest in a few years. Dow’s results proved it completely, as Q2 was overshadowed by the steep decline in sales and poor margins, and expectedly, shrunk operating income and net loss. However, in June, Dow’s CFO had already warned investors that profitability would be under extreme pressure in Q2, predicting an additional ~$350 million headwind to adjusted EBITDA. So, the market had already been perfectly informed that clobbered economic activity across the globe (and especially in North America and Europe) would take its toll on Dow’s Q2 figures.
Though bearish traders think that deeper-than-expected loss is something Dow’s stock must be punished for, I believe there are many more essential matters bullish investors should not ignore. The gist is that Dow’s quarterly revenue was way better than Wall Street expected despite sharply lower pricing and decline in the total volumes. The Street anticipated sales to fall by ~27.7%; Dow managed to beat analysts’ consensus estimate by ~$400 million, most likely because of the tailwinds from the Chinese economic recuperation (we have already seen something similar in the Q2 results of PPG Industries, Inc. (PPG), which benefited from a sharp increase in the automotive production in China), resilient demand for the DIY coatings in North America, and its recession-proof product lines. This signifies one essential thing: the slow but steady recovery is underway.
Now let’s discuss the performance by division.
All three reportable segments faced deep, double-digit declines in revenues.
- Net sales of Packaging & Specialty Plastics, the flagship segment regarding revenue, cratered. The divisions generated only ~$4 billion in sales, 23% lower than in 2Q19. During the quarter, robust demand from the recession-immune end-markets like consumer non-durables (e.g., health & hygiene, food packaging, and pharma) failed to offset pronounced softness in the automotive, infrastructure, and construction end-markets, and also in consumer durables (e.g., furniture), as customers in these industries had been managing their inventory positions extremely conservatively. Low polyethylene prices added to difficulties. As a result, the segmental EBIT margin almost halved and amounted to only 7.9%.
- The top line of Industrial Intermediates & Infrastructure was barely better. Sapping demand for acetone derivatives, vinyl chloride monomer, propylene glycol, etc., resulted in declined selling prices and low volume and precipitated a 28% reduction in sales. By the way, I expected Dow to make some remarks on caustic soda pricing to update my Q2 revenue expectations for chlor-alkali heavyweight Olin Corporation (OLN); unfortunately, DOW did not touch upon that in the Form 8-K, the press release, and during the earnings call. The segment was somewhat buttressed by volume growth in the Asia-Pacific, which is not coincidental considering the rapid V-shaped recovery of the Chinese economy; the same tendency helped PPG Industries to avoid deeper Q2 sales contraction. Anyway, softness in other regions nullified that effect. The headwinds crimped income, and the EBIT margin turned negative, as sales did not cover the cost of goods sold and operating expenses.
- Finally, Performance Materials & Coatings, the third-largest segment regarding the contribution to the top line, reported a 21% decline in sales. Precisely like PPG Industries, the paint & coatings industry heavyweight I discussed a week ago, Dow benefited from higher demand for architectural do-it-yourself coatings in the U.S. The problem worth bearing in mind is that the recently updated Leading Indicator of Remodeling Activity provided by Harvard University points to prolonged softness in the remodeling activity in the U.S., which means sales of coatings will likely be less impressive in H2 than in Q2, with some sluggishness even persisting in 2021.
In sum, while the total sales cratered, Dow failed to turn an operating profit and net profit; GAAP Q2 loss per share was 0.31.
The outlook: Dow has cautious optimism
The revenues are still in decline and Q3 sales contraction is in the cards, but the downward momentum had clearly decelerated. Commenting on the Q2 performance, the Dow CEO said that the management continues “to expect a gradual and uneven recovery.” At the moment, Wall Street is anticipating a ~15.2% reduction in Q3 sales vs. 3Q19 but there might be a few upward revisions in the coming weeks.
More cost savings mean better dividend coverage
In the press release, Dow mentioned that its 2020 cost savings target was increased to $500 million from $350 million. The company’s aggressive cost-containment program will require a ~6% reduction in Dow’s global workforce; this is a radical but inevitable step, as Dow faces material pressure on margins.
I believe the key rationale behind deeper opex reduction is to buttress operating cash flow, FCF, and not cut the dividend, as the DPS reduction will undermine Dow’s reputation and, unavoidably, result in the share price decline. What is more, the accelerated cost-containment program can help to stave off an annual loss. Another reason is that a better-than-expected operating margin can help to top Wall Street’s Q3 and Q4 expectations on EPS and boost the share price.
Cash flows bolstered by one-off tailwinds
The Q2 top line was terrible, but the silver lining is that H1 and Q2 operating cash flow remained robust despite devastating sales decline; the Q2 net CFFO touched $1.6 billion, around $639 million higher than a year ago. Being deeply unprofitable, Dow even delivered a solid cash flow surplus of $1.3 billion (thanks to scaled-down capex), while dividend payments were $516 million. Put another way, the rewards were covered 2.5x. That is undoubtedly good news for dividend investors who are likely concerned with the DPS coverage, especially considering that Dow is heavily leveraged and has humongous interest commitments. Among the tailwinds were a favorable working capital change and a $461 million ethylene capacity reservation payment from Olin Corporation. Sure, some tailwinds that shore up the Q2 cash flow were one-off in nature, and, hence, will not impact Q3 and Q4 results. However, these inflows helped to fortify the balance sheet to make it easier to weather the economic doldrums in 2020. It is worth noting here that the company ended Q2 with cash & cash equivalents of $3.7 billion. As of end-May, total cash and available committed liquidity stood at $12 billion.
The second-quarter results demonstrated that Dow is laser-focused on cash generation. Some one-off tailwinds fortified its cash position and helped to pay down ~$600 million in debt, thus reducing future interest commitments and improving dividend coverage. There are no significant maturities until H2 2023.
Among other things, Dow reiterated that the sale of “its rail infrastructure assets and related equipment at six major North American sites to Watco Companies” is anticipated to be closed by end-2020; a $310 million in proceeds will help to fortify the balance sheet further, and, perhaps, pay down some debt.
To sum up, I am relatively confident that Dow’s dividend is protected, given capex reduction, opex savings, and improved cash position.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.