Revisiting Dow-DuPont Merger Motivation As The Companies Win U.S. Anti-Trust Approval

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Dow (NYSE:DOW) and DuPont (NYSE:DD) recently cleared the final major hurdle in their proposed merger by winning U.S. anti-trust approval. This approval is contingent on DuPont selling part of its herbicide/insecticide business, and Dow selling its plastics packaging business. When the merger was first proposed, anti-trust approval was under doubt as it was clear that the combined entity will have a very strong market position. This attracted strong scrutiny from U.S. and EU regulators, resulting in numerous deadline suspensions. However, Dow, DuPont, and major regulators around the world appear to have reached a common understanding. We take this opportunity to offer our take on why the companies decided to merge, the synergy implications, and the rationale behind the expected post-merger split. Here is all you need to know about this deal.

Our price estimate of $83 for DuPont is in-line with the market.

The Rationale Behind The Merger

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The merger will allow Dow and DuPont to navigate the challenges they have seen in the last few years in the agricultural and chemical industries, and also unlock shareholder value by eliminating redundant operations. The two companies have been facing pressure from activist investors because of stagnation resulting from intense price competition, subdued commodity prices, currency challenges, and bloated cost structures. Both companies have seen their revenue fall over the last few years because of low crop prices resulting in decreased demand, competitive pressure, strengthening of the U.S. dollar, and falling oil prices. In fact, these challenging market conditions have prompted other players to pursue inorganic growth opportunities, too. Bayer has agreed to buy Monsanto in a deal valued at $66 billion, and BASF and Syngenta have recently submitted bids to buy assets that Bayer plans to sell in order to complete its acquisition of Monsanto.

The combined Dow-DuPont entity will have a comprehensive array of products in agriculture, material science, and specialty products segments. It will become a dominant player and gain significant bargaining power over their suppliers and to some extent, customers. Bargaining power becomes important in an industry which is facing growth challenges, and margin improvement can be a critical source of value. Additionally, the size advantage should help the combined companies in terms of access to funds for growth and to ward off competition.

$3 Billion In Cost Synergy & $1 Billion In Revenue Synergy

Dow and DuPont have a lot of market overlap which gives an opportunity to eliminate costs and grow revenues. The companies estimate cost synergy of approximately $3 billion which will be driven by a reduction in cost of goods (40%), selling, general and administrative costs (30%), leveraged & corporate costs (20%), and research and development expense (10%). Further, the companies expect revenue synergy of $1 billion.

The three key businesses—Agriculture, Material Science, and Specialty Products—are expected to generate about $1.3 billion, $1.5 billion, and $300 million, respectively, in cost synergies. We note that, after taking these synergies into account, the EBITDA margin of the combined entity is likely to be close to the best in the industry. In our opinion this is plausible considering the significant operations overlap and the fact that the combined entity will have a leadership position.

The Subsequent Split

Once merged, Dow and DuPont plan to split the combined entity into three independent and publicly traded companies, with different areas of  focus. This is expected to happen within a period of 18 to 24 months following the merger. Both Dow and DuPont have been divesting some of their non-strategic businesses to focus on high-margin products. Examples include Dow’s divestiture of the chlorine business to Olin Corp, and AGNUS Chemical Co. to Golden Gate Capital, and DuPont spinning off its performance chemical business, Chemours. The merger and the subsequent split is essentially a continuation of the strategy to create lean and focused businesses, which could help them navigate the current challenging and competitive environment.

The split is likely to unlock value for shareholders. Post-merger, the combined entity will operate three broadly unrelated businesses: Agriculture, Material Science, and Specialty Products, and thus will be subject to what is known as “conglomerate discount,” where the conglomerate tends to trade at a discount to their sum of the parts valuation. The split up is likely to lead to efficient capital allocation. The investors will be free to invest only in those businesses which they believe have value — which, in turn, should boost the total valuation of the three businesses.

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