Dow and Rohm & Haas - Why They Go Well Together

Summary:

I am upgrading my ratings on both Dow (DOW) (– 10.65) and Rohm and Haas (ROH) (– 56.28) from HOLD to BUY. I am not recommending buying one or the other, but both together, as I regard choosing between them as speculative and the risk unnecessary. My position instead is that today’s combined market cap of $20.7 bn for the two companies is too low, and that a way exists for them to create meaningful upside that is shared by both; specifically, a 5-for-1 exchange in a purchase for stock merger. The virtues I see include:

• After such a transaction, there would be 1.9 bn shares outstanding. Of these, ROH shareholders would own 51.3%, and thus a majority. This would require reconstituting the Board and top management. By itself, this would be an enormous positive, as it would mean a pro-shareholder group replacing an anti-shareholder group.

• No new debt, no financing needs. The balance sheet would be very strong, no need for selling assets low in a buyer’s market, or tangling up ownership of assets in “joint ventures”. In short, no more value destruction. Debt ratings would jump to a high investment grade. The dividend would have to be cut, probably to about 80 cents, but that or worse is going to happen anyway.

• No more litigation, ticking fees, etc. All claims settled, no more court documents, name-calling, posturing, lawyering. Drop the lawsuit and all talks with Kuwait, let management think about the business.

• No meat ax to the work force. No need for forced synergies beyond what actually makes sense. Actually do something about all the sympathy being mouthed about
employees, customers, communities, stakeholders.

• Upside for all, including ROH shareholders. If the stock got to just $15.60, the latter would be whole on their 78. This would seem to be about a seven-iron from here.

• Dilution in 2009, before any synergies, would be 22%-25%. This would normally be a big number but today the last thing shareholders in either company are thinking about is earnings dilution. Using today’s consensus estimates for 2009 for both companies, investors now expect net income for this year from the two companies to total $1.48 bn. On 1.9 bn shares o/s, this comes to 78 cents a share, vs. DOW estimates now of $1 or a few cents more. If 2009 were to be the trough year, an 80-cent dividend could be justified, since debt reduction would not be a
priority, and it is in the nature of the ROH business to be cash flow positive.

Price Targets

The P/E, at $20.7 bn market cap, on $1.48 bn net income is now exactly 14x. I think this is low, especially on trough earnings, and for a strong, shareholder-oriented company such as Dow/Rohm and Haas could be. What is needed to realize the value is for both sides to get over their posturing and just drop it. I believe this can happen, since the only impediment is that Dow’s management and Board would have to go. My price target for DOW is 16x-20x my pro-forma 2009 estimate of $0.78, or $12.50-$15.60. Under my assumption, of a 5-for-1 exchange, this would mean $62.50-$78 for ROH.

Risks

Aside from the usual macro issues that face everyone, the principal risk here is DOW’s legal exposure. If DOW is forced to close on its contract to buy ROH for cash, or pay a big cash settlement to ROH, the resulting debt could be harmful. For this reason, I recommend buying and holding both DOW and ROH.

Disclosure: I, Paul Christopherson, certify that all the views expressed in this research report accurately reflect my personal views of the subject company (ies). I also certify that I have not and will not receive compensation with respect to the issuance of this report.

Comments

[JR Ewing:]

I agree, in fact posted something similar a few days ago. Problem is as DOW keeps dropping and is almost 8 to 1 to get to $78. Maybe ROH should buy DOW (LOL). I know money is tight but I don't see why Carl Ican or T. Boone or Buffett don't step in and buy DOW for cash and straighten out the board and management.

Downside on ROH - if by hook or by crook if DOW is able to get out of ROH cash deal ROH could drop to the 20's based on other chem. Co's.
To buy PUT insurance is to expensive because we don't know but would have to buy April strikes. Upside is DOW finds a partner and closes the deal at $78 before court. The price of oil make MEast partner unlikely in the next 30 days. Or ROH takes half cash and 4xshares.

I have not figured out how to play this one except to gamble on the long and short options of ROH selling calls and put and covering them with the next strike. I know it is dangerous but I am long DOW and down $10 and figure that any new is good for DOW either way and nothing will happen before Friday.

Any other ideas on how to play this?

Feb 13 07:55 AM

[moose60061:]

Good points JR,
I played this long a few times and yesterday I sold at $59.14 although I think its safe to sell puts at least through Feb expiration. Beyond that its too risky for me, anything could happen although I believe $78 is dead. Maybe at $66 they could do this without borrowing themselves into extinction. But then the question is what does ROH want.......for now Im sitting back and watching but the upside appears limited here for the next week at least.

Feb 13 09:09 AM

[Get$Real:]

What a joke! Do you think that either the BOD of ROH or DOW are considering such an asinine proposal? This would mean a reverse takeover! Get real, this matter is now in the hands of the Delaware court and the most certain outcome, unless the judge decides to throw centuries of contract law in the garbage, is that Dow will have to pay $78 IN CASH to ROH stockholders.

Feb 13 10:01 AM

[windswept:]

Moose,

spoken like a true ROH Holder. Just to clarify, there are no "certain outcomes" in life. If you have not learned that lesson then you need to start over again. The only certainty is that there is none. This may go in directions we never imagined. Desperation and greed make uneasy bed fellows. Who knows what the desert people may do? Very unpredictable. Either Way Liveris is disgraced and gone.

Feb 13 11:23 AM

[JET1C:]

The DOW CEO sounds like a MORON to me. Where do they get these guys? The market was headed for the hole for 2/3 of last year and he makes an offer like this with no way out of it. No allowance for the "unforseen" developments. Then runs into the board room and closes the door, refusing to even talk to ROH. What kind of a "business man" would do that?

The whole mess make me ill. and down 75%. I'm getting less hopful of a satisfactory conclusion all the time.

Feb 13 12:28 PM

[UserThunder...:]

Your analysis is completely flawed. ROH would never agree to another way forward other than the iron clad price of 78 dollars a share etched into their merger agreement. The board of ROH would likely face shareholder suits if they backed away from the agreement. Liveris needs to adhere to the framework laid out by Paulson & Co.

Feb 13 12:31 PM

[UserThunder...:]

By the way, I fully expect ROH to trade up in the high 60's prior to the trail date on March 9th. In my estimation, one of two things will transpire: (1) Liveris uses the time to cobble the financing together and closes @78 by 3/9/09 or (2) DOW is forced to consummate after a trial.

Feb 13 12:41 PM

[Ricard:]

If DOW doesn't close the deal before trial, I see this outcome:

I believe ROH will stick to their $78 and have it upheld by a court, but more importantly, I think DOW through court will also be able to get manageable terms to break the deal IF the deal would consummate in the death of the combined entity. The key is the word "manageable" - I still think it will be a multibillion dollar hit for DOW, but 2-3 billion is much less than 15 billion.

If DOW breaks the deal, ROH will plummet, regardless of the size of the penalty award - it is currently egregiously overpriced compared to its peers. This will probably force ROH to voluntarily renegotiate. The key point I'm making is that a judge will in no way force ROH to renegotiate the contract by directly siding with DOW - a deal IS a deal.

Else, DOW finds some way to close @ $78, cash, to ROH that doesn't cripple the combined company.

As I tend to focus more on long term issues, I've played this by selling out-of-money LEAP puts on DOW. ROH's situation is too volatile - either they get the full $78, or they plummet after DOW breaks the contract. That could be a good straddle play, I suppose. However, I still think the no-brainer play is to somehow long DOW when it reaches a price that presupposes bankruptcy, a most unlikely and thus safe outcome for investors. Selling puts fits that bill.

Feb 13 11:01 PM