DuPont – Real Upside if New Management Brings Real Change

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 10th, 2015

DuPont – Has the Third Envelope Gone Back in the Drawer? We Hope Not!

  • It is hard to like anything in the Industrials and Materials space given the macro impact of a slower China and only modest US economic growth – see recent China work
    • DuPont stands out because it could be another Air Products – driven by fresh leadership, a new perspective and an appropriate focus on cost control
    • We got a taste of what that could look like from a valuation perspective earlier this year when it appeared as if Trian would succeed and the stock began to anticipate what could be
  • In past research we have talked in detail about the high cost base at DuPont and the earnings opportunity (as much as $3 per share) from running the businesses more efficiently
    • Often, DD’s technology edge has placed it (complacently) at the bottom of the cost curve –others have been forced to play catchup while DD has not focused on keeping its lead strong – TiO2 was a good example
  • The high R&D spend is not creating a shield to economic volatility, it is not creating growth and it is not muting earnings volatility – neither is the M&A activity – so what is the point?
    • The multiple expansion which followed Trian’s entry into the stock was indicative of what investors think DuPont could be – leaner, more focused and more valuable
    • The earnings revisions that we see today are not simply a function of the Chemours split but are driven by lost confidence and the impact is compounded by a lower relative multiple
  • The opportunity remains significant, but so do the risks – DD remains convinced that its broad strategy is correct and is only really paying lip service to the cost opportunity
    • The aggressive response to Trian suggests a “defensive” acquisition might happen
    • Separately – there is a scenario (albeit unlikely) where DD is forced to buy back Chemours – this would be expensive and dilutive, but less dilutive at current valuation
  • We are broadly negative on the Chemical sector because of the risks associated with weaker global demand, a stronger dollar and commodity oversupply
    • Many of the DD risks are more discounted at current values, suggesting an attractive entry point, if, as we do, you believe that change is coming

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

In the old and well known joke, an outgoing CEO gives an incoming CEO three sealed envelopes labeled 1, 2 and 3. He tells his successor to open them in order, one for each time he gets in trouble. To cut it short, the messages in the envelopes read:

  1. Blame your predecessor
  2. Blame the economy
  3. Get three envelopes…

We had assumed that DuPont management would have no choice but to open envelope 3 following the debacle surrounding the Chemours spin off and the earnings and stock performance of the last several months. We had assumed that a fresh advance from Trian might be fairly immediately successful and that the board might concede that it was time for a fresh look.

However, with all that is going on globally, we think there is a risk that the third envelope goes back in the draw and the second one comes back out again!

To be fair, the Industrials and Materials sector in general is very heavily levered to the strength or weakness of the global economy and macro events are largely hard to predict and hard to hedge for when you run a diverse international portfolio of businesses. Some degree of diversification can help, but generally when there is a macro negative swing, it is hard to stay completely clear.

However; and this is why we think it is time for the third envelope; companies with successful R&D programs should deliver relatively better results in weaker macro environments than others, as the R&D should drive innovation based growth regardless of the broader economic malaise. This is not the case at DuPont, and it has not been the case for many years. DuPont is seeing as much if not more negative earnings revisions than others in the space and when adjusted for R&D, things look fairly bleak. Exhibit 2

Exhibit 2

Source: Capital IQ, SSR Analysis

Whether it is the very poor decision made with regard to the Chemours separation, or the lack of R&D productivity, or the unwillingness to attack the very high cost base (the primary focus of Trian), it is clear to many that it is time for a change. We believe that the potential at DuPont is huge, but only with the right strategy and the right focus; including some hard decisions that need to be made around the cost base.

We remain positive on the stock only because we believe that this change will come. However, if shareholders are content with the “it’s the economy” excuse one more time, we and they will likely be disappointed. There is also the risk that the company makes another strategic acquisition, given its cash and relatively under levered balance sheet.

Horrible performance and horrible expectations

Since its high in March – coincident with the peak in expectations that Trian would win at least one board seat – DuPont has been the 8th worst stock in our (130 stock ) Industrials and Materials universe (Exhibit 3), surrounded by companies with terrible commodity exposure and or very specific problems. DuPont management was unwilling to credit Trian with any influence in the stock’s performance to its peak, so therefore must take full credit for the retreat since March. The S&P500 is down 6% since March 13th.

Exhibit 3

Source: Capital IQ, SSR Analysis

Estimates have fallen significantly. Over the course of 2015 estimates for DuPont for 2017 have fallen by 32%. The separation of Chemours would have brought down estimates by around 20% at the high end, but the value of the $4.0 billion dividend from CC to DD – if applied to share count reduction – should be an offset of at least 5%, so, ex the CC spin, DD has seen a decline in 2017 estimates of 15-20% over the course of 2015. This is a loss of confidence in the productivity of the R&D engine as analysts are putting a lower and lower value on likely future business growth. The consensus estimate for 2016 is now lower than our “normal” earnings estimate.

Exhibit 4

Source: Capital IQ, SSR Analysis

Getting nothing for all the spending

DuPont only looks cheap in our “normal” model – Exhibit 5 – because we chose to give the company the benefit of the doubt with its return on capital trajectory back in 2012 to reflect the R&D initiative and the commodity business exits in the 1998 to 2007 period – Exhibit 6 (the dotted line). However, the linear trend does look quite compelling and perhaps we are being too generous. Our current model creates a fair value for DD of around $58 per share. Reverting to the linear trend would suggest a fair value of $52.5 per share.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

The concerning takeaways are twofold:

  • The portfolio repositioning and R&D initiatives are not improving returns – as shown above
  • And, the repositioning and R&D is not making the company less cyclical, perhaps a little from an earnings perspective but not at all from a stock price perspective

Exhibit 7 shows that DD is no less cyclical than peers – peers that have much more commodity bias to their portfolios and peers that are spending far less money trying to “change.”

Exhibit 7

Source: Capital IQ, SSR Analysis

Volatility drives multiple as much as growth – investors pay for certainty and they are not getting it with DD. The rise in valuation associated with Trian’s involvement was all about an expectation that DuPont would start focusing on other drivers of earnings growth such as cost reduction.

This cost focus at Air Products, for example, has transformed the valuation of the company relative to its peer Praxair. The company has more earnings growth drivers than PX because of the cost opportunity and is expected to outgrow PX (which has a lean cost base already) for years, hence the valuation premium.

Exhibit 8

Source: Capital IQ, SSR Analysis

This opportunity exists at DuPont also.

Risks

The risk is DuPont management’s apparent absolute determination to close their ears and eyes and continue down the same path that has destroyed shareholder value year after year. While the stock looks about as interesting as it gets in the large cap industrials and materials space when looked at through the lens of focus and cost realignment, investors could be disappointed by another expensive and dilutive acquisition, like Danisco. This could take the stock lower as there is little confidence that DD can create value from a large acquisition based on its track record.

Separately, there is a risk of “fraudulent conveyance” associated with the Chemours spin. Chemours could default if it cannot cut costs faster than its TiO2 pricing is falling and its environmental liabilities escalate. Taking Chemours back would be costly and dilutive for DuPont, but less dilutive with the stock sub $50 per share than where it was when the spin took place.

 

©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.

Print Friendly