2015 may very well end up being remembered as the “year of the merger,” as the total dollar value of mergers and acquisitions in the year is on pace to set an all-time record. According to recent reports, Dow Chemical (DOW), DuPont (DD), and Yahoo! (YHOO), are doing what they can to be a part of that record. All three have faced tremendous pressure from activist investors as of late.
On December 8, Dow Chemical and DuPont were reported to be in advanced talks on a massive merger. The rival chemical producers would likely split into three separate companies following the transaction; the three independently operating businesses would be material sciences, specialty products, and agrochemicals. Though labeled a “merger of equals,” Dow shareholders could push their share of the newly combined companies to ~60% based on the firm’s slightly higher market capitalization and higher EBITDA.
The deal would be subject to customary regulatory approvals, and sources close to the situation state that the largest risk may come from Chinese regulators. Another major hurdle may be in the combining of the agricultural chemicals businesses. In the US, for example, DuPont sells approximately one third of all soybean seeds planted, while Dow sells ~5%. Farm income in the nation has fallen to its lowest point since 2002, and the probable gain in pricing power would not be taken lightly by regulators and farmers alike.
If divestitures must be pursued in the areas of soybeen seeds and corn seeds, where the combined entity would own 40% share of the US market, for example, many of the benefits of the transaction may be mitigated. In our view, it is a near-certainty that breaking up the entity after a combination will fall short of maximizing the potential synergies that could otherwise be gained in the event the tie-up is preserved. Though there are benefits to having autonomy and enhanced capital allocation options with separate and distinct companies, having three separate management teams, three separate back office functions, and three of everything-else overhead isn’t exactly what we call an efficient transaction. Even with the proposed three-way split, US anti-trust regulators will have a magnifying glass over this transaction, in our view.
Rivalries won’t let up either. Companies in the agricultural chemicals space have been shopping around, including Monsanto’s (MON) later-rescinded bid for Syngenta (SYT) in August. According to Monsanto CEO Hugh Grant, “everybody has been talking to everybody.” We think this speaks to the threat of ongoing weakness in demand for crop protection products as a result of falling grain prices and farm income. According to the Food and Agriculture Organization of the United Nations, the rate of growth in world demand for agricultural products has slowed, and the pace of expansion is expected to continue to weaken. By extension, demand for crop protection products may remain suppressed, to a degree, stimulating deal-making across the space in search of driving bottom-line growth through cost cutting endeavors.
In addition to trying to please regulators, a weak demand outlook in the agricultural chemicals space offers another reason why a combined Dow-DuPont would split into three separate businesses following closure of the deal, similar to what activist investor Nelson Peltz had been pushing for DuPont to do earlier in 2015. Billionaire investor Daniel Loeb and his Third Point hedge fund had previously been pressuring Dow to become leaner and more focused by cutting costs and divesting non-core businesses as well. Separating the companies into three would allow each to operate much more nimbly, exactly what the activists had been asking for, even if the convoluted transaction results in extra layers of overhead.
Under the proposed deal, investors would have more options to select which “pure play” company in which to invest than being forced to accept a combined, conglomerate-like structure. For example, investors may prefer their plastics and specialty chemicals businesses, which have benefitted from low energy prices, as “cracking margins” continue to climb as crude oil prices fall. In any case, the merger would be a way for both executive teams to avoid any further pressure in their respective board rooms, at least from outside activists. However, deal integration and the streamlining of overlapping costs will now become front and center at future board room conversations. There may now be too many “chefs in the kitchen” to really extract even targeted synergies that could be upwards of $3 billion.
Should the proposed transactions take place, it would increase the likelihood that Monsanto will revise its bid for Syngenta. Monsanto is currently the leader in seeds in the US with 25%+ market share, and Syngenta has the highest market share of any crop chemicals company in the US with ~20% market share. We’re monitoring the fast-changing landscape closely.
The developments taking place at Yahoo have a much different feel than a merger of two equals, but it, too, is facing obstacles from a government agency. The firm scrapped its plans to spin off its 384 million shares of Alibaba (BABA), which it previously said it had been fully committed to, and will instead begin looking to sell its core Web business. Yahoo came under pressure as investor concerns over whether the planned spinoff of its Alibaba shares would be tax free arose after the IRS did not grant a private letter ruling on whether a potential transaction could result in a tax violation. Private letter rulings are not a necessity for spinoffs of this type, but they ensure clarity into the tax implications for the company planning the spinoff.
After the request for a private letter ruling was denied, Yahoo had maintained that it would move forward with the spinoff regardless of what the IRS may rule, but it has since changed its tune. Now the company plans to package all of its assets, except for its stake in Alibaba, in a separate, publicly traded company that may very well go up for sale. This type of move is referred to as a reverse spin structure. After weighing its options, the firm will hold on to its 35.5% stake in Yahoo Japan for the time being.
This appears to be a rather savvy move on Yahoo’s part, as it has come under fire for recent share-price weakness and the increased possibility of eventually putting a hefty tax bill of several billion dollars on the laps of shareholders (if the IRS had come calling at a later date); some estimates have placed the total tax bill at more than $10 billion, certainly not an amount worth taking any chances on. The current plan now gives Yahoo tax-efficient options and opens the door for a strategic buyer to come in to reinvigorate the core assets of the Internet search pioneer. Verizon (VZ) has been named as a potential suitor after it bought Yahoo’s former rival AOL earlier this year; the telecom giant has said it would explore a possible acquisition of Yahoo’s Web assets. If nothing else, the spinoff of the Alibaba shares will add clarity into the true nature of Yahoo’s myriad core businesses.
These two unique special situations, perhaps the best way to describe them, are likely only to get investors into trouble. We continue to be cautious on the chemicals space, and while higher-margin specialty chemicals have resilient margins, the cyclical nature of their operations leaves much to be desired. We’re monitoring the Yahoo-Alibaba situation closely, but we remain comfortable holding shares of the latter in the Best Ideas Newsletter portfolio. Alibaba remains underpriced.