The merger of Dow Chemical (NYSE:DOW) and DuPont (NYSE:DD) will transform the global chemical industry. Two of the largest chemical conglomerates will cease to exist and the newly formed DowDuPont will later be split into three individual entities, focusing on different markets.
Source: DowDuPont Merger Fact Sheet.
In this article, I will concentrate on the "Agriculture Company" which will become the second largest of DowDuPont's units with pro-forma revenues of $19B in FY14. It is also expected to deliver the largest cost synergies in relation to turnover. The new pure-play crop protection and seed company will be the third of its kind globally, and it will surpass the current leaders Monsanto (NYSE:MON) and Syngenta (NYSE:SYT) by revenue.
FY14 Revenues in $M
Source: company reports,*Monsanto FY ends Aug, 31st. Total includes Syngenta's "Lawn and Garden" business.
Before the surprising merger between Dow Chemical and DuPont was announced, Dow already stated that it was evaluating strategic options for DAS (Dow AgroSciences). In the context of the ongoing transformation of Dow Chemical, this could have been seen as a sign that the business was unlikely to meet the high expectations after several years of significant investments in DAS. The segment, headquartered in Indianapolis, used to be the no. 4 player on the global agrochemical market and holds the fifth position in seeds with combined sales of $7.3B in 2014. Crop protection represented 78% and seeds 22% of revenues, according to the Dow Data Book.
In terms of profitability, DAS is trailing its mother company Dow Chemical and the other agricultural industry leaders with an underlying EBITDA of $962M or a margin of 13.2% in 2014. In a challenging year 2015, DAS reported revenues of $6,381M, 12% lower than in the year before, and adjusted EBITDA fell by 11% to $859M. While Dow Chemical was able to expand the adjusted group margin to 19.6% on an all-time record EBITDA, DAS fell short with a margin of only 13.5%.
The result of huge investments in DAS over the past years is an attractive pipeline in traits and crop protection chemicals with first products on the market. Nevertheless, the business still needs to prove that these investments will ultimately pay back. For a more detailed discussion, see my recent SA article. One major uncertainty is the success of DAS' Enlist herbicide tolerance technology, the most significant R&D investment of the past decade.
DuPont Crop Agriculture
DuPont Agriculture is the second largest seed company and the no. 6 player on the global agrochemical market with combined sales of $11.3B in 2014. Seeds stood for 67% and crop protection for 33% of revenues in 2014. Agriculture has been DuPont's largest and most profitable segment, representing about 40% of the group's revenue and operating earnings.
Despite a margin still at or above industry average, the business has underperformed in comparison to its major competitors over the past two years. Top and bottom line already started to decline in 2014, a year when the other industry leaders still reported record figures. In 2015, this trend accelerated as net sales fell by 13% and operating earnings shrank by 30%. Particularly the highly profitable corn seed business suffered from declines, indicating that DuPont Pioneer has lost market share to competitors. Corn stands for the majority of seed sales, and the US corn seed market is by far the largest single seed market in the world.
On the same day the Dow Chemical DuPont merger was announced, DuPont stated that it was initiating an independent cost savings program for the year 2016, targeting $700M savings on top of the synergies expected from the merger. Very likely DuPont Agriculture will have to contribute an above average share to the cuts.
Surprisingly, there is little overlap between Dow's and DuPont's ag businesses, and both are in fact highly complementary. Therefore, the chances that the merger will be approved with minor concessions to regulators should be high. The combined share on the US seed market might cause the biggest worries, hence some divestments could be a requirement regulators will ask for.
Synergies and Growth Perspectives
DowDuPont Agriculture will start in a difficult time for the industry. The global agrochemical market is in first downturn since 2009, and for seeds, 2015 was the first year of contraction since more than a decade. These developments are aggravated by a stronger dollar which has appreciated against almost all relevant currencies over the past 12 months, a clear disadvantage for the US companies DAS and DuPont.
On the demand side, depressed commodity prices are taking their tribute as farmers face pressure to reduce input costs. Farm income in the US, the largest market globally is declining. The situation in Brazil, the second largest market for agrochemicals and seeds combined and the biggest single crop protection market is getting more critical. Adverse weather conditions and the more stressed financial situation of farmers have led to a decreasing demand and high channel inventories. For multinationals, the rapid devaluation of the Brazilian real became a major issue.
These developments have impacted Dow's and DuPont's performance in the first three quarters. The primary lever to fight this trend and to lift the profitability of the combined entity short-term will, therefore, be cost synergies. The fact that these are expected to reach $1.3B or close to 7% of the total revenues indicates that not only redundancies in various functions will be eliminated, but that extensive cost cutting measures can be expected, also in R&D. DuPont's CEO Edward D. Breen said in the merger conference call: "In Agriculture, we will gain significant synergies through seed production cost efficiencies by maximizing the R&D programs of the 2 companies and through the optimization of our production and supply chains." A first victim are Pioneer's research operations in Delaware where most of the positions will be eliminated.
In addition to savings, there will be business synergies, and the combined units will benefit from a complementary portfolio, at least in the crop protection segment. This new portfolio will open up many opportunities, some also short to mid-term, but the true benefits are in the long run when the new company will benefit from a broader portfolio of active ingredients. This will enable formulators to develop new and innovative products, but given the long development cycles in the agrochemical industry, it will take several years before these products enter the market.
In the seeds business, DuPont Pioneer is clearly leading. Pioneer is the second largest seed company worldwide, only surpassed by Monsanto. DAS has bought several smaller seed companies some years ago to gain direct market access, and like any other major player it generates revenue through trait licensing. DAS' hope has been the new multi herbicide resistant Enlist seed technology and the corresponding Enlist Duo weed management system. After having received the USDA deregulation for Enlist corn and soybeans and the stewarded introduction in 2015, the full launch is expected in 2016. The EPA's motion before the Ninth U.S. Circuit Court of Appeals to vacate the agency's approval of Dow's Enlist Duo herbicide in November was a major setback. Although the objection was recently rejected, the question remains how well the technology will be adapted, particularly with Monsanto's competing Roundup Ready 2 Xtend soybeans now also available for the 2016 season after it received import approval in China. However, none of the two competing technologies has reached the goal yet. Enlist's China import approval is still missing whereas Monsanto's corresponding herbicide system, the Roundup Ready Xtend Crop System is not yet EPA approved.
The merger could become a big opportunity for the Enlist technology. DuPont already decided not to license Enlist soybean traits, but to choose Monsanto's technology instead. Possibly, this decision will be revisited in the future.
Geographically, the merger will not increase the footprint of the two companies significantly. Not surprisingly, both DuPont and DAS were both strong in the US, well represented in Latin America and rather weak in Europe and Asia. However, the market shares of the combined entities will grow globally and possibly reach a critical mass in certain markets where the individual Dow or DuPont entities were too small to play a relevant role.
My primary concern is (and this obviously does not only affect the ag business) how the two different cultures can be brought together and integrated. Although the merger is considered as a merger of equals, it is not for the agricultural business. DuPont contributes the larger part which represents 61% of the combined pro-forma sales. However, when looking at the individual segments a slightly different picture materializes. DAS is bigger in agrochemicals and DuPont is dominating in seeds. It will be crucial for the new company's success to implement an organization which ensures that the strengths of two entities are maintained.
I am worried that the organization will be paralyzed for the next few years until responsibilities are sorted out and decisions regarding futures sites and capabilities are made and implemented. Starting with the fight where the new headquarter will be located, there will be more battles for sites and jobs. The fact that the merger is happening in a phase of market downturn does not help either. The upcoming cuts will obviously be even more severe than in boom times.
It will take some time for the Dow Chemical DuPont merger to complete, and we will have to wait for the market debut of the three successor companies. Therefore, it is far too early to spend some thoughts about the valuation of the new entities. Having a long-term horizon, I will refrain from an investment in Dow or DuPont until things are sorted out.
The merger between Dow Chemical and DuPont will create the largest agrochemical and seed company by revenue. Unfortunately, the new entity will have to start in a difficult market environment, but based on the available technologies, the portfolio and the pipeline, it has the chance to evolve as a leader in size and profitability in the long run. Having said this, there are several obstacles which need to be overcome in order to be successful. The true challenge will be to bring the two entities together, to retain their know-how and to develop a new corporate culture.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.
Disclosure: I am/we are long SYT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.