Dow Strikes A Sweet Chlorine Deal With Olin

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The Dow Chemical Company (NYSE:DOW) recently announced the spin-off of a significant portion of its chlorine business for a total consideration of $5 billion. The spun off business will be merged with a smaller chemical company, Olin Corp., in a tax-efficient Reverse Morris Trust (RMT) transaction. The merged entity will have  annual sales revenue and EBITDA to the tune of $7 billion and $1 billion, respectively. The deal falls in line with Dow’s broader strategy to shift its focus away from more commoditized chemical businesses and divert its resources towards more profitable segments. [1]

Dow is a diversified chemical industry giant operating in specialty chemicals, advanced materials, agro-sciences, and plastics business segments. It delivers a broad range of technology-based products and solutions to customers in approximately 160 countries, and in high growth sectors such as electronics, water, energy, and agriculture. Last year, Dow reported annual sales revenue of over $58 billion and adjusted net income of around $3.7 billion. We currently have a $52/share price estimate for Dow, which is almost 17.8x our 2015 full-year adjusted diluted EPS estimate of $2.92 for the company.

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The chlorine-related businesses being spun off by Dow are a part of the company’s Performance Materials division, which contributed more than a quarter to its 2014 revenue. However, the division’s adjusted EBITDA margin was just 14.9%, around 250 basis points lower than the company-wide average of 17.4%, by our estimates. The key reason behind the division’s low profitability is not higher spending on research and development of new products, but because of the fact that some of its businesses, like the ones being divested by Dow currently, produce extremely commoditized chemicals that go into the manufacture of products like polyvinyl chloride (PVC), adhesives, and bleaches. Therefore, during the 2013 third quarter earnings call, Dow expressed its intent to divest from the businesses that fall under its chlorine value chain. The deal announced recently has been in the works since then. [2]

As a part of the deal, Dow will spin off its U.S. Gulf Coast Chlor-Alkali and Vinyl, Global Chlorinated Organics and Global Epoxy businesses to eventually merge with Olin Corp. in a tax-efficient RMT transaction. An RMT transaction combines a spin-off transaction with a statutory merger to allow a tax-free transfer of a subsidiary. It’s basically a more tax-efficient manner to sell off a subsidiary. In this transaction, the parent company first completes the spin-off of the subsidiary to its shareholders. Then the subsidiary, which is now a separate entity owned by the parent company’s shareholders, merges with a target company to create a larger company. Under section 368 of the Internal Revenue Code, this could largely be a tax-free transaction if the spun-off subsidiary is considered the buyer of the target company. [1]

The merger of Olin with Dow’s chlorine operations will result in Dow shareholders receiving approximately 50.5% of the shares of Olin Corp., valued at $2.2 billion as of the close on March 25, 2015, while existing Olin shareholders will own the remaining 49.5% stake in the company. In addition, Olin will also pay $2 billion in cash and cash equivalents to Dow and take on approximately $800 million in pension and other liabilities, taking the total value of the deal to $5 billion. This is a sweet deal for Dow, since it values its rather low-growth, low-margin businesses at almost 7x trailing EBITDA, and provides for investment support to its more profitable divisions like Performance Plastics. [1]

The Performance Plastics division best leverages Dow’s integrated value chain for a low-cost advantage and differentiated end products for higher margins. According to our estimates, the division’s adjusted EBITDA margin stood at around 20.3% last year, well above the company-wide average. Most of the products sold by the division are derivatives of the simplest unsaturated hydrocarbon, ethylene, which is most commonly derived from the steam cracking of either naphtha or ethane. With the shale gas supply boost in the U.S. resulting in a cheap source of ethane, there has been a divergence in operating margins between naphtha and ethane based ethylene production plants in the U.S.  Dow is therefore pursuing huge investments (more than $4 billion) in the U.S. Gulf Coast region to tap into this opportunity. The company expects to generate incremental EBITDA of more than $2.5 billion (on a run rate basis by 2017) by ramping up its plastics operations in the U.S. Gulf Coast region. (See: Cheap U.S. Natural Gas Is Attracting Huge Investments From Chemical Companies)

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Notes:
  1. Dow and Olin Corporation Create an Industry Leader in Chlor-Alkali and Derivatives with Revenues Approaching $7 billion, dow.com [] [] []
  2. Q3 2013 The Dow Chemical Company Earnings Release, dow.com []