A deal to merge Dow Chemical (DOW) and DuPont (DD) may have been a surprise. The two companies are reportedly in advance talks to combine. But the chemistry of Wall Street these days means there wasn’t any way around a deal.
The reason has to do with the long-term slow pace of the economy and the market’s short-term focus, fueled by the success of activist investors in getting the rest of the market on their stop-watch.
For the past year, both companies have been hounded by activist hedge fund investors. DuPont fought a pitched battle with Nelson Peltz, which it appeared to have won. But in September DuPont’s Ellen Kullman, whom Peltz’s Trian Partners had heavily criticized, exited the company. Now DuPont looks to be doing a deal that was along the lines of what Peltz was thinking.
The problem was returns. Never mind that the global chemical and agricultural businesses of Dow and DuPont are being dragged down by a slow world economy, and a strong dollar. The market wasn’t prepared to wait.
Kullman had argued DuPont’s research and development budget was essential to the company’s future. Peltz said it was hard to see a current return on DuPont’s investment. DuPont has invested an average of $2.1 billion in its businesses over the past few years. Yet its cash flow this year is expected to drop about $500 million from last year.
Dow has done better. This year Dow (DOW) predicted it will invest $3.9 billion in capital expenditures, yet its cash flow from operations this year is on track to rise by just $400 million. After taxes that’s an ROE of just over 6.5%.
Even that number wasn’t enough to get Dow out of the cross-hairs of activist investor Dan Loeb. Loeb’s Third Point, which had agreed to a truce with Dow a year ago after being granted two board seats, has been re-escalating its battle with the chemical giant for the past month or so. Third Point wants the company to spin off its petrochemicals business. Like DuPont, Dow has argued that its size creates better research synergies. Loeb hasn’t bought that, saying the market would value the petrochemical business higher on its own. The fact that Dow’s stock is up 11% this year, when the market is essentially flat, hasn’t deterred Loeb that Dow should be pushed to do better.
The plan is to merge the two companies, and then break up the combined chemical giant into three smaller companies. Along the way there will probably be plenty of cost cutting and layoffs. It will also likely mean a reduction in research spending for both companies. That’s sure to produce better short-term returns, especially for DuPont.
But will it produce a company that has better long-term returns than the two companies would have on their own. Who knows? (Recent studies show that activist investors tend to have mixed results when it comes to long-term returns.) But what we do know is the market no longer will wait around to find out.