Dow/DuPont – So Far Not So Good – But Now More Compelling

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 13, 2016

DowPont – So Far Not So Good – But Now More Compelling

  • Investors do not yet have as much faith in the Dow/DuPont merger as the companies themselves do and as we do – presenting potential investors with an even better entry point
    • The macro is driving down the Industrials and Materials Sectors as one might expect, but DOW and DD are underperforming their peers
  • This suggests that investors are not valuing the expected synergies and other value creation opportunities that the merger offers
    • DuPont is clearly taking a swing at costs already – in part to offset what will likely be quite disappointing guidance for 2016
    • Dow has been relatively quiet so far, but will need to step up the disclosure – in tandem with DD to get the attention of investors
  • The macro is a huge headwind for all and Dow has the added risk of what is now an almost flat cost curve for ethylene, and in our view a very fragile “peak” in polyethylene margins
    • The opportunities to offset the headwinds with the benefits of the merger should be grabbing the headlines and investors’ attention, but so far they are not
    • It is possible that the expectation is that a better entry point is likely after Q4 earnings and 2016 guidance and this may well be the case
  • We like the deal and believe that the story should work in 2016. However, the companies need to be more articulate around the many potential opportunities created by the merger
    • It would help if they were to suggest flexibility in terms of how the company is split. If oil looks like it could be sub $40 going into the big US ethylene expansions the combined entity may want to spin out the commodity piece and keep a bigger specialty portfolio
    • Convincing investors that they are open minded in this regard would be prudent. It would also help offset the growing investor concern that the whole deal is about protecting jobs in Midland Michigan rather than optimizing shareholder value creation

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

The initial reaction to the DOW/DD merger of equals was very positive, but it was clearly a case of buy on the rumor and then sell and keep selling. We continue to believe that that this combination will unlock tens of billions of dollars of value for shareholders, but not only are the stocks going down, but they are also underperforming their sector and peers – Exhibit 2. In this chart – Dow and DuPont are included in the Chemicals Index and the Industrial and Materials Index, which of course makes the relative picture look better than it is. It is surprising to us that Dow is underperforming Lyondell, given that LYB has 35% more polyethylene capacity per share than Dow, and so greater downside in the event of a margin squeeze and no potential merger related cost reduction offsets.

Exhibit 2

Source: Capital IQ and SSR Analysis

Obviously the Macro is the problem – lower economic growth, lower manufacturing growth in China and the US, further weakness in Ag and of course oil. However, these macro issues hurt everyone, and very few have the expected cost reduction offset that is offered at Dow and DuPont. So why are the stocks underperforming? We have a few ideas:

  • Expected weak fourth quarters and negative guidance for 2016 – is the pro-forma entity going to make $2.50 a share in 2016 or is it closer to $2.00?
    • If we get the squeeze in polyethylene margins we expect, Dow’s numbers could come down meaningfully – 75 cents to $1.00 per share
    • How bad is Ag going to be in 2016 and how low a bar will the companies want to set?
    • How much stronger will the dollar be – what should they bake into guidance?
    • What will they assume on oil?
  • A communication vacuum
    • Once the quarterly reports are out, is it possible that we hear very little until approvals are received for the merger and the deal takes place
    • In the absence of information, the macro will dominate as will likely revisions and the stocks could drift or tread water

We feel strongly that Dow and DuPont will be outperformers for the year, but it is a valid question as to whether there might be a better entry point and whether this is all going to be a second half or even fourth quarter event.

We would encourage the companies to start sharing more with investors to create confidence that the synergies can be achieved as proposed in the press release and that there are plenty more ways in which the deal can create value. Right now the confidence is clearly lacking. If there really is as much as much as $2-3 per share of unlockable earnings from cost synergies, other cost streamlining and revenue synergies, then even if 2016 is as bad as $1.50-2.00 per pro-forma share before these synergies, the stocks are very cheap.

Pro-forma normal earnings of $4.50 per new share (which is likely conservative – see Exhibit 1), suggests Dow at around $70 per share and DD at $90 and possibly higher with a relative multiple increase.

How Bad Is The Ethylene Market?

Today the global ethylene market is reasonably robust, though there are signs of weakness – prices are declining for ethylene and are stable for polyethylene, but costs are down substantially, generating very high instantaneous margins, in all regions. The US may be the weakest market today as spot ethylene prices are falling, as are contract prices, and a recent attempt to increase polyethylene prices appears to have been abandoned. However, the underlying problem is the shape of the cost curve as shown in Exhibit 3. The cost delta between the average US producer and his counterpart in Asia and Europe is down to 7.5 cents per pound from close to 50 cents per pound when oil was at $110 per barrel. The US has a substantial ethylene derivative export business today – roughly 20% of all ethylene produced and the 7.5 cents of cost difference does not cover the cost of packing and shipping for polyethylene should pricing decline to reflect costs.

Today, polyethylene exports are profitable and even products like PVC can be moved out of the US based on spot ethylene prices. But it is a long way down when you consider how far costs have fallen and the huge decline in confidence that the first two weeks of 2016 have created!

Exhibit 3

Source: IHS, Wood Mackenzie, and SSR Analysis

Today the average integrated margin on contract High Density Polyethylene in the US is around 35-40 cents per pound – for reference, the average US integrated margin from 1981 to 2010 was 18 cents per pound.

Globally the combined entity has around 18 billion pounds of polyethylene capacity – 95% of it at DOW. The Dow capacity is around 14 pounds per share, so margins do not have to fall very far to make a big dent in earnings. For the combined entity, polyethylene will be around 7.5 pounds per share and a 10 cent slide in global polyethylene margins would be very significant for Dow and significant for the combined business.

©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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