Dow/DuPont – The Very Best Looking Horse in the Glue Factory!!

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 14th, 2015

Dow/DuPont – The Very Best Looking Horse in the Glue factory!!

  • We believe that the Dow/DuPont merger is one of the most well thought through and well timed deals that we have seen in the Industrials and Materials (I&M) space in decades
    • The proposed deal could unlock billions of dollars of value and the proposed three split-off companies have further options which could create interesting investments for years
  • But the Macro looks terrible for everyone – hence the “glue factory” comment
    • Weaker oil – bad for Dow
    • Weaker Ag – bad for both, more so for DD
    • Weaker China – bad for both but hitting DD harder
    • Very weak Latin America and weak Europe – bad for both
    • Possible ethylene/polyethylene surplus in 2019 and beyond – Dow
  • In our opinion, while Dow and DuPont represent interesting absolute investments today, they represent compelling investments relative to Chemicals and other I&M sectors
    • The risk of cyclically low earnings at both companies can be offset with the many cost initiatives and synergies of the deal, which likely are much larger than suggested
    • We think that approximate normalized pro-forma earnings for the combined company of $2.70-2.80 per new share can be boosted by as much as $3.00, before considering what paths the three separate companies take
    • Separately, the combined company has none of the problematic capital structure issues that are impacting those with very high debt components of EV
  • If the market looks at trough earnings of $4.50 per share rather than a possible stand-alone $1.50-$2.00 at each company – a $90 target for DuPont – $73-75 for Dow today – looks reasonable
  • As the company finesses its story and as analysts get their numbers together we would expect the news flow to remain positive, or at least relatively positive

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

We really like this deal – we should because we have been proponents of it on and off for around 20 years! It is a merger of largely complimentary businesses which present shareholders with unprecedented opportunities for synergies and other efficiency gains.

It creates the best combination in the Ag space, at least from Dow’s perspective, with cost and revenue synergies that could perhaps only have been matched by a DuPont/Syngenta deal. At the same time it creates pressure on the rest of the Ag players, which may result in deals that handicap others relative to DOW/DD. For example, if MON were to come back to Syngenta with an all cash deal, MON’s capital structure would be very constraining relative to DOW/DD.

The specialty business becomes a portfolio management project, with opportunities to divest businesses to those that value them more highly, and add businesses that are complimentary – the specialty business could be twice its size in 10 years or not exist at all. This is why we are proponents of Ed Breen taking charge of this business as we think his skill set is best suited to the opportunity.

If we have a disappointment in what has been announced so far it is the inclusion of the building products, Dow Corning and automotive businesses in the “Materials” segment. These belong in the specialty company as the same portfolio opportunities exist here as with the rest of the group. We think that the split has been made this way to create a residual “Dow” based in Midland Michigan which is as large as the old Dow, but more Midland centric (securing jobs). This is fine as long as Dow is capable of running the business with the necessary dual mindset – low costs in commodities and flexible (from a portfolio perspective) with the rest. This is something that neither Dow nor DuPont has done well in the past – consequently we see risk here.

Going back to the Macro problem – no, or low growth has a very focusing effect on everyone. If you cannot grow your way to success you have to find other levers. Chemical industry customers are today much less interested in the marginally improved properties of a new product than they are in reformulating/redesigning to use the cheapest material available. Nowhere has this been more apparent in TiO2, and not paying close attention to this trend would be a major strategic error for the Materials business in our view. Dow has to get cost competitive in this business and here is where, in our view, the least clear, but probably largest, bucket of potential cost reduction lies.

We estimate that synergies and other cost initiatives can add between $1.70 and $3.00 per share of normal earnings to the combined company – pre-split, on a current pro-forma “normal” earnings of $2.75 per share. Note that this “normal” number reflects a “normal” crude oil to US natural gas ratio – more reflective of the current market than at any time in the last 5 years. In Exhibit 2 we summarize how we think about the buffer that synergies would create to a cyclical earnings trough. Untouched, the pro-forma company could see earnings fall as much as 41% below normal based on history – taking EPS down close to $1.50 per new share. The synergies act as a substantial buffer/offset. Focusing on the relative (rather than absolute) call this is a huge lever that is not open to others unless we see further significant deals.

Exhibit 2

Source: Capital IQ, SSR Analysis

A macro trough without this deal would suggest meaningful downside in both stocks. With synergies and other cost opportunities assumed to be at the low end of possibilities we can support current values even in a worst case macro scenario. If the companies can maximize the efficiency opportunity – before the eventual split, there is upside in the names in our view – even in a macro driven trough.

Compare and contrast with other names in the sector and other sectors and you cannot find the same risk/reward anywhere. Really cheap stocks and sectors (metals) have very concerning capital structures and this will be a subject of research that we will publish before year end. Other sectors and stocks have more downside if 2016 is as bad as some are suggesting – Exhibit 3 shows the downside by sector should each move 1.5 standard deviations below normal value. Note that Metals is already well below this, but it is the only one. Commodity chemicals has the downside because valuations are inflated by the recent oil/natural gas benefit in the US.

Exhibit 3

Source: Capital IQ, SSR Analysis

We would be absolute buyers of DOW and DD here, especially on any macro driven further weakness, but absent more significant M&A in the broader space we would be relative buyers of DOW and DD over anything else we cover. The market has given Air Products the benefit of the doubt for the last two years and continues to value the company as if tremendous costs can be cut. Dow/DuPont have much more to work with than APD ever had.

Where The Costs and Other Opportunities Lie

We could take a very purist approach and look at the long-term histories of Dow and DuPont – Exhibits 4 and 5 and say that all the major transactions of the past have not moved the normal earnings trend materially, so why should this be different. One of the major differences in this deal is that it is a merger of equals – so no-one is overpaying in cash. The other difference is that both sides appear to be very focused on costs and have no shortage of shareholders telling them that this is the right focus.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

In Exhibit 6 we look at some very approximate estimates of what we think could be achieved and we have gone beyond the announced synergies to think about structural cost improvements, as we have discussed in prior research, and revenue synergies. We have not considered any break-up benefit yet. The greatest uncertainty is the cost structure of the Materials business – with the right leadership the cost opportunity could be the greatest – after all it is by far the largest business. While we understand the mentality of “fortress Midland” at Dow and the desire to maintain levels of employment in the town, Dow has an obligation to all of its stakeholders, including its employees, to run this business as efficiently as possible, otherwise the competition will take share and Dow will ultimately lose.

Exhibit 6

Source: Capital IQ, SSR Analysis

It is an interesting time to be doing the deal because not only are the market caps of the companies similar, but if we pro-forma the business through a simple combination of our valuation models, current earnings are what we would deem normal, with Dow over-earning and DuPont under-earning – Exhibit 7.

Exhibit 7

Source: Capital IQ, SSR Analysis

Our estimate of normal earnings for the combined business, based on a fully diluted share count (including the Dow preferreds) of 2.4 billion shares, is $2.75 per share. At the top end of the synergy range we end up with $5.80 of earnings in 2019 with no EPS growth from the portfolio. Dow has averaged a higher relative PE than DuPont for the last 10 years and combined they have averaged the market multiple. If we put an 18 multiple on the stock in 2019 and assume no business growth we get a 2019 value of roughly $105 per share which discounted at 10% gives a target today of $75 per newco share – so $75 per current Dow share and $96 per current DuPont share. This is probably a best case valuation given what we know today, but even if we are 20% too high you would still want to own both versus alternatives, especially if you are worried about the macro and the relative risk of owning the group overall.

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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