When Dow Chemical (DOW) and DuPont (DD) announced their merger on Dec. 11, they made it clear that the liaison would be short-lived: They intend to break the combined entity into three within a couple of years of the transaction closing. The resulting companies will be active in materials, specialty chemicals, and agrochemicals.
What will the new companies look like?
Some 88% of the material company's projected $51 billion revenue will come from Dow's businesses in monomers, resins, and bulk plastics such as polyethylene and polyurethane. DuPont will contribute its comparatively specialized Teflon and nylon assets. Dow has invested heavily in feedstock production, and its facilities are among the largest and most efficient in the world. Plugging DuPont's business into Dow's supply chain will contribute most of the $1.5 billion cost savings the companies expect to achieve from these operations. The combined business will be smaller than BASF, but a strong global No. 2 in the industry.
DuPont will contribute 85% of the specialty-chemicals company's projected $13 billion revenue. Inevitably, its businesses will be something of a grab-bag. Specialty chemicals are "specialties" because they serve narrow markets. A business that produces $13 billion of them obviously provides numerous customer groups with many diverse items. This company's products will range from Tyvek and Kevlar to enzymes and semiconductor photoresists. Electronics and communications, nutrition and health, and safety and protection will each contribute $4 billion revenue; industrial biosciences will contribute $1 billion. Former Dow businesses will comprise half the electronics and communications segment, and little else. As might be expected, the synergies expected from combining these businesses are limited.
However, the day that the merger was unveiled, Dow announced separately that it would purchase from Corning (GLW -0.51%) the 50% of Dow Corning that it does not already own. About two-thirds of Dow Corning's $6 billion revenue comes from a wide range of silicone products and a third from polycrystalline silicon, used in solar cells and other electronics applications. Although Dow has not indicated where it might go, it obviously belongs with the specialty company. A $19 billion-revenue specialty chemical company, with roughly a third of its revenue derived from the electronics industry, would be more attractive to investors than the less-focused $13 billion revenue company that specialty chemicals would be without Dow Corning.
Agrochemicals are probably the main motivation for the merger, and the new $19 billion revenue company will be the world's largest, although its seeds revenue will trail Monsanto's, and its pesticides business will be No. 3 behind Syngenta and Bayer. Its main strengths will be in corn, cotton and soy. Dow will contribute $5 billion and DuPont $3.5 billion of insecticide revenue; they will contribute $2 billion and $7.5 billion seed revenue, respectively. There is limited product overlap. Agrochemicals and seeds absorb the greatest portion of DuPont's R&D budget, and the same is probably true, or nearly so, for Dow: Eliminating duplicative research efforts will account for much of the $1.3 billion cost synergies that the agrochemical businesses are expected to achieve.
What will be the economic behavior of the new companies?
The materials business will be highly cyclical. Although plastics and resins are used in almost everything, large portions of demand derive from automotive and construction uses. As capital-intensive process installations, petrochemical plants cannot economically idle: When demand falters, inventory overhangs accumulate. Their products are only small chemical steps away from petroleum. As 2015 demonstrated, customers know this, and expect the industry to pass along raw-material cost savings. This confuses investors: The double-digit reduction in Dow's 2015 petrochemical revenue, which alarmed them, was more than compensated for by increases in volumes and the margin they earned.
In addition to these sources of income volatility, petrochemicals have an internal cyclical dynamic. There is little point in building small petrochemical plants: These are low-margin products that require economies of scale to be viable. Consequently, capacity is lumpy: It grows slowly for years, as a result of tweaks to existing facilities, and then bumps up sharply when a new plant comes on stream. Fortunately, the next big bump will come from Dow's Sadara joint venture with Saudi Aramco. Although it began production on Dec. 8, it will not be completed until 2020.
It is impossible to generalize about specialty chemicals: They lack a common economic profile with respect to both their inputs and their customers. However, if Dow Corning is folded into this company, some useful things can at least be said about its customer base. About a third of sales will be to the electronics industry. Electronics businesses are influenced by economic conditions, but they also have an internal cycle, driven by the commercial success of innovations. Note, for instance, that the iPhone -- the source of considerable demand from suppliers -- was launched in 2007, hardly an economically propitious moment.
Another 15% of specialty revenue will be linked to the fortunes of the construction industry, through its manufacture of Tyvek, Corian, and a number of Dow Corning's products. The remaining specialty chemicals businesses will be less cyclical. Many serve the food industry, while protective products (Kevlar and Nomex) also enjoy consistent demand. Dow Corning's silicone business will add products that address most of these markets, as well as healthcare.
The outlook for agribusiness is clouded by weak prices and excess inventories. The problem is global, as is Dow DuPont's agrochemical business. But U.S. farmers are especially badly affected, because dollar strength has ruined their export competitiveness. They are the combined companies' biggest customers. While prices and volumes of agrochemicals are resistant to minor downturns, U.S. farm income has reached the point where economizing is essential. Inevitably, 2016 will see cropland taken out of production, reducing seed demand, and farmers will cut pesticide application if they can. Unless there is a harvest failure that allows inventories to be drawn down, or the dollar declines, the market into which the agrochemical business will be launched will be difficult.
There is plenty of water to flow under the bridge before these three companies are formed. Shareholder support for the merger is not assured. Justice Department scrutiny of the deal -- particularly the agrochemical portion of it -- will be intense. Authorities in other jurisdictions, notably the European Union, will want to contribute their two cents' worth. Any of them could dictate portfolio changes to Dow DuPont, rendering the new companies different from what is described above. Further deliberations by Dow DuPont might have the same result. Assuming these hurdles are overcome, the cyclical and stock market conditions into which the new companies will be launched cannot be predicted. The next several years will be interesting times for the chemical industry.
