15 March 2009

Dow Chemical / Rohm & Haas Still Have Problems

As Originally Posted to The Wall Street Journal

Dow Chemical and Rohm & Haas spent months fighting over their $15.3 billion deal, weeks engulfed in legal squabbles and the last frantic days negotiating a settlement that will enable Dow Chemical to go through with the acquisition of its chemicals rival.

A Hollywood ending? More like one of Shakespeare’s “problem plays,” in which justice is served but the audience leaves morally uneasy about the resolution. That is where Dow Chemical is, still struggling with high debt and oppressive interest payments while its revenue has fallen off and it has cut nearly one-third of its operations. And each victory of the settlement is shadowed by the prospect of a future defeat.

For instance, Dow Chemical won some attractive concessions from the syndicate of banks behind its $13 billion bridge loan: extending the bridge for one more year and giving Dow a total commitment of $20.5 billion–$12.5 billion in the first year and $8 billion in the second year. In the first year Dow will pay a modest interest rate of just Libor plus 1.25 percentage points. And all this after Dow Chemical has complained that its business wouldn’t be viable if it were forced to to through with its agreed-to acquisition of Rohm & Haas. (Dow Chemical also received money from the Rohm & Haas family trust, Berkshire Hathaway and the Kuwait Investment Authority, so it may need only around $10 billion of the bridge loan, according to Hilliard Lyons analyst Stephen O’Neil.)

Yet, the new debt agreement wasn’t enough for the folks at credit rater Moody’s, who still warned that Dow Chemical could be downgraded if it doesn’t right its financial house and reduce that debt. Debt also was spotlighted by Citigroup analyst P.J. Juvekar, who warned investors against buying Dow stock right now because:

Dow’s agreement to acquire Rohm puts it in a leveraged position going into the downturn. Dow ends up with gross debt of $25.2 billion (net debt of $22.1 billion) after drawing ~$10B on a bridge loan…High Operational Leverage AND Huge Financial Leverage – Dow’s “twin leverage” magnifies the EPS impact in a downturn, but on the flip side, this can work great in an upturn…Now to be sure, we don’t think there are any “insolvency” concerns on Dow despite the insolvency argument put forth during negotiations with ROH….We remain in a deepening recession that is global in nature, so we think investors should stay on the sidelines.

Adding to the debt issue is the $2.5 billion in perpetual preferred stock Dow Chemical sold to the Rohm & Haas family trust and Rohm’s other large shareholder, Paulson & Co. While the preferred stock sale prevents Dow Chemical from borrowing more money against the bridge loan, it also has a high price: a 7% cash dividend, in addition to an 8% payment-in-kind dividend.

Then there are the asset sales. Before the settlement, Rohm & Haas (and its investors) had pushed Dow Chemical to sell assets to raise cash to pay for the deal. But that prospect threatened the company with the loss of cash-flow generators. With the settlement, Dow Chemical no longer will try to sell its Agricultural Sciences business, one of the company’s top performers and a business valued at roughly $7.7 billion. Dow had been so intent on keeping the business that it didn’t loop in potential buyers like Syngenta, and instead discussed a stake in the business to private equity firms. But Citigroup’s Juvekar said Dow Chemical will have to sell assets anyway:

“Dow plans to pay down the outstanding $10 billion bridge loan by the end of year 1. That sounds aggressive to us since $3.8 billion of the repayment is predicated upon successfully divesting certain businesses, such as its 45% stake in a Dutch petrochemical refinery Total Raffinaderij Nederland, its equity stakes in olefins and derivatives businesses in Southeast Asia, and ROH’s Morton Salt business.”

He went on calculate that with the sales, the company would lose $760 million of earnings before interest, taxes, depreciation and amortization.

Rohm & Haas’s family trust, which threw roughly half its profits from the merger into more Dow stock, is making a vote of confidence in Dow Chemical. As in Shakespeare, we must wait for the next act to see if that confidence is justified.

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