DOW Merger Needs Some Time

In order to expand its specialty business, Dow Chemical (DOW) would takeover Rohm and Haas Co. (ROH). This will consolidate the chemical producer's higher-margin and higher-growth specialty businesses and reduce the volatility in earnings and cash flow.

However, high raw material costs have forced the company to temporarily idle or reduce production at several of its plants. Further, DOW has a high exposure to the commodity chemical cycle. We expect earnings to remain under pressure and rate the stock a Hold with a target of $35.00.

On a consolidated basis, the growth rate of the combined portfolio over 2008-2012 is expected to be between 5% and 7%. The acquisition will keep Dow's earnings from falling below $4 per share as opposed to the initial target of $3.50 per share. The merger is likely to boost DOW's earnings by 5% in 2010 and 13% in 2011. Dow will retain investment-grade credit ratings after the transaction, with a total debt-to-capital ratio of less than 40%.

After the Rohm and Haas acquisition and the joint venture with Petrochemical Industries Company of Kuwait (PIC), Dow will generate about 69% of its total revenues from the performance products and advanced material division.

The company has solid financials and strong free cash flow. We assume that most of the free cash flow ($2-$3 billion per year) would be used for small acquisitions, new joint ventures, share repurchases and debt repayments.

J&J: Fairly Priced Core Holding

Johnson & Johnson's (JNJ) revenue growth in the next few years will likely slow relative to 2007 as a number of products are expected to experience declining sales. Incremental earnings growth will come in the form of improving margins and share buybacks. Investment in J&J offers consistency, reliability, and perhaps safety in this volatile market. We consider the name a core holding.

The company continues to contend with generic competition which will keep a lid on growth of its Pharmaceutical division over the next few years. Patents of schizophrenia drug Risperdal and epilepsy drug Topamax will expire in March 2009. The safety issues surrounding erythropoietin stimulating agents have also negatively affected sales of anemia drug Procrit. While the company has a number of late-stage candidates that are expected to be commercialized in the near-term, they will not begin to make a material impact until 2010 or 2011.

We expect the Consumer division to continue to perform particularly well in the next few years, but we think revenue growth in the Pharmaceutical division will struggle to exceed a Compound Annual Growth Rate of better than 3 percent.