Nova Case

Nova Chemical

Overview:

Nova Chemicals operates in both the basic and specialty chemicals segments. The IPD division that produced basic chemicals is under review for sale to United Chemicals due to its apparent poor performance. On further review it appears that the offer of $160 million is much lower than the actual value once the R&D expense is reallocated. At the same time since the IPD division does not share synergies with the other divisions it is recommended to either spin off the division or institute a tracking stock to make its actual value transparent to the market and thereby prepare it for a future sale. In order to raise the capital for a capacity expansion for the high growth Environmental Products division we recommend a mix of debt and equity since a pure debt financing will violate the interest coverage ratio covenant.

Nova is not managing IPD efficiently, but United's offer is inadequate.

Due to the low growth in the basic chemicals segment relative to specialty chemicals, internal investments prior to 1988 were not used to upgrade IPD facilities. IPD therefore had a cost disadvantage over its competitors due to its inflexible plants. As a diversified chemicals company, Nova was underperforming. Compared with the other diversified chemicals companies, Nova had the lowest P/E ratio (10.3) and the lowest Value/Sales ratio (0.76).

Since IPD is not integrated with the rest of company, it is relatively easy to conduct a valuation of IPD. Given that IPD does not receive any benefit from Nova's R&D efforts a more representative valuation for IPD can be obtained by adjusting the EBIT upward in our calculations to compensate for the over-allocated R&D . Here are some valuation figures for IPD to compare against United Chemicals offer of $160 million which after considering the tax benefits is worth $236 million (160 + 0.4*190) to Nova Chemicals:

* Based on DCF without R&D expense adjustment - $193.26 million

* Based on DCF with R&D expense adjustment - $256.30 million

* Book Value- 160 + 190 = $350 million

* Based on the basic chemical industry Value/Sales multiple (0.84)- $501 million

Therefore, IPD could do much better if managed properly and it could be worth about $500 million, but it was only worth about half of that amount under Nova's management.

However, United Chemical's offer of $160 million is well under the value of the IPD. According to our valuation, Nova could sell IPD for a price between $256 million and $501 million.

The case indicates that United would not negotiate and there were no other offers on the table. We recommend that Nova turn down United's offer and instead either spin off the division or institute a tracking stock to make its actual value transparent to the market and thereby prepare it for a future sale.

Effect of separating IPD from Nova

By divesting IPD, Nova could focus on its specialty chemicals business, which would experience heavy investments and rapid growth in the coming years. While specialty chemicals may need to now source raw material from the market instead of IPD it maybe for the better since IPD was operating at a cost disadvantage. Our calculations also show that the rest of Nova, namely LPD and EPD, could do much better without IPD. The combination of LPD and EPD could be worth $920 million, according to projected cash flows derived from the pro forma income statement. If this value were realized, the value/sales ratio would be 2.5, which is much higher than the industry average of 0.7. The combination of LPD and EPD could be a star in the market!

Risk: The management should also keep in mind the risks associated with the capacity

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