Description

Most analysts seem to be waiting for the closing to do real work on the transaction, as there is too wide a gap between potential outcomes. I believe the confusion comes around the 35c accretion target the company provided with the announcement of the ISP deal. This guidance was provided as accretion over and above doing a $400mm share repo. Doing simple math  in the scenario of LTM $360mm EBITDA and a 35% tax rate the ISP deal is 37c more accretive for Ashland to do than the planned share repo. The true GAAP EPS accretion assuming LTM ISP ($360mm of EBITDA) is closer to 68c.

There are two areas that I think will make this transaction materially more accretive to 2012 results than what the original commentary suggested. First while the LTM EBITDA of the ISP business is $360mm, the EBITDA in the first reported quarter of the year was $110mm. Ashland mentioned that they don't believe there is much seasonality, but haven't provided any guidance as to what their projected EBITDA is for ISP for 2011 or 2012. If we assume they can achieve the Q1 2011 run rate ($440mm) by their fiscal 2012 then the accretion is closer to $1.20 (page 3 has accretion scenarios with different EBITDA targets). Second, Ashland bases the accretion on a 500bps step up in the tax rate as they plan to repatriate all foreign earnings in order to pay down debt as soon as possible. While this is possible, I believe the most likely scenario would be to repatriate only the European earnings. Since Ashland is still investing growth capex into the emerging markets there is no reason to repatriate cash only to send it back for capex projects. Ashland alluded to this on the July Q3 2011 conference call. Repatriating only the European profits should increase the tax closer to 350bps. Assuming $440mm of EBITDA and a 33.5% tax ISP is $1.38 accretive to 2012 earnings.

Ashland is more interesting based on my 2013 numbers. The Company believes it will achieve $50mm of cost synergies between the two businesses (typically they do much more than what they originally project). The fact that ISP tried to buy Hercules in 2000 suggests that synergy between HPC and ISP could be substantial. To be conservative, I am assuming no growth in ISP EBITDA other than $50mm of synergy in 2013 (2012 EBITDA $440 + $50mm cost synergy = 2013 $490mm EBITDA) @ 33.5% tax rate the ISP transaction is $1.77 accretive.

Debt repayment will unlock another source of hidden value. Ashland did its last major acquisition (HPC) at the end of 2008, the worst possible time from a financing perspective. Ashland issued $650mm of 9.125% due in June 2017. That debt is callable on June 1st, 2013. I think Ashland can generate $1.3 billion in free cash by the call date. When they call that debt it is immediately 52 cents accretive to earnings. Ashland just placed $3 billion of debt at 3.8%. For the $3 billion of debt Ashland just raised they are going to pay $115mm of annual cash interest ($130mm including amortization); when they take out the $650mm they get rid of $60mm of interest expense. The expensive debt from the HPC deal is masking huge earnings power - approximately 10% accretion to where consensus is for 2012.

Since in my estimation they are going to generate $1.3 billion of free cash flow by 2013, I think the repatriation will be over in 2 years (by start of Fiscal 2014). Adjusting for the temporary tax noise of repatriation, the ISP deal is really $2.10-2.50 accretive to 2013. Adding the benefit of the $650mm bond takeout the math suggests $2.60 -$3.00 of pro forma 2013 accretion. I believe pro forma EPS will be $8.00 for 2013 as analysts reset their models.

To Summarize - I think there are several things that are not fully appreciated:

1) Repatriation should be over quicker than what people think, thus bringing the tax rate to a lower level sooner than what's expected. Based on the $1.3 billion of free cash flow that the company will generate over the next 2 years, Ashland should take Net Debt/Ebitda from 2.66x at the end of fiscal 2011 to 1.23x at the end of fiscal 2013. At that point, I think repatriation will be over and the GAAP tax rate should return to 30%

2) With all the amortization they have I get cash EPS of $7.90 in 2012, $8.70 in 2013, and $9.70 in 2014. Since Ashland has been an acquisitive company the amortization expense is massive. D&A will be much higher than Capex even after assuming aggressive growth projects. I cover the packaging space and one of the best performers in last 5 years have been CCK and BLL on huge cash flow. The enterprise value hasn't changed that much, but as the debt is paid down with the cash that they have generated the value transitions from the bond holders to the equity holders. Assuming nothing else you get $27 over 3 years with Ashland, nearly half of today's equity value.

3) They have $650mm of 9.125% debt that is callable June 1, 2013. Interest expense associated with this debt is masking 50c of real earnings. Assuming (a) normal growth in the businesses, (b) tax rate goes back to 30%, (c) they take out $650mm of high cost debt -- my fiscal 2014 EPS is ~ $9.00.

4) They are probably dreaming, but if you plug in their mid cycle targets along with the above you get $10.25. The only major difference is their Water and Performance targets which seem high.

5) It has been an amazing run for the commodity chemical guys, but as growth slows or demand declines, some of that pricing power should abate. Ashland has been on the other side of that pricing power and any end market demand softness will likely result in better margins for ASH providing a defensive attribute to the stock. Even stabilization of resin at current levels would be beneficial.

6) Ashland could be a takeout. The Valvoline business is more valuable in big oil hands, a structure deployed by its main competitors. A sale of Valvoline is tax prohibitive, but a spin-off of Valvoline could create real value as the remaining parts of Ashland are likely candidates to any larger player interested in enhancing its specialty mix. Separation of Valvoline would make it more likely that the market values Ashland as a specialty chemical company.

Attached Information:

1) ISP Accretion Math

2)  Consolidated Income Statement

3) EPS Walk

4) EV/Ebitda as Cash Flow Pays Down Debt

1) ASHLAND ISP ACCRETION MATH

2) ASHLAND CONSOLIDATED INCOME STATEMENT

3) ASHLAND EPS WALK

4) ASHLAND EV/EBITDA AS CASH FLOW PAYS DOWN DEBT

Catalyst