Common Sense Restructuring – Some Money To Be Made

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 21st, 2013

Common Sense Restructuring – Some Money To Be Made

  • We like the construct of the HUN/ROC TiO2 transaction. It is possible that ROC might have been able to realize more value through a spin into a joint venture with HUN, however, this may be the optimum move for ROC if there is another transaction on the horizon where timing is an issue.
  • We have written previously about the need for more creative approaches to divestments in the Industrials and Materials sectors because we believe that large cash deals are going to be hard to come by at current valuations and given the economic and energy uncertainty.
  • In our view it is likely that both DOW and DD are looking at spin outs at least as actively as they are looking for buyers. The question for both is whether there is an efficient exit that minimizes taxes and creates an equity that investors will want. We believe that they could do something interesting together.
  • We keep coming back to the elegance and hugely popular PPG/AXLL deal – a divestment from PPG and a consolidation/expansion move for Georgia Gulf (now AXLL) that created value for both – Exhibit 1.
  • We like ROC, HUN and DD based not only on what announced and possible transactions might do for portfolios and future growth, but also based on current valuation.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

In one sense we have a perfect storm with regard to driving increased M&A within the Chemical industry as well as for the broader Industrial and Materials sectors, while at the same time we have a major constraint.

The drivers are:

  • A lack of organic global growth and an expectation that the next few years will be below trend. Companies have done a good job of cutting costs to create earnings growth but that opportunity is facing diminishing returns. M&A allows for cost and growth synergies that can fuel further cash flow growth.
  • High cash balances – with limited returns on cash. Capacity utilization rates are still not high enough to spur significant capital expenditures outside the shale gas driven investments, and consequently many companies are looking at significant surplus cash flows.
  • Greater focus on portfolios and where competitive strengths lie – companies more willing to think about divesting non core businesses to expose the underlying growth of core portfolio (DuPont, PPG) or take out a business or set of businesses that are causing drag (Dow, Rockwood).

The constraint is the uncertainty and potential volatility in both the economic and energy environment, which result in the need for extreme (unwise) bravery when contemplating buying any of the assets on the market for cash. At the same time, public market valuations are no longer that low. Dow has been able to sell its polypropylene technology and catalyst business for cash but this is a more straightforward sale as the business is not subject to commodity and raw material cycles in the way that ethylene, chlorine or TiO2 might be. At the other end of the spectrum, DOW has pulled its plastics additives business off the market because it could not get a “fair” price. Today possible cash buyers of many businesses might reasonably assume that they would be buying at a peak.

As a seller, if you can get cash, great, but you should probably focus your efforts on finding another way, and thinking far enough outside the box to maximize your opportunity to create real shareholder value.

We believe that both ROC and HUN have upside as a result of the transactions announced so far, in that ROC becomes an interesting target, post the TiO2 divestment and Huntsman should be able to create significant value from the acquisition and subsequent spin unless the TiO2 market takes another negative turn.

For DOW and DD, as we do not have the structure of the respective exits yet it is a little harder to see where the value creation comes from. We believe that DD offers more inherent valuation upside (DOW looks expensive on our screens)
and it is likely that the DD break-up would be cleaner
, creating two very different companies. While Dow would effectively divest a laggard business, Dow has other challenges, not least of which is its large European footprint. Valuation is most interesting at ROC, HUN and DD – Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

Creative Divestment

So far we have one really good example of what can work – PPG and AXLL – but it is worth noting that PPG had wanted to divest its chlor-alkali business for the better part of a decade, but not at any price, and was patient. When the stars aligned the company moved quickly. PPG bided their time and worked hard to get the deal that made most sense, which required Georgia Gulf (now Axiall) to be in the right frame of mind also.

To a degree, HUN, ROC, DOW and DD do not have that same degree of flexibility as they had/have stated to the market definitively that they have businesses that they want(ed) to sell. Failure to act within a reasonable time frame began to become an issue for Rockwood with TiO2 and will be an issue for DOW and DD if things drag on too long.

The HUN/ROC deal on TiO2 is an interesting one, but not without its risks for HUN, which is part of the reason why they were able to drive an attractive price. It is possible that ROC could have driven greater shareholder value if it had divested its TiO2 business directly into a JV spin with HUN. Any synergies would have accrued to the new company, but the market may well have placed a value on ROC’s share in excess of the $1.35 bn in cash and pension obligation transfers.

That being said, ROC may well create significant shareholder value if it can quickly change the complexion of the company and attract a further buyer for the balance of the business, which in our view may be the end-game.

A Lesson from Lyondell

Huntsman has an interesting opportunity, but also added risk. The company has to balance the possible upside of pulling some costs out of the combined business before spinning it out with the risk that by the time they come to market values have changed. We are reminded of Lyondell’s acquisition of Arco Chemical in 1998. This was supposed to be a two step process – Arco wanted cash ($6.7bn) and Lyondell wanted to do the deal for equity, so Lyondell raised debt with the intention of replacing the debt with an equity raise once the cash deal was done. The market and the cycle moved against Lyondell in that short interim period and the company was unable to raise the equity. Exhibit 3 shows Lyondell’s share price from 1995 to 2005.

Exhibit 3

Source: Capital IQ and SSR Analysis

The debt burden which resulted was a major constraint to Lyondell, and despite selling its Polyols business in 1999 to raise cash, the company was effectively handcuffed by the high debt load for 5 or 6 years. Now, Huntsman has not swung for the fences in the way that Lyondell did in 1998, but if the market moves dramatically, or if we see a further decline in TiO2 pricing and margins, this could become a burden for Huntsman rather than an opportunity. We think this is a very unlikely scenario, but it is appropriate that HUN paid an attractive price relative to the possible value of the final divestment for the ROC business.

The options for Dow and DuPont

Both Dow and DuPont have indicated intent to divest significant pieces of their portfolios. For DuPont it is primarily the company’s titanium dioxide business, as well as fluorocarbons and some smaller adjacent chemical businesses. For Dow Chemical the divestments target the chlorine and epoxy resin businesses.

  • Both businesses are large – approximately $7bn of revenue for DD and perhaps slightly more for DOW, depending on what is and is not included (for DOW it is harder to judge given the integrated manner in which the company reports revenue).
  • Both businesses include significant assets which sit on sites with multiple facilities, some of which will remain with the parent company – this is more meaningful for DOW than for DD.
  • Both businesses do not have a tax base that reflects the asset base and the expected value as both are legacy groups of businesses that the companies have been in for years. Consequently, any cash sale is likely to bring with it a significant tax bill.

The manufacturing site issue is not insignificant, as where a transaction leaves both the parent and the new owner on the same facility, all sorts of shared services agreements have to be drawn up to cover who will buy power or water or security etc. from whom and on what terms. Both DOW and DD have significant experience here already, but it does mean that quite a lot of work has to be done up front to present a realistic picture of what the financial statements of the businesses for sale will look like. If either company can find a buyer who already has these service agreements in place it would likely be an attractive option, partly because

a framework already exists and partly because there is an issue of how many of these types of agreements you want to manage with different companies.

Given the issues outlined above, both companies are probably gravitating towards some sort of tax advantaged spin or split, where shareholders are likely to end up with two pieces of paper rather than one and can then decide what to do with each.

On the basis that bigger is generally better from a public company perspective, and that investors are more likely to be interested in a story where there are “synergies” to be attained, one interesting option is that they do something together and combine the businesses.

There are potentially a couple of Morris Trust or reverse Morris Trust options here whereby the low tax bases of the businesses would not be an issue – either with third parties or with each other.

Our view is that both companies would like to have something to talk about by year-end, but at the same time we would not expect either to rush at the expense of leaving value on the table.

©2013, 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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