Equity Research

October 27, 2016

Equity Research

The Dow Chemical Company

DOW: Best Beat In Chems So Far!

DOW reported adj. Q3 EPS of $0.91, ahead of our $0.82 and consensus $0.79 estimates (lower taxes a $0.01 benefit). GAAP EPS of $0.63 included $40MM in litigation, $144MM from the Dow-Corning restructure, and $129MM associated with portfolio/productivity actions. Sales of $12.48B were ahead of consensus $11.93B and increased 4% yr/yr. Adj EBITDA of $2.47B exceeded our forecast with particular outperformance in Ag and Consumer Solutions. Overall, margin expanded 30 bps yr/yr to 19.8%, the 16th quarter-in-a-row of increasing margins. Given the Q3 beat, we're bumping our 2016 EPS estimate from $3.50 to $3.60 and maintaining 2017E EPS at $4.10.

Update on the DD-Deal. Though talks with regulatory bodies are noted to be taking longer than expected, DOW explained that they are progressing nonetheless, and anticipate a Q1'17 close. On the DD call, there was commentary on already identifying structural plans for NewCo in order to maximize synergies. The previously mentioned $3B cost synergy goal was reiterated as a "floor number;" procurement (among other things) could aid this potential upside. DOW gave us color on 10 approvals thus far, but the key ones are yet to be decided, including the U.S., EU, China, and Brazil.

Dow Corning Progresses. Initial forecasts included $4.5B in annual sales (35/65 across Consumer and Infrastructure Solutions) and $800MM EBITDA (60/40 across Consumer and Infrastructure Solutions) excluding incremental cost synergies. DOW is working toward its recently raised $500MM Dow Corning synergy goal ($400MM cost-based; $100MM growth-focused), and is tracking nicely ahead of plans, with 51% already realized vs. a 30% expectation.

Net Debt Stable, Buybacks Made. DOW ended Q3 with cash of $7.0B, down $277MM sequentially. Net debt/EBITDA stood at 1.5x, sequentially unchanged. DOW is tracking above its $300MM savings goal ($254MM to date), and made progress on its $2B 2016 repurchase program, purchasing $416MM during Q3. While share repurchases will likely be limited by the pending MoE, we expect to see $400-500MM in Q4, similar to that of DD's. And today's Chemical Checkpoints 1027 noted that we currently stand at 6 out of 20 days for the conversion of the preferred shares.

Valuation Range: $58.00 to $60.00 Our valuation range represents 7.5x EV/2016E EBITDA, a slight premium to its historic range which is warranted given synergy and growth opportunities with its pending merger with DD. Risks to our valuation range include a global economic downturn, raw material volatility, the success of restructuring actions, and plant outages.

Investment Thesis: Between all the actions DOW is taking to optimize its portfolio, and given a number of potential growth catalysts in the near-term, DOW's shares remain attractive despite the decline in oil, in our view. A recently boosted dividend puts the yield above the group average, and share buybacks are a key theme.

Outperform

Sector: Chemicals Overweight

Earnings Estimates Revised Up

2015A

2016E

2017E

EPS

Curr. Prior Curr. Prior

Q1 (Mar.)

$0.84 $0.89 A NC

NE

Q2 (June)

0.91

0.95 A NC

NE

Q3 (Sep.)

0.82 0.91 A 0.82

NE

Q4 (Dec.)

0.93 0.85 0.89

NE

FY

$3.50 $3.60 3.55 $4.10 NC

CY

$3.50 $3.60

$4.10

FY P/EPS

15.6x 15.2x

13.3x

Rev.(MM)

$48,778 $47,600

$50,000

Source: Company Data, Wells Fargo Securities, LLC estimates, and Reuters NA = Not Available, NC = No Change, NE = No Estimate, NM = Not Meaningful V = Volatile, = Company is on the Priority Stock List

Ticker

DOW

Price (10/27/2016)

$54.56

52-Week Range:

$40-58

Shares Outstanding: (MM)

1,121.4

Market Cap.: (MM)

$61,183.6

S&P 500:

2,133.04

Avg. Daily Vol.:

5,583,530

Dividend/Yield:

$1.84/3.4%

LT Debt: (MM)

$20,423.0

LT Debt/Total Cap.:

39.5%

ROE:

14.0%

3-5 Yr. Est. Growth Rate:

5.0%

CY 2016 Est. P/EPS-to-Growth:

3.0x

Last Reporting Date:

10/27/2016

Before Open

Source: Company Data, Wells Fargo Securities, LLC estimates, and Reuters

Frank J. Mitsch, Senior Analyst (212) 214-5022

frank.mitsch@ Kamellia Saroop, Associate Analyst

(212) 214-8011 kamellia.saroop@

Please see page 16 for rating definitions, important disclosures and required analyst certifications All estimates/forecasts are as of 10/27/16 unless otherwise stated.

Wells Fargo Securities, LLC does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of the report and investors should consider this report as only a single factor in making their investment decision.

Chemicals

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Performance Plastics Strong Volumes. Sales of $4.7B were up 2% yr/yr (vol +11%, price -9%; excluding acq/divestitures) with gains across all businesses (Q3 record volumes in Packaging & Specialty Plastics and Elastomers), but offset by lower hydrocarbon prices. However, EBITDA decreased 7% yr/yr to $1.25B as lower margins in Europe and costs tied to planned maintenance outweighed the gains from better demand in packaging, transportation and infrastructure. Equity earnings of $39MM were down from $50MM last year, largely due to start-up costs at Sadara, although 80MM lbs have been sold from the cracker and three PE units that came online during Q3. In Q4 and into 2017, Sadara will likely serve as a tailwind but for only Performance Plastics. Sequentially, we forecast a modest sequential downtick as we expect the $50MM cost from the Louisiana turnaround/ feedstock flexibility project (additional 250KT [thousand tonnes] capacity) and raw material pressures to outweigh the gains from favorable olefins/polyolefins trends.

Performance Materials & Chems Margins Down. Sales declined 7% (vol +4%, price -11%; excluding acq/divestitures), but when including the effect of the Dow Chlorine products transaction, sales declined 25% with volumes down 16%. EBITDA of $322MM decreased 40% yr/yr, with margins contracting 358 bps partly due to lower equity earnings on higher Sadara spend and the change in MEGlobal ownership. Although Polyurethane volumes improved led by double-digit growth and Industrial Solutions posted gains (both led by Asia and EMEAI), pricing pressures in both sub-segments took a hit to earnings. We expect to see a modest sequential improvement due in part to seasonal deicer sales and a ramp-up in PDH (propane dehydrogenation) operations partially offset by raw material pressures and $50MM lower equity earnings from the EQUATE ownership change. Sadara spending could continue to be a headwind in this segment through 2017.

Infrastructure Solutions Headwinds Continue. Sales decreased 8% (vol -3%, price -5%; excluding acq/divestitures). EBITDA of $379MM increased 17% yr/yr. Record Q3 EBITDA in Building & Construction was largely due to the demand for acrylic based construction chemicals and polymeric flame retardant. We forecast earnings to decline sequentially and yr/yr, as headwinds in energy and water continue along with the monomer turnaround ($35MM headwind), although the ramp-up (as we mentioned in PM&C) in PDH unit will likely provide a benefit along with the >30%% of DOW Corning EBITDA rolling into the segment in H2.

Ag Pacing Ahead of Downturn. Sales of $1.2B increased 6% yr/yr (vol +3%, price +3%), fueled by demand in Latin America. Both price and volume in the region grew by double-digits as Brazil stepped up to more technologically advanced seeds, and there was some early buying in Q3 (potentially causing some shift from Q4). EBITDA of $102MM was in positive territory compared to the $39MM loss a year ago. There were three equal contributors to the yr/yr growth in the segment: 1) seed sales of both corn and soybeans (noted to nearly triple), 2) continued productivity enhancements and cost cutting, and 3) FX recovery. While the landscape for Ag remains tough, Q4 EBITDA is also set up for a hard comp compared to the prior year period, due to the profitable sales of "non-strategic molecules."

Consumer Solutions Seeing Positive Trends. Sales of $1.6B grew 42% (vol +45%, price -3%) due to the addition of Dow Corning; organic volumes still grew 3%, though fully offset by price. Dow Automotive saw robust (double-digit) volume growth in Asia as it took share. Also unusual, Dow Electronic Materials posted strong demand, driven mainly by semiconductors and display technologies. Adj. EBITDA increased 70% yr/yr to$492MM. Cost cutting also aided segment EBITDA margins, which expanded 520 bps yr/yr. We expect that the reduced cost structure will lead to material yr/yr growth, but anticipate lower gains sequentially.

Discussion

Best Beat in Chems So Far! We believe it's fair to characterize CEO Andrew Liveris as being rather enthusiastic, especially when he offered that there has "never been a better time at Dow." He's obviously proud of the recent track record of growing earnings, margins and volumes, during a time period of "macros not being very helpful." We've been surprised to see that continuation of the strong volume trends with the attribution of DOW becoming a more consumer-oriented company, rather than one focused on the industrial landscape. Clearly, industrial markets are more challenged than consumer these days.

Although the recent past has been impressive, we're focused on the future and can see a period of continued success. The heavy capital spending period is in the rear view mirror, and now those projects (PDH, Texas-9, Sadara, acquisition of Dow-Corning, etc.) are set to materially contribute over the next few years. The cash flow engine is revving up, and management, to our eyes, is committed to being shareholder-friendly.

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The Dow Chemical Company

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Of course, another key to the story is the pending merger with DD ($69.84). We maintain our stance that the transaction WILL receive the necessary regulatory approvals although we do expect to see certain "remedies" enacted. However, as we wrote in Tuesday's DD report:

"We're becoming a little dismayed at the pace of regulatory approvals. Despite both companies being industry leaders in chemicals and materials, the overlap is less than meets the eye so we wonder what is taking the key regulatory agencies so long from blessing the transaction? The latest news out of the EU regarding ChemChina?Syngenta smacks of politics over business fundamentals - - could that have a role with DD-DOW? We'd like to think not, but to be frank, those negotiations are above our pay grade.

Nine regulatory entities have already approved the transaction [now 10!] and there appears to be some clarity on the path the EU's taking, with its Phase 2 verdict to be received by Feb 6 or before. The other three key regulatory authorities (the U.S., China and Brazil) are said to be on the same path but we've precious little clarity. We can only hope that sound business fundamentals will prevail and the transaction will be approved around this coming Groundhog Day ("I`d like to say a prayer and drink to world peace"). If so, we believe the value creation potential is such that the current share price will be looked upon by future eyes as having been a compelling investment opportunity (our Chemical Checkpoints 1217 calculated a NPV of $91 [$71 for DOW]). DD's results suggest to us that it's on the right path, even on a stand-alone basis. We reiterate our Outperform rating."

DOW's results suggest to us that it's on the right path, even on a stand-alone basis. We reiterate our Outperform rating.

Favorable Volumes. Dow has seen a nice volume recovery of late with Q3's 6% standing out among its peers. Q3 operating rates deteriorated in 2009, but have subsequently recovered to the mid 80's% in the last few years. Following Q2's increase of 200bps yr/yr, Q3 was flat yr/yr at 86%. With the investments in its assets, production is up 9% for the quarter yr/yr with 1.9B lbs more sold (5.6B lbs YTD).

Figure 1. DOW's Global Operating Rate Declines

Annual 95%

Quarterly

90%

85%

80%

75%

70%

65%

60% 1991 1997 3Q01 1Q03 3Q04 1Q06 3Q07 1Q09 3Q10 1Q12 3Q13 1Q15 3Q16

Source: Company reports and Wells Fargo Securities, LLC

Update on the DD-Deal. Though talks with regulatory bodies are noted to be taking longer than expected, DOW explained that they are progressing nonetheless. In the DD call, there was commentary on already identifying structural plans for NewCo in order to maximize synergies. The previously mentioned $3B cost synergy goal was reiterated as a "floor number;" procurement (among other things) could aid this potential upside. DOW gave us color on 10 approvals thus far, but the key ones are yet to be decided, including the U.S., EU, China, and Brazil. The transaction is expected to close in Q1'17, provided all regulatory agencies operate within stated deadlines, with spins occurring within 18 months thereafter.

3

Chemicals

Figure 2. Merger of Equals Synergies

DOW/DD Synergies

Total Est Value, $MM

Synergies

Ag

1,300

Material Science

1,500

Specialty

300

Growth

1,000

DD Cost Savings

Total Est Value, $MM

Cost Savings Cost

1,000

DOW Cost Savings

Total Est Value, $MM

Cost Savings Cost

425

2016E

2016E 750 2016E 375

2017E

650 750 150 300 2017E 250 2017E 50

2018E

650 750 150 700 2018E

2018E

-

Total

$5,525

$1,125

Source: Company reports and Wells Fargo Securities, LLC estimates

$2,150

$2,250

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Dow Corning Progresses. Initial forecasts included $4.5B in annual sales (35/65 across Consumer and Infrastructure Solutions) and $800MM EBITDA (60/40 across Consumer and Infrastructure Solutions) excluding incremental cost synergies. DOW is working toward its recently raised $500MM Dow Corning synergy goal ($400MM cost-based; $100MM growth-focused), and is tracking nicely ahead of plans, with 51% already realized vs. a 30% expectation.

Figure 3. $400 Dow Corning Cost Synergy

Source: DOW

Altogether, DOW should realize $1.4B in EBITDA coming from Dow Corning after the realization of the synergies.

Figure 4. Forecast Dow Corning Synergy Breakdown

Source: Company Reports and Wells Fargo Securities, LLC 4

The Dow Chemical Company

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Growth synergies are expected to be realized in such fast-growing sectors as consumer care, infrastructure, transportation, and packaging, which are already core DOW end markets.

Figure 5. Dow Corning Growth Synergy Opportunities

Source: DOW

Q3 Results

Figure 6. Q3 2016 Results

DOW

$MM

3Q16

2Q16

Sales

12,483

11,952

EBI TDA

2,471

2,464

Source: DOW and Wells Fargo Securities, LLC

3Q15 12,036 2,353

% Change

Sequential Yr/yr

4

4

0

5

DOW reported adj. Q3 EPS of $0.91, ahead of our $0.82 and consensus $0.79 estimates (lower taxes a $0.01 benefit). GAAP EPS of $0.63 included $40MM in litigation, $144MM from the Dow-Corning restructure, and $129MM associated with portfolio/productivity actions. Sales of $12.48B were ahead of consensus $11.93B and increased 4% yr/yr. Adj EBITDA of $2.47B exceeded our forecast with particular outperformance in Ag and Consumer Solutions. Overall, margin expanded 30 bps yr/yr to 19.8%, the 16th quarter-in-a-row of increasing margins.

DOW ended Q3 with cash of $7.0B, down $277MM sequentially. Net debt/EBITDA stood at 1.5x, sequentially unchanged. DOW is tracking above its $300MM savings goal ($254MM to date), and made progress on its $2B 2016 program, purchasing $416MM during Q3. While share repurchases will likely be limited by the pending MoE, we expect to see $400-500MM in Q4, similar to that of DD's. And today's Chemical Checkpoints 1027 noted that we currently stand at 6 out of 20 days for the conversion of the preferred shares.

5

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