DuPont Adopting a “Go It Alone” Strategy – Which Raises Interesting Questions, Such As: What is Dow Doing/What Could Dow Do?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 31st, 2016

DuPont Adopting a “Go It Alone” Strategy – Which Raises Interesting Questions, Such As: What is Dow Doing/What Could Dow Do?

  • While we wait for the DOW/DD deal to get the necessary approvals and close, DuPont CEO Ed Breen is not sitting on his hands
    • He is running the company as if there is no big event on the horizon and aggressively chasing down costs both short term and long term
    • His approach looks very much like that taken by Seifi Ghasemi when he took over APD
  • DuPont beat expectations on the revenue and the earnings side in Q1 2016 and was one of the better companies in the group on this basis – a place the company has not held for years
    • DOW’s results were okay, but not the standout that DuPont showed, especially as others in Ag were guiding down and missing numbers (Monsanto in particular)
    • APD has had quarter after quarter of positive surprises over the last two years because of the aggressive cost and efficiency focus
  • The DD stand-alone story look interesting, but we have maintained for years that there are significant costs in Dow which appear either stranded or simply unnecessary
    • If we look at proxies for Dow, before the addition of Dow Corning we conclude that Dow could have as many as 5,000 people more that it needs, suggesting a significant cost opportunity above and beyond the announced synergies and the cost opportunities that Dow has identified with regard to Dow Corning
  • The stocks do not, in our view, discount the announced cost opportunities and perhaps as much as $5bn of potentially lower costs (incremental EBITDA) is as yet not priced in. This suggests as much as $17 per share upside for DOW and $20.50 per share upside for DuPont
    • This is without any underlying business growth or what we think will be a 24-36 month recovery in the ethylene/polyethylene markets after the slowdown we expect in 2016 and which is partly reflected in DOW and DD’s share prices today

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

DuPont CEO Ed Breen is not waiting around for the deal with Dow to close, but instead is aggressively cutting costs and having a positive impact on earnings immediately. DuPont was always a company that we felt could unlock a great deal of value with a more cost conscious approach to management. Mr. Breen has that fresh management approach and the impact has been seen very quickly. Two questions come to mind:

  1. Could DuPont have been the next Air Products if it had not decided to do the Dow deal?
    1. And could that have been worth more?

(Note that when measuring APD performance it is important to measure from when investors knew change was coming – so the agreement for John McGlade to retire – not the date of the new CEO starting)

  1. How much overall value could be unlocked if Dow took the same focused cost approach?

Air Products was the clear laggard in the Industrial Gas space and new oversight and leadership has quickly dealt with what could be addressed quickly, with a positive impact on earnings and a very positive impact on valuation.

Exhibit 2


Source: Capital IQ, SSR Analysis

This is all “self-help”, looking at all aspects of costs and cutting any low hanging fruit immediately and making harder structural decisions as quickly as is practical. Praxair had the same lean focus but optimized over a longer-time frame with the relative benefits coming over the 2000-2008/9 period. Air Products has done more in a shorter time – the most recent sharp ROC improvement has been in part because of a write down, but is mainly driven by healthy forward estimates.

Anyone reading this who has worked for an investment bank will be familiar with how aggressive a short-term cost push can be – addressing such issues as hiring freezes, headcount reductions, travel limitation and entertainment limitations. Such moves can make significant changes to short term earnings.

DuPont appears to be taking this exact path today, in an attempt to offset further disappointments in revenues either from the lackluster global economy or because of Ag. The more structural “central R&D” move was bold, but in our view something the company should have done years ago.

A DuPont with more focused and shareholder friendly leadership could be a very interesting story on its own and could have been perhaps a better stock than it will be merging with DOW, though it is unlikely that we will ever be able to prove that statement. However, a DuPont/Dow combination with the same cost focus that DuPont is demonstrating today could be a fantastic story.

In prior research – long before this combination was announced and shortly after activist investors took a position in Dow – we did some work on the cost structure at Dow and concluded that, while we were sensitive to some of the structural reasons why Dow could not match the cost structure of Lyondell (not having the benefit of cleaning up liabilities through Chapter 11 for example), Dow simply had too many people. The table we used at the time is repeated in Exhibit 3 – updated for most recent headcount data. The conclusion is that Dow could be operating potentially with a headcount more than 6,500 lower than today (we are assuming that as many as 1,500 will be included in the announced synergies in Ag so we are using a net of 5,000). At an average employee cost of $200,000 – salary plus benefits plus allocated costs – this generates $1bn of further savings above and beyond the real synergies of the deal. (We are using a higher average employee cost than the published company average as we believe that the headcount opportunities are mostly US and not at the plant level). With what DD is doing and the announced synergies, with what Dow has already said can be achieved with Dow Corning and what Dow “could” do – there may be as much as a total of $6.0-6.5bn of costs that could come out of the combined operation.

Exhibit 3 – (Excludes Dow Corning)

Source: Capital IQ, SSR Analysis

With the huge break-up fee, Ed Breen would have to have a radical view of what he could do with DD alone to change direction at this point. On the other hand, if the new DOW/DD board of directors has more of a current “Breen” collective leaning, there could be a lot more to this deal than is currently priced in.

We believe that the current price of the stocks – adjusting for fears around Ag and polyethylene near term – is discounting some, but not all, of the already discussed synergies as both stocks are at a premium to the group. However – there could be as much as an incremental $5bn of potential EBITDA not priced in, which at a conservative 7x would add $35bn of value – roughly $17 to each Dow share and $20.50 per DD share.

  1. Could DuPont have been the next Air Products if it had not decided to do the Dow deal?

Air Products clearly benefitted from the management change in mid-2014. Return on capital showed a rapid and marked improvement (Exhibit 4) amid strong earnings growth (Exhibit 5) that continually surpassed expectations (Exhibit 6). Some of the return on capital and earnings improvement was a function of plants under construction coming on line – some of them large, and a coincident reduction on capital spend – so the capital employed growth slowed as earnings from new projects rose. However, at least as much has come from headcount reduction and an aggressive focus on cutting unnecessary near and medium-term spending. The culture of the company has changed also – there is a renewed sense of urgency and focus.

Our view of DuPont for years was that it was cumbersome – with money spent inefficiently chasing esoteric R&D ambitions and lots of stranded costs from the various M&A moves of the last 15 years. This was clearly part of the view Trian had when it initially invested. The company talked about simplifying DuPont as a path to cutting costs, but costs were the focus. If DuPont had simply done an Ag JV with Dow and then focused on costs and some portfolio management, it might well have been a very compelling stand-alone story. The onus will be on Dow/DuPont management to convince DuPont holders that enough extra value can be created through the combination for it to be worth the wait. Both DuPont and Dow are showing improving returns on capital at the moment – Exhibit 7 – the question is whether the combined business can do better than DD alone.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

  1. How much overall value could be unlocked if Dow took the same focused cost approach?

Over the many years we have been covering Dow and DuPont we have on occasion suggested that both companies were trying to grow into an inflated cost base rather than address underlying costs structure. Both have made life even more difficult through transaction after transaction, both acquisition and divestment, which leads to a potential for stranded costs. Using proxy companies as benchmarks, Dow clearly has more employees than a pro-forma sum of the parts would suggest – perhaps as many as 6,500 too many. Note that the three proxies each have individual corporate overhead structures versus Dow’s single structure so it is possible that the opportunity at Dow might be greater. Some of this headcount will be addressed in the Ag combination and is already included in the announced synergy targets. To be conservative we are assuming 5,000 incremental headcount as the additional opportunity.

Exhibit 8


Source: Capital IQ, SSR Analysis

Assuming a total annual average employee cost of ~$200,000, Dow potentially has a $1 billion pre-tax cost opportunity – more than $0.50 per current Dow share (after-tax) in potential headcount reduction alone – Exhibit 9.

Exhibit 9

Source: Capital IQ, SSR Analysis

If we take Ag as an example, we can show that from a revenue growth perspective, Dow has had a respectable last five years, with higher average growth than all but MON – Exhibit 10, but Dow lags all but BASF when we look at EBITDA growth – Exhibit 11.

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Dow is a serious margin laggard – and it is not about mix – Exhibit 12. Proxies for other businesses are harder to find and the comparisons can always have holes poked in them but few would disagree that the margin structure at LYB is far more robust than at Dow for example. We are seeing what a cost focus can do at DuPont in the same way that we did at Air Products – we are simply asking the question – “How great could the Dow/DuPont story be if you got the combination of the right portfolio rationalizations/combinations AND the lean cost focus?”

Exhibit 12

Source: Company Reports, Capital IQ, SSR Analysis

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