Dow Chemical's asset-light joint venture strategy may not suit everyone

Asset-light for everybody?

07 February 2008 00:00  [Source: ICB]

New ground has been broken by Dow Chemical in its latest joint venture with Kuwait's Petrochemical Industries Co, but its model may not appeal to the masses
Ed Zwirn/New York

IN A deal that is rapidly acquiring benchmark status, Dow Chemical's 50-50 joint venture with Kuwait Petroleum Corp.'s Petrochemical Industries Co. (PIC) should enable the US-based company to back-integrate its commodity assets into low-cost oil and natural gas feedstocks while receiving a hefty cash infusion.

The deal, unveiled in December 2007 and expected to close late this year, has Dow contributing commodity business valued at $19bn (€13bn) and receiving from PIC a $9.5bn payment. Expected to amount to more than $7.2bn after taxes, this will provide Dow a sizeable war chest for acquisitions, mainly of specialty chemical assets.

The JV includes 90% of Dow's plastics business and a small portion of both the performance plastics and performance chemicals segments, but doesn't extend to styrene/polystyrene, for which Dow concluded a venture with US-based Chevron Phillips Chemical last year. The planned JV with PIC will be the global leading polyurethane supplier and would be in the Fortune magazine 250, notes BB&T Capital Markets analyst Frank Mitsch.

The new arrangement was touted by management as the culmination of the company's heralded "asset-light" strategy, through which Dow aimed to lighten the commodity portions of its balance sheet while securing resources and geographically building the company. "The transaction is likely to improve Dow's earnings power in a cyclical trough as it reduces its commodity exposure," Mitsch says.

And at a time when many US companies, both inside and outside of chemicals, are openly courting Middle East partners and funding sources, the deal has garnered praise for its geography. With only 5%, the smallest share, of Dow's $5.9bn of 2006 JV revenues coming from India, the Middle East and Africa combined, recent spikes in energy costs if anything gave further impetus to the goal of expanding in that direction.

"Dow is redirecting its capital from the US Gulf Coast to places like the Middle East, Africa, Saudi Arabia, Kuwait and China," says Bank of America analyst Kevin McCarthy.

IT'S A DOW THING

But, win-win as a deal like this is bound to be flagged and tempting as it may be to predict that the rest of the commodity-seeking-to-diversify-into-specialties pack will soon be going asset-light with the aid of Middle Eastern JV partners, the reality that emerges, particularly if world financial markets remain volatile, may render the Dow-PIC deal unique.

First of all, the deal has all the earmarks of the Dow Chemical modus operandi. The company has after all been happily proliferating JVs since it helped form Dow Corning in 1943. Dow's take of the sales revenue from these nonconsolidated assets had reached $5.9bn by the end of 2006.

Dow will shift $11.5bn of its sales revenue to the nonconsolidated side of the balance sheet one the deal closes. According to his estimate for 2007, 30% of Dow earnings will have come from JV proceeds, and that was before the impact of the Kuwait deal is factored in, says John Roberts, analyst with Buckingham Research.

Dow, in fact, highlighted the success of its strategy by publishing a white paper last September listing nine JVs executed or agreed to during the first nine months of 2007, including an Americas JV with Chevron Phillips Chemical, and deals involving Libya, China, Saudi Arabia and Brazil.

"The significance to Dow of its joint venture activities has risen markedly in recent years," with nonconsolidated affiliates contributing equity earnings of nearly $1bn and cash distributions of $600m, according to the paper.

A monster-sized JV is also a Dow thing because it's such a big thing. It really helps to be the world's largest pure-play chemical company, with nearly $50bn of annual sales.

"Dow is such a large company that it can contribute $11.5bn of annual sales to this venture, which will generate $14.5bn in sales, and not decimate the company," notes John Rogers, head of the chemical group at Moody's Investors Service.

"I don't see other companies pursuing the asset-light model," says Bank of America's McCarthy.

HOPE SPRINGS ETERNAL

On the other hand, many are looking to another potential deal announced last year to auger whether or not there are still commodity-driven companies out there with the will and the muscle to pull off another asset-light JV or for that matter any asset light transaction anywhere near the magnitude of Dow-PIC.

German giant BASF announced in July 2007 that it was evaluating strategic options for selected parts of its stryrenics activities and was about to start discussions with an "interested party" which had already made an initial offer.

Assets on the block include the company's styrene monomer, polystyrene, styrene butadiene copolymer and acrylonitrile businesses, with plants in Belgium, Mexico, Brazil, South Korea and India. These posted sales of about €3.2bn in 2006, compared to the grand total of €52.6 billion for the entire company.

Hans Reiners, president of BASF's styrenics division, said at the time of the announcement that the company's remaining styrenics activities will in the future focus on foams and specialties for the construction, automobile, packaging, sport and leisure industries.

In the meantime, while no further details have been announced concerning this BASF spin-off, not to mention its structure or participants, company officials say they are sticking to their guns. Spokeswoman Kathy Dennis says that talks are still under way and that a JV is not being ruled out. "We're hoping to announce something by the end of this quarter," she says.

IT'S WHAT EVERYBODY WANTS

The fate of the BASF deal (and the form it takes) may or may not open the floodgates for more of the same. But the incentives to conclude a deal comparable to Dow-PIC are compelling enough on their own terms.

"Investors will pay premiums for earnings consistency," says Deutsche Bank analyst David Begleiter, who notes that the JVs help to shelter corporate earnings from volatility both by changing income from operations for nonconsolidated investment earnings and helping to secure access to cheap feedstocks.

The earnings consistency advantage comes with at least one caveat, according to analysts, given the way that a JV obscures earnings by reporting them as investment results.

"Dow will derive an increasingly significant percent of its overall earnings from nonconsolidated operations," says Buckingham's Roberts. "Our experience with Corning is that EV/EBITDA [enterprise value/earnings before interest, tax, depreciation and amortization] looks very high unless adjusted for the JVs, which many stock screening programs and simple valuation tools don't do."

But whether such strategic JVs are set up over the medium term depends not only on such vagaries as overall global market volatility and specifics such as the power of the purse, anecdotal evidence, at least suggests that there would be many more Dow-PICs coming up if many more companies had their way.

"Dow has gone out and done it," says Moody's Rogers. "Everybody's trying to do it."

With all the urgency that the recent spike in energy prices is giving to attempts to cushion against more of the same, the advantages of partnership become more pronounced.

"Most companies have the potential for it, but they don't have in mind a partner and most have already divested" to some extent," says Rogers. The bottom line: "No one wants to buy the business outright."








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