Dow/DuPont – Again in 2017!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 5th, 2017

Dow/DuPont – Again in 2017!

  • Dow and DuPont will likely continue to be good investments in 2017 but only if they complete the announced merger. They outperformed a weak chemical sector in 2016.
    • To outperform from here the deal needs to close – taking away the risk that the regulators say no, which hangs over both names today.
    • We would haircut price expectations by a few percent to reflect synergies likely lost because of divestments, but still see as much as 15-20% upside from getting the deal done.
    • The tailwinds from the cost initiatives and relatively impressive earnings countered a general cautious market with respect to large cap Chemicals in 2016.
  • Without the deal you have two relatively expensive stocks – DOW especially so versus other ethylene exposed names – both needing another strategy if the regulators simply say no.
    • We think the cost and break-up opportunity at DD is significant and consequently the DD stand-alone plan probably looks better the day after the deal is blocked than the DOW plan.
      • We would own DD over DOW as a result.
      • Longer-term, with a potential strong ethylene/polyethylene cycle Dow may be the better investment, but today LYB looks like a much cheaper way to play that cycle.
  • Pre-deal there are plenty of potential positives and negative which could move the stocks:
    • Upside from better polyethylene margins, new capacity at Dow, infrastructure spending etc.
    • Downside from Teflon related litigation, dollar strength and economic weakness, etc.
  • Real upside comes from a successful transaction, the Ag spin, some select additional divestments rather than a specialty spin, in our view, coincident with a polyethylene cycle.
    • This generates as much as $7.00 per share of peak earnings and as much as 40-50% upside.
    • At best this would be a late 2018 event – more likely 2019.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

The risk of owning Dow and DuPont in 2016 was that a lack of action would result in a waiting game until the deal closed and the stocks would likely languish. We called for news flow from both companies during the year with respect to unilateral cost cutting opportunities and both delivered, while at the same time delivering solid earnings. Consequently, shareholders did get some outperformance, but not much – Exhibit 2. DOW’s outperformance versus DD in 2016 closed an arbitrage around the deal terms which existed at the beginning of 2016.

Exhibit 2

Source: Capital IQ and SSR Analysis

We had called for cost cuts well in excess of the $3bn of synergies suggested by the companies, but we have now seen much of that in the unilateral moves that both sides have made in 2016. These moves have helped support the stocks in the face of several headwinds:

  • A view that the polyethylene market would weaken from 2017 – LYB underperformed in 2016
  • The C8 litigation issues at Chemours – CC itself was a major outperformer in 2016 despite this fear, as the TiO2 cycle turned
  • Increasing regulatory concern regarding the deal itself:
    • Delays to this deal
    • Delays – another one this week – to the ChemChina/Syngenta deal
    • An arbitrage in the MON/Bayer deal which still suggests considerable doubt

The cost cutting and much greater focus on operations at both companies resulted in much better results in 2016 than peers – Exhibit 1. Despite this and the news flow, the stock only outperformed in line with the more “value” based rally which started mid-year – Exhibit 3 – and was not really driven by the cost news flow, which happened before the rally. The stocks rallied on earnings at the end of Q2 and Q3. However, both DOW and DD did significantly better than our Chemical index which underperformed the S&P 500 by 4%. It is cap weighted, and includes both DOW and DD – performance by stock is summarized in Exhibit 4 – of the larger-cap names only PX outperformed DOW/DD.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Given DOW and DD’s outperformance versus the sector and versus the market in 2016 and given that most of the additional cost initiatives are now public, should these be the go to stocks for 2017 also?

Whether these stocks are winners or losers in 2017 on a relative basis depends on whether the deal gets done, when it gets done, and what concessions need to be made to get it done. Estimates for 2017 for either company have not moved materially in the last 12 months, which likely reflects the consistent performance in 2016, but does not give credit for the costs taken out in 2016 and expected further cuts in 2017. There are of course plenty of swings and roundabouts for earnings with both companies:

On the positive side:

  • Cost controls
  • A boost from new capacity at Dow
  • Synergies from the deal, should it close
  • US manufacturing/infrastructure spending – both companies have some leverage
  • A likely “value” bias to the market – see recent research
  • Repatriation of offshore cash – 8% of market cap for DOW, 5% for DD
  • Possible lower US tax rate

On the negative side:

  • Uncertainty around the polyethylene cycle – we are more bullish than the stocks imply but less bullish than earnings expectations for LYB imply
  • DD’s Teflon related litigation (through Chemours)
  • The risk that the deal will not close – we strongly prefer DD in this event – at least in the short term
  • The strength of the dollar – significant overseas exposure
  • Risk of a global slow-down with increasing geopolitical tensions

In 2016, things within DOW and DD’s control (cost initiatives and portfolio focus) were enough to offset things that were outside their control, such as delays to the deal closure, economic weakness, etc. Unless the deal closes – and soon – it is likely that things outside the companies control, whether positive or negative, become larger drivers in 2017. In which case:

  • LYB has more exposure to a better polyethylene cycle and is much cheaper
  • WLK has the same cyclical driver but in addition has less dollar exposure because of more limited non-US business
  • Neither stock is particularly attractive to a “value” investor anymore – Metals and Paper and Packaging are better sectors than Chemicals, and within Chemicals, LYB, WLK, CF and OLN all look like more levered “value” bets today

To buy DOW today over LYB, you have to believe in the deal closing and that the companies can achieve the synergies and the splits/sales etc.

We believe that DD will go down a value creative break-up route anyway if the deal does not close and consequently we would prefer DD to DOW as a way to own the pending transaction.

Given the limited move in the stocks relative to the S&P in 2016 we would only haircut the valuation targets that we had for the combined entity in January of last year by the amount of synergies that might be given up by forced divestments. Worst case would likely be the synergy targets being cut by $500 million, which is $0.15 per share of earnings – $2.20-$2.50 per share in terms of value. This would still give 15-20% upside from current levels assuming the deal closes – until it does we struggle to see another catalyst.

DOW/DD remains one of our favorite stories, but it is not without its risks today, and in the large cap space we prefer LYB as a way to play the commodity cycle.

Neither Stock Is Cheap

Dow and DuPont are expensive stocks versus their own history – Exhibits 5 and 6 – and versus the group – Exhibit 7. They are not the most expensive names in the space and neither is as expensive versus its own history as at prior extremes, but even so, you have to believe a lot to be a buyer here. You have to believe the deal and that the synergies can be delivered and retained – this effectively boosts “normal earnings” by around $1.00 per DOW share ($1.28 per DD share) and on that basis the stocks have some room to run – Exhibit 8.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

The Real Bull Story Needs Some Luck and a Bold Strategy

To get more than the implied value of the synergies a couple of things need to happen: we need to be right on the polyethylene cycle and the combined company probably needs to make some bolder/different moves than currently proposed.

  • The Ag spin-off is a “no-brainer” even if the business is smaller because of required divestments
    • It needs a different management/operational approach than the rest of the chemical business
    • It should be valued more highly than a cyclical chemical company
  • We remain unconvinced that the specialty business should then be spun out – we think there may be more value to current shareholders through selective divestments, smaller spins resulting in a Materials Company that is perhaps a little bigger than DOW and DD are currently suggesting…
  • …Or the company spins out its ethylene/propylene, (commodity) polyethylene and polyurethane business and keeps the rest. The spun out business would then focus on driving costs down to a LyondellBasell level, resulting in a platform that should be larger and more profitable than LYB
    • This could leave a large specialty portfolio – buying plenty of raw materials from the commodity business and sharing locations, but DOW has mastered this concept with the Trinseo sale and the Chlorine Products sale and so has the template
    • It is still likely that some of the specialty businesses would be worth more to others and some value added sales could follow

The polyethylene cycle is less important to DOW/DD than to DOW alone, but the combined company will still have as much as 8 pounds of polyethylene per share (Exhibit 9), more with the expansions in the US and Saudi Arabia – closer to 9 pounds per share by 2019. Integrated margins peaked at around 50 cents per pound in 2014 and are in the 25-30 cents per pound range in the US today with margins expected to weaken in 2017. A move back to the 2014 peak would add as much as $2.00 per share to combined DOW/DD earnings.

Exhibit 9

Source: Company Reports and SSR Analysis

At a stretch the new company could earn $7.00 per share in a peak with the cycle and with synergies – not accounting for any accretive divestments. This would support a Dow share price in the $80-85 range, 40-50% higher than today. We would consider this an “everything goes right” stretch target for 2019/20.

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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