DOW-DD: We’ve Discussed the Upside, Now What Are the Risks?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 24th, 2016

DOW-DD: We’ve Discussed the Upside, Now What Are the Risks?

  • In prior research we have discussed the proposed DOW-DD deal in detail, focusing on the choices around the ultimate split, the cost opportunity, portfolio simplification and how the Ag combination may be a game changer for that industry – we like the deal and both stocks
  • There are many examples of deals in this sector and others which look good but perform poorly and we use this piece to try and frame the risks. These can be broadly grouped:
    • Macro
      • Energy – a flat ethylene cost curve globally would materially impact legacy Dow
      • Trade/tariff potential – if the West fights China on steel, aluminum and some chemicals, will China fight back on others (polyethylene for example)
      • Slower economic growth – once the integration/synergy story is over it is all about incremental margins – no growth or a recession is always bad news
    • Company specific
      • Commoditization quicker than expected – does the proposed split anticipate the risk that many of the “value add” sectors in materials have commoditization risk
      • A failure to integrate well, most likely fueled by a larger cultural rift than anticipated
        • Offset to a degree by one company being largely legacy Dow and another legacy DD – Ag would be the bigger risk
    • Regulatory
      • Specifically related to Ag, we are looking at three mega mergers (DOW-DD, Bayer-MON, Syngenta-Chem China) effectively halving the number of global players
  • The greatest long-duration downside risk is probably a flat ethylene cost curve, but an economic shock could drive the greatest short-duration risk

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

We like the Dow/DuPont deal. We think that it brings opportunities to both companies that they otherwise would not have going it alone:

  • A chance to create three more focused and less complex companies with for the most part a logical focus on customer solutions as a route to growth
    • We have questions about some of the split logic in terms of which businesses best belong together, but this is fine tuning, and the broad concept is good
  • A game changer in the agriculture space, raising the bar for others and causing possible further deals as others look for a response
    • The opportunity to sell both seeds and chemicals across the powerful Pioneer salesforce should drive revenue synergies driven by share gains
  • Significant cost opportunities, which we believe go beyond the discussed synergies and what Dow and DuPont have done independently already

Possible upside ranges and some of our assumptions behind them are summarized in Exhibits 2 and 3.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

However, there are plenty of examples of deals that have not worked out as planned or delivered what was promised. Many have disappointed because of a combination of timing and deal value, especially when cash based acquisitions have been followed by either market declines or business declines.

Dow’s all-cash acquisition of Rohm & Haas at the top of the cycle in mid-2008 is now a Harvard Business School case study. The performance figures in Exhibit 4 are distorted by the extreme volatility of the ’08-’09 period and obscure the integration difficulties. Timing was clearly an issue but the price was also notably viewed as a stretch – the all-cash bid came in at a 74% premium to Rohm & Haas’ last sale price. Dow would argue that the company’s specialty mix was significantly upgraded but the numbers suggest the acquisition destroyed a large amount of capital, the benefits of which have yet to be realized by shareholders – Exhibit 5.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Albemarle underperformed the Chemical sector and the broader market following its acquisition of Rockwood (the former ROC) – Exhibit 6. The price paid may have been part of the issue but timing likely paid a larger part. Exhibit 7 shows the Solactive Global Lithium Index which tracks the performance of stocks involved in lithium mining and/or production. When ALB acquired ROC in mid-2014, the index was well off its highs of early 2011 but there was another leg down still to come – the anticipated demand-driven spike only now appears to be taking place. This has turned out to be a good deal for ALB.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Bloomberg, SSR Analysis

In Exhibit 8 we show that DD has also done deals that did not immediately create shareholder value. We show all of these examples only to suggest that we should not take for granted that the Dow/DuPont deal will be an immediate or even long-term success.

Exhibit 8

Source: Capital IQ, SSR Analysis

Merger of Equals Takes out the Price Risk

However, this deal takes the price risk out as the merger of equals does not leave either side hanging, trying to justify a premium regardless of the way the market could go from here. Valuation aside, there are specific risks which might make either company look back and conclude that they could have done better alone; for example:

  1. A flattening of the global ethylene cost curve – low oil/higher US natural gas – would penalize earnings at legacy Dow much more than at legacy DuPont
  2. Further weakening in Ag would be worse for DuPont than for Dow

We look at risks with regard to our expectations – that this deal creates equities that are worth owning today and have considerable upside.

The risks fall into two groups; those that the companies can control and those they cannot. In the first category, we worry about whether the synergies can be delivered on time and whether the integration can happen as planned – leading to a successful and efficient split into companies that keep the low cost focus and can drive better growth. Most of this comes down to culture and how well these two groups can work together. In a perfect world the company needs to go through as few rounds of lay-offs as possible – ideally one. That way the remaining employees focus on their future roles and are not distracted by the expectation that another round of redundancies is just around the corner.

Macro

Energy

In our prior trough earnings analysis of DowDuPont the most significant potential negative impact we highlighted was related to polyethylene. A 10-15 cent per pound decline in polyethylene margins (which we think is likely during the next 12-18 months) would result in a $0.55-$0.85 EPS hit based on updated share counts as of Q1. The bigger risk would be a combination of a weaker polyethylene market and a flattening of the global ethylene cost curve (with respect to the US) – possible if crude is range bound in the $50-60 per barrel range and US natural gas rises to encourage more drilling as domestic and export demand grows. A worst case could double the impact suggested below.

Exhibit 9

Source: Capital IQ, SSR Analysis

Tariffs/Trade

The US recently implemented duties on imports of Chinese steel and there is a strain of current political rhetoric that advocates further and more broad ranging protective tariffs. If China were to decide to fight back by imposing tariffs on goods that the country is still net short of (polyethylene for example), the potential impact to DowDuPont would depend on the size of duty.

Dow and DuPont had roughly a combined $9 billion in sales into greater China in 2015. The available data is not granular enough to know specific volumes but we can get a high level feel for the impact of a Chinese tariff.

If we assume a potential tariff would trim 20 cents off every dollar of DowDuPont sales in China, at an assumed 10% margin and a 35% tax rate, spread over the ~2.4 billion shares this equates to a $0.05 hit to the combined entity’s EPS.

Most impacted would be Electronics & Communications at DD (Asia-Pacific 56% of segment sales), Consumer Solutions at DOW (45%), and Performance Materials at DD (34%).

Economy

In the crisis of 2008-2009, DOW and DD were among the most affected stocks in the Chemical universe – Exhibit 10. DOW is certainly less cyclical now than it was in 2008 – that said, it is also considerably leaner. Both DOW and DD likely have less levers to pull in the event of an economic downturn.

From 2007 to 2009, global GDP growth declined from 5.5% to effectively 0%. For that period, DOW-DD earnings per share declined ~62% (weighted by net income), or approximately 11% for every lost percent of GDP growth. Even assuming lower cyclicality for DOW, every percent decline in global GDP will likely impact DOW-DD earnings per share by a high single digits percentage.

Exhibit 10

Source: Capital IQ, SSR Analysis

The combined DowDuPont is still very much a Western facing business – 70% of sales come from Europe and North America – Exhibit 11. Latin America (particularly Brazil) has perhaps the most currently precarious economic environment – the biggest impact of a crisis in this region would be in the Ag business (driven marginally more by DOW than by DD – Exhibit 12).

Exhibit 11

Source: Company Reports, SSR Analysis

Exhibit 12

Source: Company Reports, SSR Analysis

Regulatory

A recent article in the Wall Street Journal highlighted the regulatory scrutiny that major deals are likely to receive in the US, a troubling indication since US M&A regulatory authorities are typically less stringent than their equivalent bodies in Europe.

In regards to DowDuPont, there is a real risk that that the proposed Ag combination fails to pass regulatory muster in multiple jurisdictions given the current level of consolidation in the industry and the fact that we are facing the prospect of not one, but three mega mergers – Syngenta-Chem China and MON-BAYER in addition to DowDuPont Ag.

Agricultural Chemicals as an industry has consolidated significantly over the past 20 years – Exhibit 13. At the start of this decade both Chemicals and Seeds & Traits were at the lower end of what would be considered a moderately concentrated industry as measured by the Herfindahl-Hirschman Index (equal to the sum of squared market shares). If all three of the potential Ag combinations go through, the HHI value will almost certainly exceed the 1,800 level that denotes a highly concentrated industry.

Exhibit 13

Source: USDA, SSR Analysis

Company Specific

Any deal, and particularly a deal of the scale and magnitude of the DOW-DD deal, comes with the risk of a culture clash from combining two distinct corporate identities. This risk is mitigated to some extent in this case, given the way the split is structured – the specialty company is mostly legacy DD and the materials company is mostly legacy DOW – Exhibit 14. Ag may be more of a concern.

Exhibit 14

Source: USDA, SSR Analysis

More Rapid Commoditization of Products

This issue is not new and both companies have struggled with high value products migrating to low value products for years – both have made significant divestments – DuPont – nylon, polyester and most recently TiO2, being the largest. For Dow the recent exit of most of its chlor-alkali assets follows earlier divestments of the styrene chain and polypropylene.

The materials business will be the one with the greatest risk of commoditization and we believe that polyurethanes will be on the short list for the next exit. It is critical for the company that Dow maintains its technology edge in polyethylene, but not at a cost that penalizes returns. Exhibit 15 is illustrative only.

Exhibit 15


Source: PWC, SSR Analysis

Summary of Risks

In the table below – Exhibit 16 – we show the assumptions and numbers behind Exhibit 1. Note that there is a duration issue with some of these risks. If a polyethylene margin collapse is prolonged, the stocks could trade meaningfully lower.

Exhibit 16

Source: SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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