INSIGHT: Untangling Dow's Gordian knot

24 January 2014 17:41  [Source: ICIS news]

By Joseph Chang

Alexander cutting the Gordian knotNEW YORK (ICIS)--It’s no secret that the chemical industry moves in cycles, and not just the traditional cycles of boom and bust. Sometimes, diversification is the name of the game – a game often played with acquisitions. At other times, it’s all about the ‘pure play’, where asset sales (acquisitions to others) and spin-offs follow.

Today, activist investors going after diversified US chemical companies with long-standing managements are clearly in vogue. DuPont attracted the attention of activist Nelson Peltz and his hedge fund Trian Fund Management earlier in 2013, and now Dan Loeb’s Third Point has set its sights on Dow Chemical.

Both Dow and DuPont have presented break-up plans – for Dow a carve-out of its chlorine and derivatives businesses, and DuPont its performance chemicals assets, including titanium dioxide (TiO2).

In his criticism of Dow, Loeb highlights capital misallocation from running both commodity and specialty chemical businesses – a comment echoed by several Wall Street analysts. For DuPont, this charge was never specifically mentioned in public.

However, the parallels are easy to notice – DuPont, a specialty chemicals company, was planning to put much of its capital spending (CAPX) into TiO2 – a decidedly commodity business. The same with Dow – it may emphasise its specialty businesses, but the big CAPX is going into new petrochemical projects in the US Gulf Coast and Saudi Arabia, along with associated downstream assets.

Commodity businesses by their nature are capital intensive. There’s nothing wrong with investing capital. But one of Loeb’s points is that by investing more resources in commodities than is needed, the specialty units often don’t get what they require to reach their full growth potential.

Activist investors believe certain diversified companies can get more bang for the buck by separating out the commodity components, as the specialty assets can achieve greater potential with proper investment, and be valued at higher multiples.

The latter may be true at any given point in time – like now – but it’s important to remember that it’s not always the case that specialties are valued higher than commodities. Even those valuations swing back and forth, sometimes depending on the commodity chemical cycle, and what’s in vogue!

Interestingly, Cowen & Co analyst Charles Neivert believes Dow should actually focus on its commodity chemicals business, selling off specialties.

He likened the situation at Dow to the fabled Gordian knot, and said slicing that knot with assets sales would unlock value to the tune of $64/share – around 40% higher than the price of $45.68 as of the close of 22 January.

“The Gordian knot represents an intractable problem that has resisted any and all attempts to solve it. The solution comes not via a nuanced, finessed approach but a brute force assault,” said the analyst.

In a popular account, in the 4th century BC, Alexander the Great attempted to untie a knotted rope that tied an ox cart to a pole in the city of Gordium that held great symbolic importance in the city’s history. After failing to find the ends of the knot to untie it, Alexander simply cut it with his sword.

“Dow Chemical shares seem to present just such a conundrum. They have resolutely resisted all attempts to bring value to shareholders. As such, the solution we see is not trying to meticulously untie this knot, but to simply hack it apart,” Neivert said.

While the focus of Dow on commodities is a different approach to that of many other analysts, the capital allocation theme between commodities and specialties is consistent with Loeb and certain others.

“We see a conflict trying to run commodity or commodity-like businesses alongside specialty/performance businesses. 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,” said Neivert.

“We believe other companies will be able to capture value where Dow cannot and it is also our opinion that Dow can capture some of the upside value in the sale of its businesses,” he added.

Loeb points out that Dow’s stock has “woefully underperformed” over the past decade, generating a return of 46% (including dividends) versus a 199% return for the S&P Chemicals Index and a 101% return for the broader US market as measured by the S&P 500.

The root causes for this underperformance, according to Loeb, are a poor operational track record, under-delivering versus guidance and expectations, and the ill-timed acquisition of Rohm and Haas in 2009.

It is the last part - ill-timed acquisitions – that is likely to be the greatest cause of underperformance. More specifically, for chemical companies, it would be ill-timed acquisitions that add considerable debt.

Prior to Rohm and Haas, where Dow paid top dollar for a specialty chemical asset at the bottom of the cycle in the heart of the financial crisis in 2009, it acquired Union Carbide in 2001. This was during a time then called “the worst downcycle in industry history”.

DuPont’s acquisition of Pioneer Hi-Bred in 1999 was widely panned (later) by Wall Street as a case of grossly overpaying at the top of the ag biotech frenzy.

To get a clue as to whether diversification itself is the culprit, it’s worthwhile comparing the performance of Dow and DuPont to Germany’s BASF – the largest and arguably the most diversified chemical company in the world. BASF’s Verbund strategy is synonymous with integration.

BASF has consistently beaten both Dow and DuPont, as well as the S&P 500 – in the past five years, 10 years, and since 2000. BASF itself has made significant acquisitions and divestments through the years. Yet none could be called disastrous. None stretched the balance sheet to troubling levels.

It’s a fair question to ask whether a chemical company focused on commodities and specialties is inherently misallocating capital, reducing the growth potential of the specialties businesses. That analysis should be done for each company and each business segment.

But while a diversification strategy has its hazards – just ask former ICI folks – it is ill-timed acquisitions adding significant leverage that are the likely culprit of underperformance – not diversification itself.

Read Paul Hodges’ Chemicals and the Economy blog
Bookmark John Richardson and Malini Hariharan’s Asian Chemical Connections blog

By: Joseph Chang
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