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When Dow Chemical reported strong Q3 results, it also announced further goals in the company's portfolio transformation program which now includes actively examining strategic options for the agrochemical and seed business Dow AgroSciences ("DAS").

Not too long ago, Dow has signaled that a bright future lies ahead for DAS, and the business has been considered as one of the pearls in the group's portfolio. Dow has invested large amounts in DAS over the years through acquisitions and R&D expenditures, and the top line grew solidly over the past years. In addition to new products which were already launched, there is a promising pipeline of crop protection products and seed technologies which are expected to come to the market in the next years.

So why has Dow changed its mind and is now considering to sell the business if the price is right? First, despite revenue growth, DAS' margin continues to fall behind the chemical businesses. Second, although the crop protection and seed markets are in decline, the time might be right for a divestiture since a new wave of consolidation is expected to hit the industry. The starting point which triggered this development has been Monsanto's failed attempt to acquire the global crop protection leader Syngenta a few months ago.

Dow AgroSciences

DAS is the no. 4 player on the global agrochemical market and holds the fifth position in seeds with combined sales of $7.3B in 2014. Crop protection represented 78% and seeds 22% of the revenues in 2014.

Source: company reports, *Monsanto FY ends Aug, 31st, +Vilmorin & KWS FY ends June, 30th. Not included Syngenta's "Lawn and Garden" and Bayer's "Environmental Sciences" businesses.

DAS' adjusted EBITDA margin is the lowest of Dow's segments, and the EBITDA of $962M corresponds to a margin of only 13.2% compared to an average of 16.0% for the group as a whole. To make things worse, this gap has widened during the first nine months of 2015. After Q3, DAS reported revenues of $4,478M, 12% lower than last year. Adjusted EBITDA in the period fell by 14% to $639M, and the margin of 13.4% compares to an overall adjusted group margin of 19.3%.

To conclude the business performance of the recent years, DAS has been successful in achieving top line growth, but profitability is an issue. Crop protection sales have grown by in average 8% over the past five years whereas the CAGR for seeds stood at an impressive 20%. While the growth drivers for the seed business have been primarily acquisitions of seed companies, growth in the agrochemical segment has been organic.

DAS' margin however did not move in the same direction and declined from a peak in 2011. The comparatively low margin, also in relation to DAS' peers can partly be attributed to "aggressive growth funding to expand a leading innovation pipeline" which was seen as Dow's strategic lever to foster the Ag business. Particularly, the investments in the new Enlist seed technology have affected margins in the past couple of years.

During the Bank of America Merril Lynch Global Agriculture Conference in February 2015, DAS' President and CEO Tim Hassinger presented the ambitious goal of doubling the business' EBITDA from $1B to $2B within the next 5-7 years. Seeds are expected to be the main driver contributing about two thirds and crop protection standing for the remaining one third of EBITDA growth.

Dow Agrosciences Fall from Grace

Why should a company divest a growing business which is about to double its EBITDA in a foreseeable period of time? The simple explanation for not keeping DAS is that its mother company does not believe in the ambitious growth plans any more which were presented to shareholders year after year.

DAS' major R&D investment has been the "Dow Herbicide Tolerance" ("DHT") technology which comprises the new multi herbicide resistant Enlist seeds and the corresponding Enlist Duo weed management system. The launch of Enlist has been delayed, presumably causing cost overruns, and to make things worse, there are signs that the ambitious projections might not become reality.

Multi herbicides resistant traits are the next big thing in seed biotechnology after more and more weeds have developed resistances against the single most important herbicide glyphosate. Dow has received the EPA registration of the Enlist Duo herbicide and the USDA deregulation of Enlist corn and soybeans. In 2015, the company started the stewarded introduction in the U.S. and Canada.

DAS' Enlist technology is based on resistance against the herbicide 2,4-D and competes with Monsanto and the new Roundup Ready Xtend technology which is based on the herbicide dicamba (instead of 2,4-D). Unfortunately it seems that DAS has already lost the race against Monsanto even before the seeds make it to the market. Already last year, DuPont Pioneer, the second biggest seed company has stated that it will not license the Enlist soybean traits from DAS.

Seed biotechnology companies such as DAS have two paths to generate revenue from its traits, first licensing to partners and second selling seeds bearing the traits through their own distribution channels. Since DAS' ability to sell directly is limited due to the relatively small size of the own seed business, licensing is mandatory to realize the full revenue potential.

A Divestiture would be a short-sighted Move

Despite these issues, there are good reasons to stick to DAS and should Dow really decide to divest the segment, it might be a short-sighted move for several reasons. First, the Ag business is a stable earnings contributor and traditionally less cyclical than the chemical businesses. In the Q3earnings presentation, Dow still considers it as one of the "lowest beta" businesses. Admittedly, after Dow's recent portfolio transformation measures, it trails the chemical segments' profitability, but this trend is likely to reverse in the next recession which will inevitably come. The Ag business has always helped integrated chemical conglomerates like Dow Chemical, DuPont, BASF or Bayer in difficult periods, the last time during the Great Recession.

Second, Dow Chemical has already spent large amounts of money in developing the business, but it will not see the payback if DAS is sold now. While it is truly questionable whether the expectations for the Enlist technology can be met, the products will nevertheless be profitable and gain a certain market share. Beyond seeds, the company has also developed a leading crop protection pipeline. Some of these products are already successful on the market and fetch higher margins than the old pesticides which they replace. DAS' agrochemical portfolio and pipeline is also more diverse which reduces the risk if one project does not take off as expected.

Third, the crop protection and seed markets are in a phase of weakness due to depressed commodity prices, but the long-term growth prospects for the industry remain intact. This is not a structural crisis, but a temporary one, and I believe that patience will be rewarded. Once the phase of stagnation is over, DAS will return to top and bottom line growth.

The strength of the dollar is another headwind which affects DAS more than the group's other businesses. DAS generates 60% of its revenue outside North America, and especially Latin America is an important market. The region represented 31% of sales in 2014, and obviously the economic crisis in Brazil and the currency devaluation are negatively impacting the profitability at the moment.

Conclusion

I believe that a sale of Dow AgroSciences would be a short-sighted move. A likely reason for Dow Chemical to suddenly evaluate strategic options for its Ag business is that the new Enlist seed and weed control technology might fall behind expectations. While this would mean that the significant R&D investments of the recent years will not pay off as expected, I doubt that this justifies the divestiture of an otherwise successful segment. The alternative is to stick to the less cyclic business which has helped to provide a sustainable income stream during recessions and to actively participate in the expected industry consolidation instead.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.