Dow and Kuwait Petro: Profit-Margin Play

The U.S. chemical giant hopes the joint venture will help it become a specialty player to avoid down-cycle margin squeezes

Roughly two years from now, during the next downturn in the commodity-chemicals business cycle, Dow Chemical (DOW) and its rivals will endure a profit-margin squeeze. Dow, for its part, is determined to escape that fate as much as possible.

The joint venture the largest U.S. chemicals company announced Dec. 13 with Petrochemicals Industries (PIC) of the State of Kuwait is a key step in Dow's strategy to minimize its exposure to the low-return commodity-chemicals sector—not to mention a bid for a higher valuation by Wall Street, according to an HSBC analyst.

Dow will provide the assets and industrial know-how, while PIC, a wholly owned subsidiary of Kuwait Petroleum (KPC), will provide low-cost raw materials such as oil and natural gas, which are far more expensive for Midland (Mich.)-based Dow to procure in the U.S. and other Western locations. The new company, to be headquartered in the U.S., is expected to generate $11 billion in revenue and employ more than 5,000 people worldwide. It will manufacture and market polyethylene, ethyleneamines, polypropylene, and polycarbonate, all key products used in making plastics and used in food packaging, beverage containers, nonwovens, and automotive parts.

"An Important Milestone"

To form the new venture, Dow will sell PIC a 50% stake in the assets of the five global businesses that will be included in the transaction. Both Dow and PIC will then put their share of the assets into the joint venture, each taking a 50% equity interest in the new company. Dow will receive about $9.5 billion, pretax—half of the $19 billion value of the five global businesses it's contributing—from PIC for PIC's 50% interest in the company. The deal, which still requires the signing of definitive agreements and regulatory approval, is expected to close in late 2008.

In a statement, Dow Chairman and Chief Executive Andrew Liveris called the deal "an important milestone in our transformational strategy" to grow commodities businesses through joint ventures while cutting capital intensity and freeing cash to invest in more end-user businesses.

The deal is consistent with the "asset-lite" strategy Dow has been pursuing since Liveris took the helm three years ago. That strategy has focused on transferring its commodity-type businesses into joint ventures formed with state-owned companies in Russia and Middle Eastern countries such as Oman, where cheaper raw materials can be sourced. The rising cost of raw materials necessary for making petrochemicals derivatives has eaten into Dow's profit margins in recent years.

A Specialty Chemical Company

Hassan Ahmed, an analyst at HSBC Holdings (HBC), sees the transaction as the first step in a two-part process designed to dramatically boost Dow's identity as a specialty, rather than a commodity, chemicals leader. At the end of last year, Dow had $2.9 billion in cash on its balance sheet, and will have $10 billion in cash, including roughly $7 billion after-tax, once the deal with PIC closes, he said.

"They will need to do something with that cash. My take is they will buy a specialty chemical company," which might focus on water treatment capabilities or paints and coatings, Ahmed said. Acquisition targets are likely to be located in emerging markets rather than full-price ones such as North America, he added.

The benefit of such an acquisition would be a re-rating of Dow's valuation, from the current 12 times earnings—a typical commodity-chemicals multiple—to something approaching the 15 to 16 times more common for specialty-chemical names, Ahmed said. A large part of his overweight rating on the stock is based on the probability of a higher valuation rating, said Ahmed, who has a $55 target price on Dow. However, given Dow's vast commodity-chemicals exposure, it's fair to wonder whether a $10 billion acquisition would justify a re-rating of that magnitude. Dow shares rose more than 6% on Dec. 13 to $44.39 on the NYSE.

Skepticism Remains

"Dow already generates close to half of its revenues from specialty chemicals. By shedding these commodity assets and by acquiring a specialty chemical company, you could see that mix of specialty/commodity favoring specialty by as much as 70% to 80% of overall revenue once they were to make such an acquisition," Ahmed said.

There's a fair amount of skepticism about whether or not the company will be able to escape significant pressure on its margins during a trough in the business cycle.

In an Oct. 25 research note, Morningstar (MORN) said while Dow's shift into higher-value and higher-margin offerings nearer to end-market customers will help to reduce the magnitude of its cyclical swings, "We still think Dow will struggle to earn a premium to its cost of capital over a full economic cycle."

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