I want to give credit to Roger Nusbaum on his brief commentary on Dow Chemical. Too many people think short term about investing, and don’t consider how much a company might be worth over time, versus a buyout today.

I faced the same problem on National Atlantic Holdings. I believe it is more valuable as a going concern than as a buyout candidate at present. I was happy when the Commerce Group negotiations broke down, because Commerce wouldn’t pay up!

I don’t have to get all of my gains today. So long as I do well enough over the next 3-5 year period, I will be happy enough. I don’t have to make a killing today. Having slightly better than average performance over a moderate period of time is reward enough.

Long DOW NAHC (the firm I work for owns 17%)

I remember once being at a First Boston Insurance conference and talking to the (now former) CEO Ed Liddy afterwards. I mentioned that we were shareholders and that I thought the stock was cheap (then around $40). He looked at me intently and said that he could not figure out why the market valued Allstate so cheaply. It was an incredible free cash flow machine.

With the hurricanes of 2004 and 2005 after that, one can see that the performance since then has been superb. But now we are in a soft pricing environment; profits will not rise rapidly, if at all. But even if profits remain level, Allstate looks cheap. EV/EBITDA is near 5x.
That should attract private equity. If one can take over Texas Utilities, Allstate should be easier. Here’s why: one can sell the life arm, Allstate Financial for $5 billion to one of the major life insurers. Along with that, the private equity buyers can lever up the holding company balance sheet to a BB- rating, which would leave the operating entities at a marginal investment grade of BBB-. The private equity buyers would use the free cash flow to repay the bank debt incurred, and five years from now, would IPO Allstate at a higher valuation.

Though I am not crazy about all of the increased leverage, a scenario like this could happen. It is just another ramification of interest rates that are too low.
Long ALL (the funds I work for and me personally)

The two chemical names in my portfolio are both doing well on an otherwise tough day, supporting my broad market portfolio. Lyondell Chemical [LYO] sells its Titanium Dioxide business to the Saudi-owned National Titanium Dioxide Co. This will allow them to focus on petrochemicals and refining, and (what!) reduce debt. Looks like a good multiple on the sale and a good deal strategically.

Dow Chemical [DOW] is a buyout target?! I would have thought that it was too large. Strange times indeed, where any asset with a low EV/EBITDA not only can be bought and refinanced, but are almost required to be so. And, with less leverage and a simpler structure, might not Lyondell be a target also? It’s much smaller.

In the short run, all of this is bullish for the market. Remember, bubbles are financing phenomena. Bubbles pop when cash flow is insufficient to continue financing them. We’re not there yet, but watch for signs of difficulty in these newly levered creations. Private equity is doing these deals at lower and lower IRRs from what I’ve heard, and eventually, that is not sustainable, given the levered up risks taken.

Long DOW LYO