Dow DuPont – So Many Scenarios, Few Companies Unaffected

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 26th, 2016

Dow DuPont – So Many Scenarios, Few Companies Unaffected

  • We remain convinced that the Dow DuPont merger offers one of the most interesting and investable opportunities in the Industrials and Materials large cap arena today, but we think the companies will likely become more flexible in thinking about next steps
    • Upside from current expectations will come from more aggressive cost targets and/or from opportunities to sell businesses in tax efficient, accretive transactions
    • More value could probably be created with a different grouping of the businesses (ex-Ag)
  • NewCo (post-merger) could be approached to sell businesses with some offers sufficiently compelling that management/Board will need to take them seriously
    • There are interesting potential owners for almost every segment of Dow/DuPont, including the Ag business
  • Other players could wait to see what falls out of the merger, or decide to be pro-active, either influencing the deal outcome or looking for other deals for themselves
  • Regardless, this is a story with more value than is reflected in the share prices today, either because the potential break-up will surpass the spin-off plans or because DOW/DD will raise the cost bar to ensure that alternatives are unattractive
    • Potential bidders on businesses are going to have to fully value any expected synergies to get any deal done – which will be good for Dow DuPont holders
    • Dow DuPont will need to identify/discuss increasing cost and revenue opportunities to keep the high-ground – possibly changing the spin compositions to do so
  • We would look through the risks of another weak Ag year and potential weakness in polyethylene and focus on the longer-term potential – we stand by our prior price suggestions of $68 for DOW and $87 for DD (based on updated share counts in the trough earnings analysis below)

Exhibit 1

Source: Company Reports, Capital IQ, SSR Analysis

Overview

The merger of Dow and DuPont, and whatever follows, will be a significant step change in the evolution of the US and global chemical industry. At the very least, the combining of these two 100+ year old companies will alter the industry’s landscape and have profound effects on market structure, competitive positioning, customer relations and technology evolution. In addition, the merger can serve as a catalyst that could lead to a series of further follow-on transactions as all companies reassess their options. The effect of these moves is hard to predict but cannot be ignored. See our recent piece on BASF.

We believe that “phase 2” (the post-merger split into three companies) of the expected plan may not happen as originally announced, in part because there may be some internally driven realignments of business units as the companies evolve the due diligence and listen to some very strong shareholder opinions. In addition, we believe that the newly combined company will likely be pre-emptively presented with external offers to buy or combine businesses. If these offers are sufficiently value enhancing they may either delay or change the shape of “phase 2”. For example, does SpecialtyCo have to be separated for the board of directors to consider an offer for the electronics platform? We do not see why the company would need to wait for the spin to consider such an opportunity if it adds shareholder value more quickly.

With so much potential change possible from the proposed merging of two companies into one followed by the de-merging of one company into three, we expect that the planning/strategy departments of companies all over the world are sharpening pencils and trying to answer one or more of the following questions:

  • What does this mean for us if we do nothing?
  • What can we do to react to or respond to the risks that this deal brings to our current market position/strategy?
  • Is there a Dow DuPont business we want and is there a tax effective, value creative, way to make an offer that the company would take seriously?
  • Is there another transaction/alliance that we should be pursuing that makes sense in light of the Dow DuPont merger?

Dow and DuPont should expect interested parties to emerge as the year progresses and while some of these prospective deals will likely be in line with some of the original thinking, especially with respect to SpecialtyCo, some may be decidedly unwelcome relative to the original plan. Consequently, we believe that, within the limits of what is allowed pre-merger, the individual company stories are going to need to converge quickly with a real focus on the industrial logic and shareholder logic of the second phase of the plan.

The initial external focus will mostly likely be on MaterialCo given its diversity, size, cost base (number of employees) and Dow’s very clear statements that the company does not expect to go down a Lyondell-like path with this business (i.e. lowest cost commodity). We are willing to be persuaded that the MaterialCo strategy could be the best way forward, but the integrated, technology-rich (customer solutions based) polymers strategy to date, while possibly resulting in stronger than industry average volume growth, has arguably not delivered shareholder value. Every way you look at the business it either has too many people or too little EBITDA per person, so either the headcount is right (and margins are going to expand to justify the headcount) or there ARE too many people. Modestly rejigging the business mix through the merger and spin is not going to take shareholder attention away from this issue.

In our opinion, there are potential interesting bidders for every sub-segment of the materials business. Clearly some options are more far-fetched and more challenging to pull off than others, but the offers might come if the companies cannot articulate how MaterialsCo is going to be so much better than the legacy businesses of the separate companies.

The Industrial/Strategic Logic For The Merger Is Good…..

Bringing together Dow and DuPont offers several very clear opportunities to increase shareholder value.

  • Overlapping costs – synergies: these are substantial by the companies’ own calculations and are focused on optimizing IT systems, sales focus (especially in Ag)
    • Company presentations refer to COGS, SG&A, leveraged services, and R&D
  • Revenue synergies
    • So far the focus has been on revenue synergies in Ag, but there are likely other opportunities in MaterialCo and SpecialtyCo, which might lead to different views of what should constitute each company, or whether they should be separated at all!
    • The combination creates a more significant player in automotive related products, electronics, construction, and coatings intermediates – all of these areas should be able to take some share because of the combination
    • Simply combining the ethylene business should remove the DD hit from selling lower value ethylene in Q1 2016
  • Lower on-going R&D costs – streamlined in Ag and more focused in the other areas
  • Possible additional cost reductions at both the head-office and business support levels

We believe that the cost opportunity is as much as twice the $3.0bn announced so far, though much of the delta is right sizing the platforms from a headcount perspective relative to proxies – something we have written extensively about for both companies in the past. Achieving this level of cost reduction will depend on the focus of new management and the overall business objectives.

Exhibit 2

Source: Company Presentations, SSR Analysis

….But The Subsequent Separation is More Evolutionary than Revolutionary

We do not believe that there is much debate about whether the combined Ag platform should be divested – it makes sense as a stand-alone business and does not make much sense to be part of a very different chemicals and polymers portfolio.

Beyond Ag, the debate gets more interesting. Looking at the proposed split in to three separate companies, we could argue that apart from the Ag consolidation, not much is really changing. Effectively DuPont’s $6 billion revenue Performance Materials segment is being swapped for a $2 billion revenue Electronic Materials carve out from Dow’s Consumer Solutions segment. Said another way, ex-Ag (and not including the folding in of Dow Corning), the new Material Science company will be nearly 90% legacy Dow while the new Specialty Products company will be 85% legacy DuPont. It would seem intuitive, at the very least, that with $64 billion of combined non-Ag revenues, more than $8 billion of revenue was in the wrong place.

Exhibit 3

Source: Company Presentations, SSR Analysis

Exhibit 4

Source: Company Presentations, SSR Analysis

As part of the merger presentation back in December 2015 when the deal was announced, the companies highlighted that the merger creates a leading specialty company that will be comprised of “unique businesses that share similar investment characteristics and focus in specialty products”. While there are a number of different factors that can define specialty versus non-specialty, it is hard to imagine getting much pushback by saying that specialty products tend to have higher margins and lower capital intensity. If we simply look at recent financials for all of the current segments for Dow and DuPont, the segment which has the most “specialty” combination of high margins and high sales turnover is DuPont’s Performance Materials – and that’s the one segment that’s being moved in to the Materials company!

Exhibit 5

Source: Company Presentations, SSR Analysis

If you should separate at all, what metrics should the company use? There are many:

  • Similar capital requirements – or disparate capital requirements for some sort of balance
  • Raw material/integration driven
  • Customer/end market driven
  • Geographically driven
  • Growth
  • Volatility
  • Return on capital

If you look through these different lenses you can get some very different answers.

Examples might be:

  • If you use the customer focus lens why would you separate the automotive business from the electronics business – especially given Dow’s own statistic that the company has 3x the value in an electric car than in a conventional car?
  • Safety and Protection is really an advanced polymer business and perhaps also belongs with the performance polymers or automotive segments
  • Nutrition and Health on the surface does not look like it fits with the rest, but if there is an opportunity to “up-sell” packaging solutions to these customers, perhaps this should stay also. Early hopes at DuPont were that the company could sell other products to its new Danisco derived customers – this may not have been that successful, but given that Dow has a much bigger packaging solutions business, maybe it’s worth trying again?
  • If you focused on reducing volatility – something which has clearly created value at PPG in the last few years – you would separate the volatile base chemicals and plastics business from everything else
  • Is Industrial Biosciences, a $1.2 billion, lower-growth, higher asset intensive business a viable stand-alone segment?

Dow has done an impressive job of offsetting volatile pressures in several businesses (Ag, chlor-alkali and its non-US commodity businesses), over the last three years with well-timed divestments and an aggressive focus on cost controls and share buyback. DuPont is likely to do the same in 2016 in our view. However, at the heart of the combined Material Science Company there will remain a very cyclical base commodity business which will continue to require high levels of capital spending and will likely drive stock valuation. Shareholders might be better served from separating the company along the lines of margin stability and capital intensity. While this might look like a complex proposition, Dow has the roadmap, having very successfully divested both Trinseo and Dow Chlorine Products in the last six years. Instead of MaterialCo and SpecialtyCo, why not CommodityCo and Advanced MaterialsCo?

There are lots of ways to think about this opportunity and because of that we believe that lots of people are looking at it. We are not convinced that the industrial logic for the proposed split is optimal. If we are not, then others with more data and a more strategic interest are likely not also, possibly opening Dow DuPont up to offers for businesses which will force them to rethink. The onus is on Dow and DuPont to justify the composition of MaterialCo and SpecialtyCo and it is likely that they will attempt to do so over the coming months. This will result in more disclosure, more data and hopefully more confidence in the likely value to be created.

We continue to believe that this transaction will unlock much more value than is currently reflected in the share prices. What Dow and DuPont choose to share over the next few months will decide whether it is their actions which drive the value or the actions of others.

©2016, 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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