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Dow Chemical's Kuwait Deal Fizzles

With a central piece of its asset-light strategy eliminated, analysts wonder how the chemical giant can withstand the economic downturn

The fallout from the global financial crisis has claimed yet another victim. The Kuwaiti government's 11th-hour cancellation of a $17.4 billion joint venture puts a big crimp in Dow Chemical's (DOW) long-nurtured strategy to cut production costs and reduce its vulnerability to economic downturns by shifting focus from commodity chemicals to higher-margin specialty products. And with the Kuwaiti deal kaput, another major piece of Dow's transformation strategy—its planned $18.8 billion acquisition of Rohm & Haas (ROH)—is now in question.

The Kuwaiti deal, along with the Rohm & Haas purchase, would have increased Dow's exposure to specialty chemicals from 55%, to nearly 75%, of its total business. The joint venture would have netted Dow $7.5 billion in pretax proceeds from the sale of a 50% stake in the assets of its five global businesses to the Petrochemical Industries Corp., or PIC, a wholly owned subsidiary of the state-owned Kuwait Petroleum Corp., plus an additional $1.5 billion in cash that both partners planned to take out of the new company.

The main reason the Kuwaitis cited for terminating the deal was the plunge in oil prices from the rich levels they were trading at when the K-Dow Petrochemicals joint venture was announced about a year ago.

Too Pricey for Dow Shareholders

Meanwhile, there has been resistance to Dow Chemical's plan to buy Rohm & Haas even before the financial crisis escalated in September and accelerated the economy's downward spiral. The price for Rohm & Haas —$15 billion in cash plus $3.7 billion in assumed debt, or $78 per share—was a bit rich for Dow shareholders to stomach and the merger was regarded as too damaging to earnings over the two years after the deal would have closed. That had put Dow's shares under pressure since the deal was announced in July.

In response to the news, Barclays Capital Equity Research lowered its opinion on Dow Chemical shares to equal weight from overweight on Dec. 29, citing the company's downside exposure to the slide in the commodity chemicals market, without the benefit of more than $7 billion of expected cash and a higher debt ratio from the pending Rohm & Haas acquisition.

The merger agreement with Rohm & Haas wasn't predicated on the joint venture closing, and with a $13 billion bridge loan plus $4 billion in proceeds from preferred shares still in place, Dow has the financing needed to complete the acquisition, Deutsche Bank Securities analyst David Begleiter wrote in a Dec. 29 research note. It will be difficult for Dow to terminate the deal, given the terms of the merger agreement that gives Rohm & Haas the advantage.

Long-Term Financing Problematic

Other analysts are less optimistic. While the Rohm & Haas merger wasn't contingent on the Kuwaiti deal closing, "we believe the proceeds from the JV [joint venture] were in essence earmarked for funding it," Frank Mitsch, managing director of BB&T Capital Markets in New York, said in a Dec. 29 note. Dow secured financing for the acquisition in July through a combination of a $3 billion investment by Berkshire Hathaway (BRKa), $1 billion from Kuwait, and $13 billion in 12-month bridge financing. "We believe securing long-term financing to replace the bridge would be especially problematic in the current environment," Mitsch said in his note. "If this scenario were to play out, we believe the dividend would likely be a goner, and so could Dow," which could be forced to drastically cut costs by possibly cutting more than 25% of Rohm & Haas' 16,500 employees.

If bank financing for the Rohm & Haas acquisition falls through, it wouldn't be the first time a specialty chemicals merger had been scuttled by the seriously impaired credit markets. Huntsman (HUN) and Hexion Specialty Chemicals, privately held by Apollo Management, have been engaged in lawsuits since Credit Suisse and Deutsche Bank reneged on their commitment to finance the companies' $6.5 billion deal earlier this year, claiming the resulting company would be insolvent. Huntsman settled with Apollo in mid-December, and Hexion is likely to drop its lawsuits against the banks, but Huntsman's lawsuits against the banks in Texas will probably go ahead, according to em The New York Times' DealBook blog.

Dow has said its agreement with 16 different lenders for a bridge loan to help finance the Rohm & Haas purchase is as secure as it can possibly be, but Apollo and Hexion made the same claim about two of the better-capitalized banks only to have financing withdrawn and end up in court, says Hassan Ahmed, an analyst at HSBC Securities. "Nothing is airtight in the credit market these days. Even though Dow talked to about 18 different lenders, what we don't know is who these lenders are," he says. "I struggle to come up with more than five banks in this environment that would be willing and able to provide financing to Dow for this deal."

Fee Payment in Doubt

The more than $2.0 billion termination fee that Dow might be able to collect from the Kuwaitis will be little help, since the merger agreement with Rohm & Haas doesn’t include a breakup option. There is, however, a $750 million regulatory failure penalty that kicks in if the merger doesn’t receive the required approvals by Oct. 10, 2009, a spokeswoman for Rohm & Haas confirmed. The Kuwaiti breakup fee could be used to cover that penalty, but there's some doubt as to whether the Kuwaitis are obliged to pay the fee, having canceled the joint venture before Jan. 1.

A more likely scenario is that Dow pushes to renegotiate the purchase price of Rohm & Haas from $78 a share to less than $70 a share, which is justified given the financial crisis that has unfolded since the deal was first negotiated, said Begleiter at Deutsche Bank in a note.

Mark Bulriss, a consultant to the chemical industry and former chief executive of Great Lakes Chemicals, which merged with Crompton to form Chemtura a few years ago, doubts that Dow will be able to collect the breakup fee from the Kuwaitis. He believes the company would be assuming a huge risk taking on a $13 billion bridge loan without getting $7.5 billion in cash from Kuwait and an additional $1.5 billion in cash that the two partners had planned to take out of the joint venture.

"Dow's shareholders might be better served if the deal with Rohm & Haas didn't happen, especially if Dow does wind up getting the breakup fee from the Kuwaitis, because it's a very tough environment whether you're a specialty chemical company or a commodity chemical company," Bulriss says. "To go into the next year and a half with a weakened balance sheet is a very onerous position to put yourself in."

Speculation About Dividend Cut

If the economy doesn't pick up in the next year and a half, the cost of the acquisition would force Dow to look for other ways to cut costs, including reconsidering its commitment to its dividend, Bulriss adds.

Even with its debt-to-capital ratio pushed to 70% and its balance sheet stretched if it goes ahead with the Rohm & Haas purchase, Ahmed at HSBC says he doubts Dow would renege on its commitment to preserve its dividend. In the wake of the 2001 recession, Dow's dividend payout ratio was over 200%, and surged above 400% in 2004, he says. "I doubt very much that even in this environment with these conditions [Dow] would cut the dividend," he says. "Their earnings profile is far superior to the 2001-2002 trough because over the last six to seven years they have announced and brought into production a lot of raw material-advantaged projects," particularly in the Middle East, which are profitable regardless of the economic cycle.

The company would warrant a higher price-to-earnings multiple if it transforms itself into more of a specialty chemical producer, and that is probably on hold for now, says Ahmed. But after the 19% drop in the stock price on Dec. 29, to close at 15.32, it's already trading well below the lowest valuation levels, making it fairly attractive, he adds.

Selling Assets at a Discount

Scrapping the acquisition doesn't mean Dow couldn't move forward with Chairman and Chief Executive Andrew Liveris' aggressive strategy to transform the company. It will just take longer, says Bulriss. Given the harm the recession has caused all chemical manufacturers, it's likely many of them are open to selling assets at discounted prices, he says.

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