There were several interesting tidbits in The Dow Chemical Company’s (DOW) second quarter conference call on Thursday that I thought I would share. 

As we all know, the company is struggling to communicate effectively to the market its ability to navigate surging commodity prices while at the same time reinventing itself.  The company has raised prices considerably across the board on all of its products in an effort to protect its margins. 

While it is still early, it appears that management has been fairly successful in this effort.  The price increases represent an effort by the company to price its products in a manner that takes into account higher input costs down the road.  While I wouldn’t go as far as to say that its pricing index is becoming forward looking, it nevertheless has proven to be a lot more easily changed to protect margins than in the past. 

Dow Chemical has also been burdened by the impression that it is just another, albeit larger, commodity chemical company.  As a result, the company trades at a very low earnings and cash flow multiple, especially in light of its successful joint venture operations.  The company has sought to rectify this situation and expand the its growth potential by purchasing Rohm & Hass (ROH).  While the company paid a terribly high price for Rohm & Hass, the synergies may just be enough to make the deal work.

The first interesting comment on the conference call came from a man by the name of Peter Butler who asked if the coming quarters could potentially be similar to 1974.  Apparently, 1974 was a huge earnings beat on the part of Dow Chemical after it was able to hold the line on its prices even as its input costs dramatically decreased following a long term run up.  If oil and natural gas prices were to retreat and Dow Chemical was able to maintain prices and prevent dramatic demand destruction the potential for margin expansion would be tremendous.  Such an action would drive the stock tremendously higher on strong earnings. 

The exchange between Mr. Butler and Andrew Liveris, CEO of Dow Chemical can be found below:     

Peter Butler - Glen Hill Investment     

“If this were 1974 instead of 24 years later, Dow would be looking at huge positive earnings surprises coming in the next couple of quarters. Is this management seeing the same things? In other words, is this management as tough as Dow's management back then in getting and holding price increases, even if oil does decline?”

Andrew N. Liveris - Chief Executive Officer & Chairman

“Peter, this is Andrew, yes. And you know me well enough to know that I have talked to the tough management of that timeframe. And what it takes to not only restore margins, but obviously get reinvestment grade pricing into the value creation that we all have to have to make the chemical industry robust, not just in United States, but globally. We have a lot of customers who are putting price increases through right now in their value chains. That would not have happened without Dow's leadership. And I think it is a good question to ask. And maybe I should just leave it with the one word, yes.”

Peter Butler - Glen Hill Investment

“That yes did include the acknowledgment that the earnings should be looking pretty splendid?”

Andrew N. Liveris - Chief Executive Officer & Chairman

“I think the very first question -- I can't remember if it was Don or Dave now -- but I would tell you this, we are going to move the earnings profile northwards, not just with how we have performed on financial discipline despite these horrendous increases, these huge unprecedented surges, but also because of our footprint shifts, the two big ones. The asset-light, which I know you are a fan of and we are a fan of and our partners in the low-cost feed stocks and the cash machine that we are generating out of our joint ventures, these are cash machine that no other chemical company on the planet will be part of.

Then second, the Rohm and Haas transaction and the value creation that will occur because we will be in solid downstream growth markets around the planet. Those two things will give this company a northeast earnings profile, heading to the right growth side of the equation.”

The second key driver for the stock, even if oil and natural gas prices stay high, will be the acquisition of Rohm & Hass.  The deal is rather pricey but should be accretive to shareholders in the long run, especially if it drives multiple expansion.  Rohm & Hass is a leader in specialty chemicals.  These chemicals are dramatically different from Dow Chemical’s because they typically have higher margin, are less cyclical and have potential for revenue growth well beyond GDP.  As a result, companies like Rohm & Hass tend to have higher multiples. 

This is something that the analysts at HSBC have been suggesting for sometime and it has been fun to watch their hopes for Dow Chemical materialize over the last couple of quarters.  It is clear that multiple expansion is something that management is desperately trying to get at, as it represents the easiest way to build shareholder value. 

During the past year, the company has been removing its focus from its legacy commodity chemicals and refocusing on specialty chemicals.  This has meant that the company has entered into a large number of joint ventures that have helped make the company much “lighter.”  While these joint ventures are good for the company in the long term, the analysts over at HSBC believe that they are only being valued by the Street at 3-4xs earnings.  The joint ventures provide a solid safety net for the company should it be unable to expand margins or make the most recent acquisition work. 

The Rohm & Hass acquisition speeds up the process of refocusing Dow Chemical into the specialty chemical business.  This new segment will give the company the growth conduit that it needs to convince the street that it deserves an earnings multiple equal to or greater then DuPont (DD). 

Over the next 12-18 months, if everything falls into place, I have no doubt that The Dow Chemical Company could potentially be trading at as much as twice its current price.  To achieve this lofty goal the company needs to only hold prices should oil and natural gas fall considerably, as such an action would allow margins to expand considerably. 

In addition, the company needs to ensure that multiple expansion occurs in its stock beyond what would occur because of the margin expansion.  This can be achieved if the Dow Chemical’s management team can show to the Street and the investment community that the Rohm & Hass acquisition was not nearly as expensive as it appeared at first glance and that the new segment will help to dramatically lift the company’s potential revenue growth both here and abroad in the years ahead.  

Disclosure: None.

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