Dow Chemical Investors Need Some Unexpected Good News

Includes: DOW, ROH
by: Todd Sullivan

It is finally done, Dow Chemical (NYSE:DOW) and Rohm & Haas (ROH) are one. Some details:

From the SEC Filing:

As part of today’s agreement, Rohm and Haas’s two largest shareholders have agreed to purchase $2.5 billion in face value of perpetual preferred equity issued by Dow. In addition, one of the shareholders, the Haas Family Trusts has agreed that at Dow’s option, they will make an investment in an additional $500 million of Dow’s equity. These equity investments substantially reduce the debt financing required to fund the acquisition, Dow has restructured the transaction to essentially pay the equivalent of $63 per share in cash, and $15 per share in face value of preferred equity securities. To fund the acquisition of Rohm and Haas, Dow will use the proceeds from the equity issuances to reduce the amount it would otherwise be required to draw down from the $12.5 billion bridge loan, which was renegotiated last week to provide a one-year extension on $8 billion of the total loan. The financing for the acquisition also includes equity investments of $3 billion by Berkshire Hathaway and $1 billion by the Kuwait Investment Authority (KIA) in the form of convertible preferred equity.

Acquisition Delivers Significant Cost and Revenue Synergy Opportunities

Dow plans to achieve its long-term goals for the Rohm and Haas acquisition with a carefully conceived path forward built upon the cornerstones of financial discipline and operational excellence. Dow has put into place an even more aggressive plan to realize combined synergies of $1.3 billion, up from $910 million, as originally outlined. With a long history of operational excellence, Dow has a demonstrated willingness to make the decisions necessary to maintain and improve financial performance. Cost savings will come from increased purchasing power for raw materials for the combined company; manufacturing and supply chain work process improvements; office consolidations and the elimination of redundant corporate overhead for shared services and governance.

Finally, as part of the Company’s plans to improve its financial position, Dow has commenced an aggressive asset divestment program involving a number of Dow and Rohm and Haas business units expected to yield approximately $4 billion including:

1. Dow’s 45 percent stake in Total Raffinaderij Nederland NV (NYSE:TRN), the Dutch petroleum refining partnership with Total Group. The sale process is underway;

2. Some of Dow’s equity stakes in its olefins and derivatives business in SE Asia. Preliminary discussions with the relevant parties have already begun;

3. Morton Salt, a division of Rohm and Haas, contingent upon the closing of the proposed acquisition of Rohm and Haas by Dow. Interested parties have submitted bids, and Dow will evaluate these bids as appropriate over the course of the coming weeks to determine timing of the sale process.

Divestments from this program, in addition to the increased equity financing will essentially address the cash shortfall created by the failure of the K-Dow transaction to close as scheduled.

Here is the presentation done immediately after:

Dow Chemical / Rohm & Haas Combines Entity

For those who do not want to go through the whole presentation, here is the slide that answers most people's questions, the financing and the bridge loan:

So, where are we?

Dow is offically no longer a commodity chemical company after April 1. 70% of 2008 EBITDA will be from specialty products. This will cause immediate PE expansion from high single digits that commodity producers tend to have in the mid to high teens the specialty ones enjoy, to their more consistent earnings. Dow will be cash flow positive in 2009 and have the term loan used to settle the transaction paid off within the year.

Interestingly enough, only $4.3 billion of the loan reduction will come from asset sales. Remember Dow was looking at $9.5 billion from the Kuwait JV that Kuwait bailed on essentially at the signing. Let's also not forget that Dow is entering arbitration with Kuwait over damages in the case. Dow has said in the past they are owed the $2.5 billion breakup fee in the deal. There is also a scenario in which Kuwait decides to re-enter talks with Dow for some of the businesses they were originally suppose to buy. Neither of these scenarios are baked into current projections, yet are very real possibilities.

But let's look around. Negativity is everywhere. Few would question the operational ability of the combined entity and the global powerhouse it now is. But, management at Dow does have a real credibility problem. For the price paid for this deal, to the failed Kuwait JV and the dividend cut, investors are left wondering "what's next?".

That is going to be a bit of a cloud over the company until they can report some positive news. We need some unexpected good news, not bad. Yes, I know that Rohm & Haas is a one of a kind company and that Dow's was not even the highest offer in the auction for it. Yes, I know Dow had no control over the Kuwait decision. Yes, I know that the dividend cut had to happen and were it not for the Kuwait decision, would not have happened. I know all this and all of it is true.

Knowing that does not change perception, it helps us rationalize the bad news. We need something unexpected to happen that is good. I want to hear Dow wins in arbitration and is awarded $1 billion plus. I want to hear the global de-stocking that happened in Q3 is over and orders and pricing are firming at a faster than expected pace. I want to hear that Kuwait has come back to the table or Sabic (Saudi Basic Industries) wants the commodity business and the proceeds are far more than currently projected. I want to hear that because any of these would partially restore the dividend. We see the projection for debt reduction, come back to us in 6 months and tell us you are ahead of pace paying off the bridge loan.

Any of these will tell investors that rationalizing the bad news was not insane but logical and that the events that happened could not be avoided. More bad news tells us that perhaps management is not taking into account various alternative scenarios when planning, or if they are management is not putting enough stock in them possibly happening and is not preparing appropriately for them.

I see one of two books being written about Dow CEO Andrew Liveris down the road. One is about how the global slowdown forced a poorly planned merger on the company and eventually cost him his career. The other is a book about how he deftly managed the company through the worst economic conditions in over 80 years, completed the merger and created the world's preeminent specialty chemical company accomplishing the vision he had when he took it over. Either one could be written now. We are at the proverbial fork in the road. Personally, I am rooting for the second one...

Disclosure: Long DOW