DD – Still An Interesting Investment

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 30th, 2013

DD – Still An Interesting Investment

  • The ball is firmly in DD’s court today with regard to where the stock goes from here as, without more data/action from the company in 2014, it is going to be hard for the company to repeat the performance seen in 2013. However, there could still be meaningful upside.
  • DD has had a very strong December, appreciating by 4.6% and taking its annual performance to more than 40%. We still see a discount to “normal value” ($71 per share) and consensus calls for 12-13% EPS growth for 2014. This, together with the current discount could drive a respectable 15-20% total shareholder return in 2014.
  • Our view remains that DuPont has moved on to a path of accelerating return on capital and that after the exit of TiO2 this acceleration will become more evident. Post the TiO2 divestment we expect lower volatility and higher growth to drive an improved multiple and values (both absolute and relative) above historical normal levels.
  • Talk that the TiO2 divestment will take 18 months is concerning as this is likely neither a logistic or financial issue. We are concerned that it might be a delay with the expectation that the residual DD numbers will look better with full year 2014 included than they do today. Otherwise put, the residual DD numbers don’t look good enough today.
  • As we have stated several times in the past, we would also like to see more granularity around returns on R&D investment to help us better judge what level of growth could be possible from the core business.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

DD has been a great performer in 2014 and while we think that further upside exists in 2014 we do not have the same degree of valuation support behind our recommendation that we did a year ago. There is still reasonable relative upside, but DD is likely to be hit at least as hard as the market in a general decline and is less levered in any further confidence driven rally – stocks like DOW, LYB CAT, AA and others would likely do better. DD saw minimal negative revisions (setting it apart from the crowd) in 2013 and consensus expects around 13% EPS growth in 2014, which, while not stellar, supports further relative and absolute upside in 2014.

Today there is probably not enough in the “old” DD to justify a core long position today alone – we calculate relative normal value to be $71 per share. Furthermore, looking at the chart in Exhibit 2, it is a brave man who expects consistent year on year limited volatility from DD – in other words history would suggest that the likelihood of DD hitting estimates for 2014 would be low. We are interested in DD because we think things have changed already and because of the potential to see further advancement in returns on capital, as illustrated in Exhibit 2.

As the company sheds is more commoditized and less R&D leveragable businesses, its return on capital appears to be improving, but we need to be confident in a more aggressive slope, suggested by the arrow, to expect a step change in multiple and further appreciation. For this to occur in 2014 we are going to need to see something more pro-active from the company such as a better set of metrics about current and expected future returns on R&D spending or a faster exit from TiO2 – why the process should take the stated 18 months is very unclear.

Exhibit 2

Source: Capital IQ and SSR Analysis

Net Income Is Rising – But Remains Volatile

The trend in DuPont’s net income is not only positive but improving, as shown in Exhibit 3, and while it sits well above a simple linear trend today, it is less extreme relative to a trend driven by return on capital. (Note that the return on capital trend in Exhibit 3 is driven by the dashed/green line in Exhibit 2). It is much easier to understand the bull case for DD if you look at Exhibit 3 and assume a growth trend that starts low in 2000 and then moves quickly higher and then overlay a reduction in volatility – which is expected as the TiO2 business moves out of the portfolio.

Exhibit 3

Source: Capital IQ and SSR Analysis

Still Cheap Versus The Broader Market

DuPont has seen its relative multiple decline over the last 40 years, not uncommon for Industrial and Material companies and in DuPont’s case the negative trend is less severe than for many. As shown in Exhibit 4, despite its great performance in 2013, DuPont remains below its trend relative value. The goal/hope at the company is that by moving to a higher tech and higher growth portfolio, the relative trend of the last 40 years can be reversed. It is hard to find examples of companies that have turned this trend around (Apple is probably the best example), but even if DuPont cannot make the change as quickly as it hopes, there is still valuation support today – Exhibit 4. Compare and contrast this chart with PPG, Exhibit 5, where the market is clearly giving the company the benefit of the doubt. Granted, in the case of PPG, the story is easier to understand – see recent research. Note that both stocks have done very well in 2013 to stay ahead of a very positive broader market.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Skepticism remains high for DD – and this will drive its selection as a preferred stock for 2014

While DuPont’s valuation remains below “normal” in our view, earnings are above normal – as suggested in Exhibit 3 and shown more clearly in Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

Our Skepticism analysis is based on the relationship between earnings (versus normal) and valuation (versus normal). A company over-earning and undervalued suggests that investors are skeptical and our Index is a measure of the alignment between earnings and valuation. See prior research for more details around definition. Exhibit 7 shows a time line of Skepticism for DD, while Exhibits 8 and 9 compare current values for DD with the chemical group and other large cap industrial/material names. Within the Chemical space, DD is the only large cap investment option with any degree of earnings/valuation support. It is also the most attractive among a group of its Industrial/Material peers

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Risks are not insignificant

Risks to DD in our view sit in a couple of areas – first, a growing concern that we have around corn acreage in the US, if corn ethanol volumes decline (not a 2014 event, but possibly a significant change post 2014). This is a concern that requires further analysis and is a work in progress with our colleague Rob Campangnino so that we can integrate conclusions across the entire Ag chain – we would expect to publish this work in mid-to late January.

Second, we are concerned that DuPont may be playing a waiting game with TiO2 in the hope that its 2014 earnings from the residual businesses paint a more attractive growth story 2012 through 2014 and better support the proposed separation than current numbers. If so we could have limited data points in 2014 and

the stock is likely to little more than drift in that scenario – there is some valuation support and consequently we think that downside is limited barring some major “own-goal”.

©2013, 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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