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Shale Gas And Buffett's Billions Fuel Turnaround At Dow Chemical

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This story appears in the November 2, 2014 issue of Forbes. Subscribe

Dow Chemical's 7,000-acre complex on the Gulf Coast in Freeport, Tex., at the mouth of the Brazos River, is a sprawling monument to the shale gas revolution. The bustling site, surrounded by marshland and waterways, is crowned by a 360-foot propane dehydrogenization tower, which is crawling with construction workers and next year will start converting cheap propane from fracked natural gas wells into hundreds of thousands of tons a year of raw materials for everything from house paint to automotive epoxy.

Funny thing is, a few years ago Dow Chief Executive Andrew Liveris was trying to get rid of the place. Back when few people suspected North America was sitting on a lifetime supply of cheap oil and gas, Liveris engineered a plan to spin much of Dow's low-end domestic petrochemicals business into a joint venture with the Kuwaitis. He was waiting for a $7.5 billion check in late 2008 when the financial crisis and the murky crosscurrents of Kuwaiti politics killed the deal.

It was a nearly fatal blow for the century-old company, which founder Herbert H. Dow started in 1897 to produce bleach. At the same time as Liveris was trying to get out of low-end products produced in Freeport, he'd agreed to pay $15.7 billion in cash--a 75% premium over prebid levels--for specialty chemicals maker Rohm & Haas just as the financial crisis was worsening. Dow shares plunged 80% to $6 a share as Liveris tried to delay the Rohm & Haas purchase, then scrambled to find cash to close it, finally tapping Warren Buffett for $3 billion in high-cost preferred stock.

Then came the shale boom, and suddenly petrochemicals were back in style. Dow shares have risen eightfold from their 2009 lows to a recent $50 per share, and now Liveris is pumping $5 billion into the company's Gulf Coast petrochemicals operation.

"Things change," says Liveris, 60, the son of Greek immigrants who speaks with the Australian accent of his youth and enjoys the occasional bottle of Mollydooker Shiraz blend. "We pivoted very fast."

Maybe even fast enough to keep the raiders at bay. In January Daniel Loeb of Third Point LLC disclosed an estimated $1.3 billion position in Dow stock. On May 1 he issued a scathing report accusing Liveris of squandering capital by manufacturing everything from bulk chemicals to plastics to agricultural products at one company. Loeb made an unflattering comparison between Dow and LyondellBasell, the chemical maker that rebounded from bankruptcy in 2009, creating an $18 billion windfall for owners Apollo Group and Len Blavatnik in what FORBES has described as "the greatest deal of all time." Based on LyondellBasell's performance, he said, Dow should be earning an additional $2.5 billion a year.

"After a decade of underperformance, shareholders deserve greater transparency and a comprehensive reassessment of Dow's strategy," Third Point said.

Liveris dismisses Loeb's analysis, which he says is based upon incomplete information and unworkable assumptions, such as selling Dow's vast production of ethylene and other basic chemicals on the open market. Dow is the world's largest producer of ethylene, for example, but it's also the world's largest consumer of ethylene. Thus it's hard for outsiders to figure out how much Dow is making by converting the feedstock into higher-value plastics instead of selling it to somebody else.

"We know the model: They're in it for a period of time," says Liveris of Third Point. "They want to make changes based on what their data tells them, and their data's only as good as what's externally available."

Ultimately a gain in Dow's stock price since Loeb's May report may have calmed the activist. There was no mention of Dow in Third Point's July letter to investors. Loeb declined to comment for this story.

Liveris may be dismissive of takeover artists and private equity firms that would milk Dow for quick cash, but his strategy is to silence them with buckets of the stuff. Dow reported $8.4 billion in earnings before interest, taxes and depreciation in 2013 (excluding a $2.2 billion settlement with the Kuwaitis over the busted joint venture, which Liveris used to pay down debt). It has projects under way that Liveris says will boost Ebitda by another $3 billion a year by 2017, including shale-backed developments in Louisiana and Texas and the giant Sadara petrochemical joint venture with Saudi Aramco in Saudi Arabia. Those projects lead analysts to project that Dow will earn $4.24 a share in 2016, up from $3.72 in 2013.

Investors also have their eyes on Dow's growing agricultural business, which has doubled sales and pretax earnings over the past decade and is expected to do so again before 2020. The company has focused on both genetically modified seeds and agricultural chemicals. Dow's new Enlist system, a combination of herbicide-resistant corn and two herbicide sprays, is designed to counter the spread of Roundup-resistant weeds, which are forcing some farmers to resort to old-fashioned mechanical weeding to maintain crops. Dow Ag reported close to $1 billion in Ebitda last year. With Monsanto valued at 13 times Ebitda, Dow Ag is probably worth $12 billion, or $10 a share.

"Look, I will listen to every interesting offer" for the agricultural unit, Liveris says. "I know it's a hot property. But it's a hot property for us as well."

Liveris might have gotten some of his ability to navigate swiftly changing waters from his Greek ancestors, who for generations inhabited the island of Kastellorizo, off the coast of Turkey. Liveris' grandfather, a laborer, immigrated to Australia during World War I and later brought along his family to the Outback town of Darwin, where his grandmother washed miners' clothes for a living.

"I grew up in this amazing bipolar world," he says, where his relatives spoke Greek at home and he mixed with Anglos and aborigines at school.

As his father and uncles prospered in the construction business, Liveris went to the University of Queensland and earned a degree in chemical engineering. He took a $9,000-a-year job with Dow in 1976 because the company offered him the opportunity to see the world.

Liveris was posted to Asia, where the chemicals industry was a lot like the chemicals industry in the U.S. today: booming. There was no particular need to innovate or keep an eye on efficiency, he says, because demand was growing and chemicals were in short supply.

"Most of us were making fat margins because we didn't have any global competition," says Liveris.

All that ended when oil-producing nations like Saudi Arabia and Kuwait jumped into the petrochemicals business, not to make money but to convert their natural wealth into jobs. So investor-owned chemical companies started cutting costs and centralizing management. Dow shares quintupled in the 1980s and 1990s as the company slashed costs and return on equity soared.

By the end of the century, however, Dow managers were running out of tricks. The industry was consolidating, so Dow acquired Union Carbide for $12 billion. That bought a little time. Then, soon after Liveris was promoted to chief operating officer in 2003, oil prices spiked and drove Dow's annual hydrocarbons cost from $8 billion to $32 billion.

"Margins went from 30% to zero," Liveris said. It was then that he drafted a white paper that got him promoted to chief executive and set the company's strategy going forward. The plan would be to jettison Dow's low-margin commodity petrochemicals businesses, including founder Herbert H. Dow's original chlorine business. Otherwise, Liveris concluded, Dow was prime meat for a state-owned petrochemical company or a private equity firm looking to slash costs even further, goose cash flow and sell for a quick profit.

The proceeds from selling the so-called upstream businesses would be poured into higher-margin downstream markets where Dow had some control over pricing, such as specialized plastics used in packaging and adhesives, and composite materials that Detroit was using to replace welded sheet metal in cars. Liveris also would bulk up Dow's agricultural business.

Other parts of Liveris' strategy didn't go so well. He negotiated a top-of-the-market price for Rohm & Haas in 2008 to get hold of the Philadelphia company's specialized products, including electrical components used in cellphones. "We've basically been trying to fix [the acquisition] ever since," admits Liveris.

Luckily he had Warren Buffett on his side. Liveris says he originally met the billionaire over a three-hour lunch at Buffett's country club in Omaha in 2008, soon after Berkshire Hathaway had invested $6.5 billion to help Mars complete its $23 billion takeover of Wrigley. Liveris figured he might need help on a future deal. "When you buy something, let me know," Buffett had said.

A few months later when Liveris was in a pinch, he called Buffett seeking money for the Rohm & Haas takeover. Buffett ultimately invested $3 billion in 8.5% preferred stock that Dow could convert into common when its price passed $53 a share. After a long wait Dow is now close to being in a position to convert Buffett's shares and shave an estimated $255 million a year in costs.

Now Liveris is concentrating on Version 2.0 of his old plan. He's already sold off lower-margin businesses that had about $15 billion in annual sales and replaced them with an equivalent stream of higher-margin revenue. The trick is selling commodity chemicals units, like the century-old chlorine business, while retaining access to the molecules they produce. As Earl Shipp, manager of Dow's Gulf Coast operations, explains, "The short answer to 'Why integrate?' is this is the only way you can make some of these products."

Dow uses chlorine to make the propylene glycol in cough syrup, for example, but it's also used in epoxies and polyurethanes, and in some cases Dow pulls the molecule from one waste stream and uses it to make something else. Such intracompany transfers abound. Dow turned the waste from epoxy into a valuable soil fumigant for pineapple production in Hawaii, for example. It also operates the largest independent electrical distribution system in the country--its power plants in Freeport generate enough power to run Houston. So Shipp's employees monitor power prices during the day to determine whether Dow can make more money producing chemicals or selling into the grid.

LyondellBasell and other chemical producers may be coining money on ethylene, Liveris says, but the volatile chemical is hard to transport and the price can fluctuate wildly.

"I don't want to buy it; I want to build it," he says. "For Dan [Loeb] to suggest we split this out, it would disable the downstream businesses."

With five years left before Dow's mandatory retirement age, Liveris has time to see through the rest of his shale-modified strategy. At the company's Philadelphia-area research and development center scientists are working on plastics and epoxies for coatings and personal care. Dow has exclusive development programs with Mercedes and Audi to produce new adhesives for bonding steel body parts, for example, and it's working with Ford on speeding up the process of making carbon-fiber components. Plastic pellets and adhesives made in Freeport show up in specialized films used in popular transparent food packaging for soup, as well as peel-open Oreos containers.

Low-cost feedstocks are "what's going to make us a cash machine," Liveris says. But a lot of that cash will be invested in downstream products that can earn higher margins than bulk chemicals. Quoting his savior, Warren Buffett, he says he's running the company "for those who are staying, not those who are leaving." He adds, "Let's see if Third Point is in the stock in the year 2025."