ANALYSIS: Dow's Bid for Rohm Looks Rich

Still, even if shareholders should be cautious about committing new capital to the stock, the hefty dividend yield is impressive for current investors.
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Dow Chemical

(DOW) - Get Report

initially put a charge into the anemic market Thursday morning, offering to buy

Rohm & Haas

(ROH)

for $15.3 billion, or $78 a share in cash, but some Dow followers might argue that the company overpaid.

The price tag, after all, does represent a hefty 74% premium to Rohm & Haas' closing price Wednesday. Dow, though, believes the deal was in line with the price paid for recent similar deals by BASF, Akzo Nobel and

PPG

(PPG) - Get Report

, especially when you factor in the expected cost savings.

Dow CEO Andrew Liveris is confident that the purchase can generate $800 million of annual pretax synergies, phased in over two years. The largest factor of this is expected to be realized by increased purchasing power for raw materials, as well as combining overlapping operations.

Still, despite the Warren Buffet seal of approval (

Berkshire Hathaway

(BRK.A) - Get Report

is pledging a $3 billion equity investment), Dow shares are down about 4% on the session, recently changing hands around $32, roughly $2 below the intraday high. Additionally, the stock was downgraded by analysts from BB&T Capital.

Dow's New Model

The purchase materially changes Dow's business model. Rohm & Haas is more focused on specialty chemicals, rather than basic commodity chemicals, where margins are at the whim of soaring input costs.

And, according to Dow, specialty chemicals will contribute 70% of revenue and earnings after the deal is consummated, compared with the current approximate 50-50 split with basic chemicals.

As a result, Dow predicts the deal will be accretive in 2009. Dow, which had previously targeted earnings of at least $3.50 in the next cyclical business trough (expected around 2010/2011), believes the earnings floor will now be closer to $4 following the acquisition.

In comparison, analysts expect Dow to earn about $3.30 a share in 2008, which would mark the third straight annual decline, from the peak of $4.37 in 2005. Under its former commodity-centric business model, the company's trough earnings in 2002 were 34 cents a share.

Were Dow's Hands Tied?

I'll concede that the deal makes strategic sense for Dow, but that still doesn't answer why the company paid such a giant premium. Throughout 2007, speculation circled around Dow itself, with foreign buyers reportedly interested in buying some parts or all of the company.

Judging by Liveris' comments on the conference call, it appears that Dow was completely handcuffed by soaring input costs for polypropylene, and it needed to take drastic action. In fact, Dow had tried to pass along price hikes of as much as 25% twice in the past several weeks, as feedstock and energy costs rose 40% year-over-year in the first half of 2008.

Back in December, the company also raised some $9.5 billion, selling half of its commodity plastics unit to a Kuwaiti company and creating a joint venture to provide access to low-priced energy commodities.

At that point, Liveris said that Dow would look to reinvest those funds into a sizable acquisition of a specialty chemicals firm or use the cash to execute an accelerated buyback program.

Given the reaction of Dow shares to today's news, maybe the buyback, which most likely would have been more accretive to earnings, would also have been more helpful for near-term shareholder value.

Rohm Burning?

That's because Rohm's business has been struggling of late. The company is a leader in coatings and electronic-materials businesses, where demand has slowed in recent quarters. Margins in the specialty materials division have also been hurt by slower automotive and housing end-markets.

In the meantime, Dow's dividend yield has been bid up today to 5.2%, some 300 basis points higher than average payout of the

S&P 500

. While the purchase will boost the company's debt load, management believes that its debt-to-total capital ratio will remain within target levels.

Considering that Liveris remains confident of higher trough earnings going forward, the 42-cent quarter dividend appears secure. Trouble is, it will take at least a year to see if this deal will pay off.

In the meantime, Dow remains at the mercy of higher energy and feedstock costs. So while I wouldn't commit new capital to the stock at current levels, the hefty dividend yield makes me stop short of advising readers to abandon Dow.

David Peltier is a research associate at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback;

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