On March 13, 2003, Standard & Poor's lowered its ratings on Dow Chemical (DOW) and its units, citing slower-than-expected progress in improvement to the company's financial profile. The company's long-term corporate credit rating was lowered to Long-term corporate credit rating 'A-' from 'A', while its short-term corporate credit rating was reduced to ' A-2' from 'A-1'. Also, Standard & Poor's lowered its short-term corporate credit rating on Dow's Union Carbide Corp. subsidiary to 'A-2' from 'A-1' and withdrew the rating. The ratings on Union Carbide remain on CreditWatch with negative implications, where they were placed on Feb. 28, 2003.
Midland, Mich.-based Dow Chemical, with annual sales approaching $28 billion and approximately $13 billion of outstanding debt, is a premier global chemicals producer.
The rating action reflected the likelihood that challenging industry fundamentals, including substantially higher raw material and energy costs and sluggish economic conditions, will limit Dow's capacity to reduce debt this year. Dow's credit quality remains under pressure due to elevated debt levels and a prolonged earnings slump.
A series of debt-financed acquisitions in 2000 and 2001, totaling almost $3 billion, stretched the balance sheet during a period that has developed into the deepest chemical trough in more than a decade. In addition, the financial profile has been weakened by a meaningful increase in the unfunded pension position and sizable obligations associated with variable interest entities for which Dow provides residual value guarantees. Profitability and cash flow have been hurt by the downturn in the chemical industry--especially in basic commodity chemicals--which has resulted from weak demand, oversupply conditions in key petrochemical sectors, and high and volatile feedstock costs. The recent surge in oil and natural gas prices raises concerns that operating margins could be compressed, thereby limiting prospects for improvement to free cash flow over the near term. Despite the expectation of weak near-term financial performance, Standard & Poor's expects Dow to focus on debt reduction and improve financial performance over the longer term. However, the company has been unable to fund its common dividend through free operating cash flow for the past three years.
The ratings continue to reflect Dow's status as one of the largest worldwide chemical producers and its moderate financial philosophy. Dow holds leading integrated positions in most of its core businesses, with sales balanced between highly cyclical basic chemicals and plastics and a broad array of less-volatile performance chemical products. Geographic diversification is above average, and Dow will continue to broaden its geographic reach, with an emphasis on emerging economies in Asia, Latin America, and Eastern Europe. Over time, the company is likely to bolster its market presence in the performance chemicals and other specialty chemical sectors, and key international arenas.
The company's focus on downstream integration and diversity somewhat offsets the adverse effect of volatility of the commodity sectors, but Dow's financial performance will continue to fluctuate according to the supply versus demand balance for major commodity chemicals. The Union Carbide acquisition in early 2001 has enabled Dow to attain meaningful cost reductions and operational synergies (the company estimates $1.2 billion) because of the complementary nature of many of the businesses, increasing the prospects for sustaining above-average profitability measures in an increasingly competitive global chemical industry. The implementation of Six Sigma is also expected to significantly bolster earnings.
Still, profitability and cash flow have been hurt by the downturn in the chemical industry, especially in basic commodity chemicals. Operating margins (before depreciation and amortization) have declined to about 12%, compared with an 11-year average of about 19%. Earnings will likely remain under pressure throughout 2003.
Dow is expected to maintain a solid financial profile across the industry cycle. Nevertheless, credit protection measures have weakened during this cyclical downturn: debt leverage is well above the 45% to 50% range that Standard & Poor's has established as acceptable for Dow, particularly after consideration of the company's unfunded pension and postretirement obligations and debt-like preferred securities, while funds from operations as a percentage of debt is in the mid-teens (compared with about 25% during the last trough in the early 1990s, and the 40% average over the cycle considered appropriate at the ratings). Adjusted for unfunded pension and postretirement obligations, the funds from operations to debt ratio is less than 10%. Over the intermediate term, ratings are supported by Dow's capability to generate significant cash flow during better times in the economic cycle.
Ratings incorporate expectations that a gradual recovery in business conditions should result in cash flow generation that will be applied mostly to debt reduction until credit protection measures are returned to more appropriate levels. Standard & Poor's expects the company to limit share repurchases and debt-financed acquisitions. Standard & Poor's incorporates in its evaluation of financial risk the firm's contingent liabilities and the off-balance sheet financing of various ventures.
Based on the most recent information provided by management, Dow's economic exposure to asbestos claims at Union Carbide appears manageable. The company points to significant insurance coverage that should cover a substantial part of the costs associated with pending and future claims (although the magnitude of future liabilities is uncertain).
Liquidity: Dow's liquidity remains satisfactory, with $3.1 billion of undrawn committed bank facilities supporting its commercial paper program. Additional unused credit facilities totaling $857 million are available for use by foreign subsidiaries. Borrowings under the revolving credit facilities are unsecured. There is no material adverse change clause, and Dow has ample room under its covenants. Dow utilizes an accounts receivable securitization program as an alternate source of funding. The cash position was $1.5 billion at the end of fiscal 2002. The company indicates that it does not have rating triggers that would accelerate debt maturities.
Cash on the books, availability under bank lines, good access to capital markets, and assets that could be monetized provide the company with sufficient resources to meet upcoming debt maturities. Outlays related to pension funding over the next few years should be manageable, as should asbestos-related payments. Dow is expected to prudently fund treasury stock repurchases and bolt-on acquisitions, thus helping to maintain liquidity at an acceptable level.
Outlook: The outlook is negative. Strong competitive positions, and continued focus on cost reduction and business-mix enhancement, should enable Dow to improve credit quality, even if a return to more favorable market conditions is somewhat delayed. However, elevated raw material costs or geopolitical developments that could forestall Dow's ability to generate free cash flow sufficient to fund dividend outlays or raise additional concerns about prospects for improvement in the chemical cycle, would likely lead to another modest downgrade.