DuPont Question 2: Chemours is a No Win Scenario

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 5th, 2015

DuPont Question 2: Chemours is a No Win Scenario

  • The spin of Chemours could be a headache for DD which-ever way it goes; if the stock flops DD will be criticized; if it does not it will only be a result of cost actions taken by Chemours management. In the latter case, DD will be criticized for not going after cost before the spin and it will shine a light on Trian’s key question: how much cost can be cut out of DD?
  • We believe that there is more EBITDA upside at DuPont from cost control than from organic business growth. DD is missing a sizeable opportunity if it tries to grow the company into the cost base rather than address the cost issues today. With a focus on costs DD could earn as much as $7.00 per share by 2018 – Exhibit 1. This would support a valuation well above $90 per share today.
  • In our view, DuPont management cannot ignore the cost and the R&D productivity issue raised in research last week. The risk is that they do ignore these issues in 2015 and have another disappointing year as a result. If this is the case, then the stock could decline before it improves.
  • Chemours will struggle with organic earnings growth in our view because the TiO2 market looks very weak and unlikely to recover near-term. The company may have some offsets in the fluorochemical business with new refrigerant products but it is unlikely that “business as usual’ at Chemours will generate enough cash to cover obligations. We expect a dividend cut in the near future.
  • The bull story for Chemours is cost cutting, with the company already focused on headcount reductions, though so far very short of what we think is possible. We believe that Chemours can add 10-12% per annum to EBITDA growth for 3-5 years with an aggressive focus on costs.
  • If we assume that Chemours can cut 25% of its workforce over time, and assume that most of this falls to the bottom line, given the cost position of most of the products, then there is an EBITDA opportunity of $400-500 million.
  • Applying the same logic to residual DD, you could call for as much as $2.0-3.3 billion of cost opportunity (ex. Chemours), which is consistent with the numbers in Exhibit 1.

Exhibit 1

Source: Capital IQ, Company Reports, SSR Analysis

Analysis includes Chemours – Adjusting for Chemours, assuming a stock split and that the $4bn dividend is used to repurchase DD shares, we get an approximate DD EPS of $7.00 in 2018.

Overview

DuPont plans to spin off Chemours one month from now. Chemours will either be a success story or it will not. Sadly, neither outcome will be interpreted positively for DuPont and its current strategy, in our view. As we see it, Chemours management has been thrown what in rugby terms would be referred to as a “hospital pass” (where the ball is thrown to a player who is surrounded by large aggressive members of the opposition and consequently is likely to end up in hospital). Our rationale is laid out in the following bullets:

  • Cash flows are falling at the company as the TiO2 business remains weak and new fluorochemical products are not growing fast enough to provide the needed offset.
  • The company is being burdened with significant, high cost debt. This will add as much as $250-270 million of interest costs – at the parent’s average cost of debt this would be around $100 million lower.
  • The company is being asked to pay a dividend (at least for its first operating quarter) that it cannot afford.
  • Other costs, such as pension, are not insignificant.
  • There is still a capital spend program on-going to finish the Altamira TiO2 expansion, which will add TiO2 (albeit low cost) into a market that clearly does not needne it.

The math does not work; Chemours cannot afford to pay its bills and it is highly unlikely that the dividend will be maintained beyond the first quarter. There is no real visibility around a recovery in TiO2 and to borrow to maintain an artificially high dividend is not a sound business practice.

If Chemours management does nothing radical, then the dividend gets cut, the company has effectively zero free cash flow and is strategically hamstrung as a consequence. The stock will likely perform badly and DuPont will take the heat for making a bad deal.

More likely, Chemours management will take the most obvious strategic path offered, an aggressive focus on cost reduction. In our view the cost structure is way too high and is in part a function of the complexity and over confidence issues that we have highlighted recently. DuPont has simply not focused on an appropriate cost structure broadly and more within the more commodity businesses (like Chemours) specifically. Chemours could conservatively add as much as $50-75 million per annum to EBITDA through headcount reduction for the next 3-5 years. This will also reflect badly on DuPont as, like the Axalta story it, will highlight the bloated cost structure at the parent and the missed opportunity for DD holders.

We think that the second option is the more likely as the CEO designate of Chemours has been talking about cost issues and needing to reduce SG&A to sales meaningfully in recent roadshows.

It is highly unlikely that Chemours stock will remain in the hands of DuPont shareholders, particularly if the company cuts the dividend. As a result, the benefit of a better managed Chemours will not accrue to DuPont shareholders. While a few hundred million of EBITDA (the penalty of the higher interest cost and the cost cutting related gains) may be small in the grand scheme of DD’s EBITDA, as the saying goes “if you look after the pennies, the pounds will look after themselves”.

Valuing Chemours – Nothing Special

Chemours had around $1 billion of EBITDA in 2014, according to company filings, but this number has been cut for 2015 because of further weakness in TiO2 and currency and while the company has not given guidance for the year, it is likely that the number will come in the range of $850-875 million, barring any significant changes in pricing. While a reasonable multiple might be in the 8-9x range, investors will need to think about the impact of the very high interest charges, which will absorb as much as $250-270 million annually and consequently the lower end of the multiple range is probably hopeful. The lower end of the EBITDA range and the lower multiple gives an enterprise value of $6.8 billion, less debt of $4.0 billion gives an equity value of $2.8 billion.

At the upper end of the value scale you could get very excited about the dividend, if you believed that it was going to last more than 10 minutes. If Chemours were to pay out as much as $400 per year, even with a very high yield (7.5%) you could value the equity at $5.3 billion.

Again at the lower end, a 10x multiple of 2014 earnings leads to an equity value below $3.0 billion. Possible value ranges are shown in Exhibit 2. We do not believe that the market will value Chemours base on its dividend as the cash flows are obvious to all and the expectation is that it will be cut. It would be far better for Chemours to set an appropriate payout and then focus on dividend growth as cost cuts are realized –
see our recent research on dividend growth
.

Exhibit 2

Source: Company Reports, SSR Analysis

We think it is likely that investors will focus on the cash flows, the limited EBITDA and the very high demands on that EBITDA. We struggle with an equity value much above $3 billion, but this then emphasizes the value of the cost cutting opportunity. An increase in EBITDA by $100 million through cost reduction, would, if it were all retained, add $800 million of value on a $3.0 billion base – 27% upside. If, as we suggest above, Chemours could drive $50-75 million of EBITDA growth a year for the next 4-5 years, through cost reduction, investors could see 12-15% a year appreciation, absent any movement in the gross margin of the businesses themselves.

Chemours could be an interesting story, but whether it is and interesting stock depending on where it prices and how it performs initially.

Cost Opportunity – Lessons for DD

DuPont’s management is talking about cost cutting. The company has a program in place today to cut as much as $1.3bn of costs, but some of this is associated with costs leaving the company with the Chemours spin and so will not reside as benefit to residual DD holders. The company also expects the savings to be realized by the end of 2017. Trian suggested that $3-4 billion of costs could be taken out of DuPont and we have done some rudimentary analysis that gets us into the same ball park –
this has been published in prior research
.

While we did not get very granular in our work, we suggested that costs could be cut in R&D (
see our recent piece – Question 1
) in SG&A, and also at the cost of goods sold level given the large contribution to COGS of non-raw material and logistics costs at DD – Exhibits 3 and 4. While some of this is clearly the large R&D spend, there are likely other technical service and marketing programs that do not add value in the more commoditized businesses.

Exhibit 3 Exhibit 4

Source: Company Reports, SSR Analysis Source: Company Reports, SSR Analysis

If we look at the problem differently and simply focus on headcount, we can draw some additional conclusions. Chemours is looking at an initial 5-7% headcount cut and we think that there is scope at Chemours for as much as 25%. At the high end, a 25% headcount cut for DD (ex-Chemours), would be 13,500 employees – clearly a very large number and a stretch goal.

DuPont has a high cost base associated with being a big company – a high pension expense, IT, location etc. While it may be hard to get all of the savings, it is likely that the average DuPont employee costs more than the average Lyondell employee, for example. We have assumed a high and a low in the analysis, with the low at $150,000 per employee per annum and the high at $250,000. This gives us a range of possible savings from headcount reduction as summarized in Exhibits 5 and 6. At the high end, DD could save almost $3.4 billion through headcount reduction over a multi-year period. If these savings were realized, DD’s EBITDA would increase by roughly 73%. Even in less optimistic scenarios, the company would see EBITDA gains of at least 9%.

Exhibit 5

Source: Capital IQ, Company Reports, SSR Analysis

Exhibit 6

Source: Capital IQ, Company Reports, SSR Analysis

©2015, 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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