Dow and Rohm & Haas: Some Deals Are Too Risky These Days

Last July I wrote a blog entry that discussed the possibility of margin and multiple expansion at Dow Chemical (DOW). The thesis of this recommendation centered around Dow Chemical’s acquisition of Rohm & Haas (ROH) and the company’s ability to pass on price increases and its ability to hold these price increases should the price of oil retreat.

While I still hold shares in Dow Chemical, the investment story behind the company has clearly deteriorated. This has been caused in large part by the collapse of the company’s deal with Kuwait, further deterioration in the credit markets and by the U.S. economy’s significant turn for the worse. While I am thoroughly convinced that the company would have done quite well had economic growth only slowed and not collapsed and had the company been able to complete the sale of a select group of low performing units to the Kuwaitis, it is clear that the company is facing a completely different environment than it was six months ago.

Given how awful the earning reports from Eastman Chemical (EMN) and Nova Chemicals (NCX) have been, it is clear that Dow Chemical will likely not be able to fund the repayment of the debt taken on to complete the Rohm & Haas acquisition. Without the cash from the Kuwaiti sale, Dow Chemical simply cannot risk a purchase of Rohm & Haas in this economic environment. Should the acquisition of Rohm & Haas go through, the bridge loan that the company will be forced to take out will be crippling.

It is clear that if Rohm & Haas had been trading freely, without Dow Chemical’s support, that it would be trading at a level well below its 52 week low of $44 and nowhere near its current price per share. More likely than not, Rohm & Haas’ business has suffered a significant hit as its specialty chemicals, with their considerable ties to electronics, has likely been disproportionally impacted by a significant slowing of consumer spending.

Should the management of Dow Chemical still wish to complete the deal or if they are not able to escape the confines of their agreement with Rohm & Haas, it is evident that the purchase price must be significantly reduced. In addition, the terms of the deal must be changed so that a significant amount of the purchase is in the form of Dow Chemical stock instead of cash.

The company’s dividend, while considered sacred by most because of the company’s ability to either raise or maintain it for the last 389 quarters, will likely need to be cut in any event. However, if the Rohm & Haas acquisition is called off completely it will assuredly not need to be reduced to a mere pittance of its current value.

The deal between Rohm & Haas and Dow Chemical simply does not work in today’s world. The economic situation will likely prevent the combined company from paying back the bridge loan that would be needed to complete the purchase given the failure of the company’s deal with Kuwaitis. The management team of Dow Chemical and the company’s shareholders simply cannot want to be faced with the task of raising billions of dollars as the bridge loan approaches expiration, especially when the company’s core business is in a free fall. It is time for the company to hunker down, conduct small niche acquisitions, retool plants and pay down debt. A blockbuster acquisition cannot be supported given the current shape of the economy.

Upon the next quarterly report by Dow Chemical, we will likely see a company that has been battered by a slowing U.S. economy. The stock will undoubtedly come under significant pressure, when this happens it will be a clear buying opportunity as it will likely signify the abysmal shape of Rohm & Haas’ business and the subsequent calling off of the acquisition.

Disclosure: Long DOW

Comments

[HIGHWATER 888:]

Like most traders who are 'long DOW' your opinion is being infulenced by a burning desire for a "get out of jail free" card. The DOW-ROH merger agreement does not admit that as a possibility.

The merger agreement is tight, well drafted by ROH and was poorly negotiated by DOW, in that, Liveris & Co. seem to have negotiated away all the normal protections for 'unforseen' circumstances that might have allowed them to walk away from the transaction. I'm told that ROH and its lawyers will even be able to show the Deleware Chancery Court the history of the merger negotiation and demonstrate that Dow negotiated away the specific protections for adverse business and credit conditions in order to induce ROH to sign the deal. If you think that type of 'sucker-punch' legal ploy (a.k.a. 'Buyers Remorse') is a well regarded legal argument in Deleware Chancery Court, you should think again.

Even if the Court --acting in equity-- decides not to force the merger, under these facts it is highly likely that it would, nevertheless, enforce the merger contract by awarding ROH the 'benefit of its bargain' by giving ROH a giant amount of damages. How much? If we use your estimate of a non-merged value for ROH below $44, it seems safe to say that 'damages' under the broken merger contract would exceed $4 Billion.

My six month target price for DOW is $5 per share.

Feb 02 08:46 AM

[UserThunder...:]

What a surprise! A long dow shareholder thinks the deal should be reworked. I stand by my earlier post that dow's "world has changed" argument only seems to work in their favor!A logical extenstion of his faulty argument would be that if the economy dramatically improved, ROH would be legally entitled to demand, say 100 dollars a share instead of the 78 written into the merger contract. DOW is has truly painted itself into a corner.

Feb 02 02:54 PM

[Wolfeman52:]

I must agree with Highwater 888 regarding Dow's deal with ROH. I haven't read anywhere that Dow has a legal excuse not to proceed, or to bargain for a reduced price.

At best, Dow might be able to delay the deal by paying an ever increasing purchase price (about $100 million/month as I understand it). How long Dow can delay isn't clear from the reports - maybe six months or so.

To finance the deal (or pay damages), Dow wil have to do some combination of the following: (1) sell assets in a depressed buyer's market, (2) find investors who - if they even exist - will extract the proverbial pound of flesh, and (3) borrow in one of the most difficult debt financing environments seen in decades.

I'm long Dow and short on hope.

Feb 02 05:44 PM

[buyitcheap:]

I would think buying puts on Rohm would be a good play in the event the deal fell apart which I believe is better than 50/50 for lack of financing. They're cheap given how far Rohm would likely fall. Long Dow or long calls would be the other side of that.

Feb 03 07:30 AM

[prudentinve...:]

Another example of the extent to which corporate governance has collapsed. Highly paid, but incompetent management, aided and abetted by an ignorant and irresponsible board, brings one of our great companies to the brink of ruin.

It seems inconceivable that anyone with any busines sense, would (a) pay such a premium for an acquisition, (b) sign an irrevocable deal for the acquisition without financing being in-place, and (c) predicate the financing on another deal (Kuwait) which, it turns out, was revocable!

If the shareholders of Dow Chemical do not fire the entire management team, along with the board, then they just deserve what losses they get.

(Disclosure: Buy and hold investor in Dow)

Feb 03 08:18 AM

[HIGHWATER 888:]

You must read DOW's Answer to the ROH Complaint (PDF copy on Fly On The Wall . Com). It is a classic of legal perfidy.

But, more to the point, DOW's lawyers have made a big mistake: They have presented Judge Chandler with a childish 'Christmass Wish List' of so-called equity rationals for not enforcing the clear contract agreement between ROH and DOW. While the court might fashion some limited remedy in equity (ie. more 'time' to perform the merger agreement or a debt or equity substitute for the 'cash' consideration) it would only be well justified in doing so based on the equities between the parties to the contract and even then only as it relates to CONTRACT PERFORMANCE and not the ultimate (read as 'future') success of the merger.

DOW's lawyers are over-reaching by asking for equity for 3rd parties outside the contract and seem to be dreaming of 'pie-in-the-sky' when they say to the court "don't make us honor an agreement that might not suceed...our business integration models just didn't game the current market conditions....". The Deleware Chancery Court is not likely to fashion any equity remedy for Dow based on their lawyers' foolish request that Judge Chandler 'look into their CRYSTAL BALL....'.

The equitable relief requested by DOW's lawyers is based on such broad an diverse considerations that it is comic in the extreem; however, don't expect the court to be amussed: Courts are very reluctant to fashion remedies in equity that may set broad legal precident -- sometimes Judges even take this sort of over-reaching in the 'wrong way' and loose their 'judicial temperment' with the lawyers trying to putone over on them.

Feb 03 10:37 AM

[Prudent Spe...:]

Highwater 888, I was disappointed to read about the efforts of Dow's lawyers. They've taken a poor approach in their efforts to get Dow out of the company's merger with ROH. As a longtime Dow shareholder I can only hope that the company comes to some sort of compromise with ROH.

Feb 03 05:50 PM