Dow Chemical's Risky Gambit

THE REPURCHASE

Dow Chemical announced that they will repurchase $4.5 billion worth of stock over the course of 2014 amounting to roughly 8% of the float of the stock at the current price. The vast majority of this repurchase will be done with borrowings as there will likely be very little cash left over after capital expenditures and dividends. Share repurchases of this size are generally very bullish for the near term performance of a stock but there is more than meets the eye to this repurchase.

THE CONVERTIBLE PREFERRED SHARES

In 2009 Dow issued a total of $4 billion in convertible preferred shares to Berkshire Hathaway and Saudi Aramco (SA) in order to complete their acquisition of Rohm & Haas. These shares pay a preferred dividend of 8.5% and have a strike price of $41.32. It is unlikely that Berkshire or SA will opt to convert these shares because of the hefty dividend and the value of the call options. However, this large dividend is burdensome to Dow and Dow can force conversion if the common stock price exceeds $53.72 per share for any 20 trading days in a consecutive 30-day window. I believe this share repurchase is essentially a risky gambit to force conversion of these preferred shares. If this plan is successful then there will actually be more shares outstanding following the plan than before the repurchase.

THE RISKS

On the surface this plan appears to be sound as it removes burdensome preferred shares paying an 8.5% dividend and replaces it with cheaper debt. The risk is that the plan fails (ie. Dow can’t force conversion) and that Dow enters the next down cycle with an additional $4.5 billion in debt, the burdensome 8.5% preferred and an enormous pension gap that would likely balloon further. It seems that Dow has the debt coverage ratio to take on the additional debt but that ignores the gaping pension hole and the likelihood that EBITDA would contract dramatically in a cyclical downturn. I am not predicting a cyclical downturn but noting the risks if it does occur.

THE OUTLOOK

My experience with share repurchase of this size is that they are positive for near term performance even if they are not in the best long term interest of the company. However, once the stock price approaches $53.72 Dow becomes a compelling short. In addition to the very rich valuation there would likely be enormous selling pressure at that price. At that price Berkshire and SA would need to start selling down shares unless they want to be owners of Dow Chemical stock. If Berkshire & SA sold down their stake it would amount to over $5 billion, greater than the amount of the Dow repurchase. It is also possible that funds aware of this situation would sell ahead of that price.

MY PLAN


Dow Chemical is one of five chemical stocks I am short against Eastman Chemical, a stock I believe is far more attractive. As a result of the share repurchase announcement I covered a portion of my Dow short despite the fact that I believe shares are overvalued. I don’t want to stand in front of an 8% repurchase as there is no money in being a martyr and I want to be in a position to short with reckless abandon if the shares approach $53.72.