Dow Chemicals Bid - Case Analysis

1. What are the critical success factors in the polyethylene business?

Polyethylene is produced from ethylene or alpha olefins. Both are the product of a cracking

process using either naphtha molecules derived from crude oil or ethane molecules derived

from natural gas. The production of ethylene and derivatives such as polyethylene is highly

integrated, requires large capital investments and goes along with a high operating

leverage. Polyethylene is a commodity product, which trades globally and within a narrow

price band.

Critical success factors in the polyethylene business are:

Large plant sizes as large plants offer significant economies of scale

Vertical integration as a result of the highly integrated production process

Stable supplies of ethane of naphtha to support the highly integrated process

and to allow for operating rates near 100%

Ethane as input

o Plant cost for ethane cracking are about half of plant for cracking naphtha.

o Operating cost are lower as dracking ethane requires less energy,

manufacturing intensity and equipment than cracking naphtha

Low transportation cost including duties and levies as a result of the commodity

product nature and the narrow price brand of polyethylene.

High global capacity utilization, as prices and profit margins are closely linked to the

global operating rate i.e. industry overcapacity.

Technology leadership and operational excellence to keep and enhance the cost

leader position required to compete with government-subsidized chemical

complexes having different targets (loss leader, zero return)

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 Dow Chemicals Bid - Case Analysis

2. How would you convince Dow headquarters to invest in the PBB project?

Dow Chemical has no foothold in polyethylene in Argentina or the rest of the Mercosur

region and Dow Chemical cannot afford to risk its globally leading position in polyethylene

by not being represented in a strong growth region with increasing demand, particularly in

Argentina. At the same time, Dow Chemical has already collected country experience in

Argentina via Dow Quimica which offers other products than ethylene and polyethylene.

The project perfectly fits Dow Chemicals strategy to be a low cost producer looking for

horizontal/vertical integration, technological leadership, and an international presence. The

competitive attributes of PBB site are also very attractive : [a] availability and proximity of

the two largest Argentine gas basins, [b] easy access (sea, rail, road), [c] close to Buenos

Aires (50% of market), and [d] adequate service infrastructure and human resources.

The project stages 1-3 represent a very rare opportunity to quickly build scale and be

established in a new market, but stages 2 and 3 depend on the acquisition of PBB. It will be

very difficult to become a cost leader in the region if another company acquires PBB.

PBB is important for the Argentine economy. Dow Chemical would for the foreseeable

future be the only producer in Argentina while representing about 25% of Mercosur

production. Competitors will have a cost disadvantage, especially in Argentina.

PBBs importance and the Argentine governments intention to keeps 49% is an advantage,

not a disadvantage. The Argentine government will also appreciate the jobs being created

in the later project stages, if successful, and a good relationship with the government will

likely also be beneficial when discussing with YPF about long-term ethane supply.

Profitability risks from FX fluctuations and freight/duties are limited because most of the

demand is expected to come from Argentina. Capital repatriation regulations are much

improved and expected to stay without any limits and restrictions on transfers in the future.

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 Dow Chemicals Bid - Case Analysis

3. How would you conduct a valuation of this project?

The valuation should consist of the following components:

Value each stage of the project independently using DCF valuation

Build decision tree to combine the valuations for each stage estimating probabilities for

successful bidding and analyzing the valuation sensitivity to success probabilities

Discounted cash flow valuation using USD cashflows calculated using forward rates

8-10% WACC with relatively higher WACC for stages 1 and 3 due to development risk

No WACC adjustment for FX risk given Dow Chemicals international presence and

assuming that shareholders are sufficiently diversified w.r.t. FX risk

No WACC adjustment for country risk e.g. on the basis sovereign spreads. Instead

appropriate adjustments to the projects local currency cash flows. Adjustments are not

required if one assumes that shareholders are sufficiently diversified w.r.t. country risk.

Risk analysis to understand the valuation sensitivity with respect to [a] different

competitive environments, [b] different tax rates (31%, 36%), [c] mix of $ cost and local

currency cost, [d] different transport cost (feight, duties), [e] different financing models.

4. What would you bid for this project?

The minimum bid is USD 150mn. My stand-alone DCF valuation of stage 1 ranges from

USD 160mn to USD 220mn for a 51% stake in PBB depending on assumptions. I would

actually bid as much as USD 220mn for a 51% stake in PBB, mainly to secure an option on

stages 2 and 3. I assume [a] a high probability that Polisur can be bought at a reasonable

price relative to my DCF value estimate of USD 330mn for 100% in stage 2. Furthermore,

I assume [b] that there is at least a 50% chance for stage 3 which I consider highly

attractive with a conservative NPV of USD 400mn and an optimistic NPV of USD 1,0bn.

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