A Dow LBO: Is it even possible?

Joseph Chang, ICIS news, 17 April 2007
NEW YORK (ICIS news)–With all the talk about Dow Chemical in the crosshairs of private equity, the big question is: Can it even be done?
Wall Street has its doubts, and for good reason. Dow is a big pill to swallow and will not come cheaply. But let’s see if it is possible.
Shares of Dow Chemical trade at almost $46. With 971.1 million diluted shares outstanding at the end of 2006, that gives the company a market capitalisation of about $44.7bn (€33.1bn).
Add on $6.6bn in net debt and you come to a total enterprise value of $51.3bn in the public market.
That’s the current public value of Dow, but a private equity buyer would have to offer more, even with a buyout premium already priced into Dow’s stock from all the takeover speculation. But we’ll get into that later.
Let’s look at the cashflow side of Dow to see if there’s enough cash generated from the business to warrant a buyout at today’s price levels.
In 2006, Dow Chemical generated $4.15bn in cash from operating activities. The company also spent $1.78bn on capital expenditures. So free cashflow (cash from operating activities minus capital expenditures) came to $2.37bn in 2006.
Taking the $51.3bn enterprise value of Dow and dividing by the 2006 cashflow of $2.37bn gives a multiple of 21.6 times cashflow – a hefty figure.
From 2000-2006, private equity buyouts of chemical businesses have taken place at an average of 7.9 times cashflow for specialty assets and 6.8 times for commodities, according to New York-based investment bank Young & Partners.
And while the multiples paid in private equity buyouts have risen lately towards 10 times EBITDA (earnings before interest, tax, deprecation and amortisation) in certain cases, they are nowhere near 21 times.
And that could very well have been peak-of-the cycle earnings for Dow in 2006. The consensus on Wall Street is that Dow’s earnings will fall in 2007 and further in 2008.
So a private equity buyout of Dow Chemical looks impossible on this basis.
But if only things were so simple.
Let’s take a look at the best-case buyout scenario, seeing how a deal could be done.
The first thing would be to exclude working capital adjustments in the cashflow numbers. Sometimes inventories and accounts receivables are built up in one period, reducing the underlying cashflow.
In 2006, Dow built up a net $1.16bn in working capital. Adding that amount back into cashflow of $2.37bn would give Dow underlying cash flow of about $3.53bn.
Excluding working capital adjustments, Dow still trades at a high multiple of 14.5 times cashflow.
But Dow is pursuing what it calls an “asset-light” strategy where it will seek to reduce its exposure to highly cyclical, capital-intensive commodity chemical businesses.
For the sake of argument, let’s say Dow management or private equity owners would be able to slash the company’s capital spending by half, saving $890m/year.
Adding the $890m back to an underlying cashflow of $3.53bn yields a figure of $4.42bn in potential cashflow.
Using this best-case figure, Dow trades at a multiple of 11.6 times 2006 cashflow – much more reasonable than the original 21.6 times.
But as mentioned before, a private equity buyer would have to pay a premium to Dow’s current market value to buy it out.
So let’s say private equity offered to acquire Dow at $53 per share – around the price from the latest rumour.
At $53, the buyout would value Dow’s stock at a total of $51.5bn. Add on the $6.6bn in net debt and you have a total takeover price of $58.1bn.
Taking that figure and dividing by the “best-case” cashflow of $4.42bn yields a multiple of 13.1 times cashflow.
The verdict: a tough deal, but still within the realm of possibility. And selling off non-core assets could make the numbers work even better.
It appears the only way any leveraged buyout (LBO) of Dow could take place is if private equity buyers already have agreements in place to sell off some of the assets to help finance the deal.
Private equity would probably have to team up with at least one strategic player.
It is not likely that any public company in the US or Europe would want to buy Dow at this price.
But large firms in Asia or the Middle East may want a big piece of the largest chemicals market in the world, the US, and be willing to pay for it.

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