Capital Allocation – Why The Activists Are Where They Are

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Graham Copley / Nick Lipinski

203.901.1629 / 203.989.0412

gcopley@/nlipinski@ssrllc.com

November 6th, 2014

Capital Allocation – Why The Activists Are Where They Are

  • Activists are targeting companies with ineffective strategies, plenty of opportunities to reduce costs and valuations that reflect an expectation of continued disappointment. In all cases, historic misallocation of capital has been driven by overestimating both the broader market and the companies’ own capabilities, often leading to bloated costs relative to revenues.
  • Dow Chemical and DuPont have destroyed tens of billions of capital over the last 15 years, when comparing cash and capital spent with shareholder return generated. In the case of Air Products capital has not been destroyed but the return on the capital has lagged peers significantly.
  • We have looked through the rest of our coverage universe for companies that show similar capital allocation/return profiles as DD and DOW and also offer some level of valuation support. The following names are highlighted: BRC, BGC, and TRN**.
  • Few of the companies we have analyzed have underutilized capital bases that offer superior operating leverage – in most cases the lost capital is truly lost. Activists in these industries are looking to correct past behavior, establish appropriate strategies and reduce costs. Any underutilized capital/capacity that can still be exploited is a bonus.
  • Companies screening poorly on the metrics we discuss here and trading at historic discounts need to explore self-help strategies if they do not want someone else calling the shots.
  • Both IP and CTY have a poor history, but a better recent trend and valuations which suggest some faith from investors that discipline has improved.

Exhibit 1

Source: Capital IQ, SSR Analysis – See
Appendix
for a more complete list

** We are not focusing on the metals names identified in Exhibit 1 above because the swings in commodity pricing can overwhelm the effects of capital spending – when we did our work on “optimism” in 2013 neither the metals nor the energy space fitted the relationship demonstrated by all other sectors because of the commodity price effect.

Overview

The new CEO of Air Products has stated a number of times that the primary job of a CEO is making appropriate capital allocation decisions. This is sometimes stated as if it is an unusual approach, or a novel idea. Of course, in capital intensive businesses, where you spend is paramount. Spending needs to be thought of as investment, whatever that spending might be, and it is the job of company management to get an adequate return on that investment.

Some companies have been exceptionally poor at this exercise and some much better. It is interesting that the three large chemical companies currently pressured by activists have all been very poor: Dow and DuPont in absolute terms and Air Products relative to the industrial gas industry. When DuPont CEO Ellen Kuhlman talks about generating positive shareholder return in her recent shareholder letter, she is taking some liberty with the starting point as illustrated in the complicated chart below.

Exhibit 2

Source: Capital IQ, SSR Analysis

DuPont, like Dow Chemical (Exhibit 3), has destroyed billions of dollars of capital over the last 13-14 years and it is completely appropriate, in our view, that investors are asking for a change of strategy. As we have suggested in
plenty of prior research
, there are a variety of drivers behind these allocation missteps.

  • Very poor R&D returns – very few R&D centric companies achieve consistent R&D returns that cover the full cost of investment.
    • Companies overestimate the value of what they are developing and generally fail to get enough pricing to cover the full costs.
    • New products often substitute old products or improve on them – either resulting in redundant production capacity or lower volume demand from customers.
  • Over-optimism around growth and market share when it comes to major capital decisions.
    • We think that the ethylene industry is overestimating growth today as it plans new capacity in the US. Producers are underestimating how hard it will be to place additional product offshore without a negative impact on domestic US profitability.
  • Acquisitions that are often overpriced, do not generate the synergies expected, or overcomplicate the company story in the minds of investors.
    • In consolidated industries demand can fall as customers seek to diversify suppliers when two suppliers merge.
    • Costs of integration – particularly of IT – can more than outweigh synergies.
    • Diversification strategies can make a simple story complex and the market does not like complex stories.
  • A lack of self-awareness!
    • Not recognizing the true nature of your business and your competitive threats can lead to strategies that suck up too much cash either fighting a battle that you cannot win or fighting the wrong battle.
    • Pretending/hoping a commoditizing business is really not commoditizing has historically been a huge driver of value destruction as companies have thrown good money after bad and there are plenty of possible current examples.

Exhibit 3

Source: Capital IQ, SSR Analysis

From an activist perspective there is no expectation that the wasted capital can somehow be recovered, although perhaps at the margin returns can be improved on businesses that are being run inefficiently. The primary goal of the activists is to stop the practices that have caused the capital destruction and start practices/strategies aimed at running the businesses better. In most cases, we can point to examples of businesses which are run differently, with a different approach to capital/cash allocation and that have created materially better shareholder returns – the most obvious example is Air Products and Praxair and their two histories are shown in Exhibits 4 and 5.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

We looked across the rest of our groups for companies that might show capital allocation/return histories similar to DD and DOW and we then cross referenced with valuation. We took the view that an activist is going to want an attractively valued target – this was clearly the case with APD and DD in our view – less so for DOW. The results of our search were summarized in Exhibit 1.

But You Don’t Need an Activist!

Activists generally take a stake in companies where they believe a refreshed strategy can unlock significant value. However, there are plenty of examples of companies where management/boards of directors have made that change proactively and delivered great results. For example, Praxair was underperforming Air Products through much of the 1990s and the early part of the last decade – a change of focus at Praxair resulted in the more recent difference in the charts in Exhibits 4 and 5.

Another good example is PPG – Exhibit 6. PPG has aggressively repositioned its business over the last ten years and pursued a relentless drive to improve margins. The company has achieved this while still spending on acquisitions, but it is the margin improvement and accompanying EPS growth that has attracted shareholder attention.

Exhibit 6

Source: Capital IQ, SSR Analysis

Both DuPont and Dow can claim that they are on an improving trend, and this is the core argument being made by DuPont CEO Ellen Kuhlman in her response to Trian’s suggestions, but part of the share price appreciation that drives the better 2013 numbers in Exhibit 2 is a function of Trian’s presence. Returns and margins remain disappointing and the company continues to send a lot of money. Furthermore, DuPont has a very flexible balance sheet today and the company has made no secret of its desire to make further acquisitions.

In the case of Dow Chemical, the recent performance is actually quite poor when you factor in the benefit of the US shale gas advantage for Dow. Normalizing US ethylene margins (something that looks more reasonable every time Brent Crude declines), Dow Chemical looks like it is continuing on its path of declining return on capital, and has a current huge capital spending backlog.

Company Profiles

Cheap

BRC

BRC has performed well since it screened in our small cap analysis (published in mid-October), but the stock remains significantly cheap, with strong cash flows financing a sizable yield (3.4%). We noted Brady’s struggles in adopting digital sales channels, but management’s confidence in the company’s trajectory is evident given the widespread insider buying seen in September (at prices just below current trading levels).

Exhibit 7

Source: Capital IQ, SSR Analysis

BGC

General Cable (BGC) did not make our small cap screen as the lower bound of our market cap cutoff was over $1 billion (current market cap is $700 million) but was otherwise excluded only due to its diverse geographical exposure – were we to rerun this analysis now that the company has announced its plants to exit the Asian and African markets, BGC would be a standout with a 5% dividend yield. There has already been talk that General Cable would make an attractive target for industry leaders Prysmian (Italy) and Nexans (France), offering these European competitors valuable North American exposure. Operating difficulties have plagued BGC, but the core wire and cable operations business (with a range of applications in the construction, communications, energy and industrial sectors) is not about to go away anytime soon, absent the development of an industry changing replacement product (unlikely). It was recently announced that CEO Greg Kenny will step down once a replacement is identified.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

TRN

Our recent
monthly review
highlighted TRN as the worst performing stock in our coverage in October (down over 20% after an unfavorable legal ruling related to the company’s Construction Products segment). Trinity drives the bulk of its sales and earnings from its highly profitable (particularly in these times) rail car manufacturing and leasing segments, and the fundamental story that drove the stock up more than 100% from September 2013 to the September 2014 highs is still intact. The company has destroyed value at virtually the same level as DD on a market cap adjusted basis – compare this to competitor Westinghouse (WAB) which has generated positive value 56% in excess of its current market cap over the same time frame.

Exhibit 10

Source: Capital IQ, SSR Analysis

Expensive

CYT

Cytec destroyed as much as $3bn of capital from 2000 to 2008, but has shown some slight improvement since 2008 and has changed tack somewhat, preferring share buybacks to acquisitions and capital spending. The result has been significant share appreciation over the last two years and a significant improvement in returns on capital from what had been one of the worst trends in the industry – Exhibit 11.

Exhibit 11

Source: Capital IQ, SSR Analysis

With the value destruction behind the company today and a share price that discounts further improvements in return on capital above historic highs, there is not much left to “shake-up” unless you believe that the specialty nature of the portfolio could have a materially higher margin and return on capital.

Exhibit 12

Source: Capital IQ, SSR Analysis

MWV

MeadWestvaco is already the subject of activist interest – Starboard Value LP announced a large stake in June and pushed the company to separate the packaging company’s non-core specialty chemicals segment. Management has been agreeable to exploring all options and recent comments indicate this transformation will come sooner rather than later. MWV stock spiked on the announcement and has held but not added to those gains as there have been no further developments beyond “all options are on the table.” The longer history return on capital trend is driving the current premium in MWV, but the stock is undervalued relative to the upward sloping ROC trend from 2002 (when the merger of Mead and Westvaco led to the company’s current incarnation).

Exhibit 13

Source: Capital IQ, SSR Analysis


Appendix:

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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