24 January 2014 09:54 [Source: ICB]
Hedge fund Third Point has taken a $1.3bn stake in Dow Chemical and is urging the company to spin off its petrochemical business, arguing that the move would benefit the new company as well as the specialty-focused parent.
Third Point did not disclose how many shares it owned, but a $1.3bn equity stake would represent about 2.5% of Dow’s outstanding shares based on its previous closing price of $43.07 on 17 January. Shares of Dow surged $2.86, or 6.6%, to close at $45.93 on 21 January.
Third Point CEO Daniel Loeb, a high profile activist investor, said the standalone petrochemical company could generate more than $9bn in earnings before interest, tax, depreciation and amortisation (EBITDA) on a standalone basis. In comparison, Dow’s entire 2013 EBITDA base is about $8bn, Loeb estimated.
“We suspect that Dow’s push downstream has led the company to use its upstream assets to subsidize certain downstream derivatives either by sacrificing operational efficiency or making poor capital allocation decisions, or both,” said Loeb in Third Point’s quarterly investor letter.
The standalone petrochemical company could move away from downstream migration and integration and focus on maximising profits, Loeb said. “Management could transform these businesses into a best-in-class, low-cost commodity petrochemical company.”
Charles Neivert, analyst at Cowen & Co, recommends that the “new” Dow focus on commodity chemicals, while selling off specialties – agricultural sciences, electronics and functional materials, coatings and infrastructure and parts of the performance materials segment.
“Part of the issue at Dow is trying to manage a diverse business portfolio with little connection between the businesses. More fundamentally, we see a conflict trying to run commodity or commodity-like businesses along side of specialty/performance businesses,” said Neivert, who sees a break-up value of $64/share for Dow.
“The strategies do not mesh well, the customer demands are divergent and the capital needs are nearly opposite. In addition, we do not see a core competency for Dow in the performance business,” he added.
However, Loeb said the spin-off of the petrochemical assets would speed up Dow’s strategy of becoming a true specialty chemicals company, focusing on agriculture, food, pharmaceuticals and electronics end-markets.
A specialty-focused company “should command a premium to Dow’s current multiple, and potentially a premium to other specialty chemicals companies given its attractive EBITDA growth prospects”, Loeb said.
The specialty company could achieve EBITDA of $4bn-5bn over the next 3-5 years, compared with a 2013 base of about $2.8bn, he added.
“Favourable valuations of basic chemicals and specialty peers could make the timing right,” said John Roberts, analyst at UBS. The analyst raised his price target on Dow’s stock from $44, to $50, based on a sum-of-the-parts analysis. He applied a 7.5 times EBITDA multiple to the commodity business, and a 10 times multiple to specialties.
Loeb suspects that Dow is concerned about maintaining the integration of its upstream and downstream assets. However, most of the integration in Dow’s assets exists within its petrochemical business, he noted. Any integration between specialties and petrochemicals is limited to commoditised raw materials.
Such integration does not significantly increase margins − unless the petrochemical assets are subsidising specialty chemicals, he said.
Loeb noted that Dow has generated a return of 46% during the past decade − compared with a 199% return for the Standard & Poors (S&P) 500 Chemicals Index and a 101% return for the overall S&P 500.
“These results reflect a poor operational track record across multiple business segments; a history of under-delivering relative to management’s guidance and expectations; and the ill-timed acquisition of Rohm and Haas,” Loeb said.
Some of Loeb’s comments echo concerns raised by analyst Paul Christopherson, analyst with Gilford Securities, who on 9 January downgraded Dow’s stock from “neutral” to “sell” with a 12-month price target of $36, or $10 below the current stock price.
“There has been no transformation. Dow’s upstream concentration is further reflected in the company’s capital plans. These include chiefly Sadara… a Saudi JV… described as supporting downstream growth but amounting to a big upstream investment; and a big new project at Freeport, Texas, for 2017,” said Christopherson.
“Our attitude is unsophisticated, certainly, but it is that investment in ethylene is investment in ethylene,” he added. While the analyst acknowledged the commodity projects are meant to support investments downstream, “the overall asset composition is shifting upstream”.
“Obviously, there is nothing inherently wrong with being a commodities player. Our point would be only that, that is what Dow remains, that is how investors will continue to see it,” said Christopherson.
Regarding Loeb’s comments, Dow said: “We believe our investments have yielded sustainable value for our shareholders and will continue to in the near and long term. We constantly review our company at the management and board level to increase our shareholder value and competitiveness. We intend to continue an open dialogue to further enhance value for all of our shareholders.”
Wells Fargo analyst Frank Mitsch notes that after activist investors took stakes in DuPont and Air Products earlier in 2013, there has been increased speculation on similar interest in Dow.
“Dow’s Q3 conference call in October was rife with references to ‘shareholder remuneration’, suggesting that Third Point’s motives perhaps may have been known to management for some time,” said Mitsch.
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