DuPont – The Case for $85 – But Why We May Need To Be Patient

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 13th, 2014

DuPont – The Case for $85 – But Why We May Need To Be Patient

  • In a recent meeting with DuPont management I was reassured that the focus is in the right places and there is the right level of intensity, both around the divestment of the performance chemicals business and around the delivery of real growth and real returns from the R&D initiatives. The question is; what is it worth?
  • Consensus estimates for 2015 suggest that the stock should be more highly priced than it is today, based on historic multiples relative to the market – as high as $85 per share. The stock continues to suggest a large degree of skepticism around whether the consensus view is correct, and as shown in Exhibit 1 skepticism has increased even as the stock has outperformed – i.e. the stock has not appreciated as much as improving expected earnings would support.
  • History would suggest that this skepticism is warranted, as on average for the last 13 years, DuPont has delivered earnings approximately 16% lower than the estimate two years prior. If we apply that hair-cut to current forward estimates we get a target price range which includes both current value and our view of “normal” relative value which today is $73 per share.
  • DuPont will need to start surprising to the upside if the stock is going to appreciate much further this year – something the company has only done twice on an annual basis since 2001. This will give investors confidence that 2015 estimates are achievable and on that basis a target in excess of $85 per share by year-end is reasonable.
  • For DuPont, this is where the rubber hits the road. If the R&D platform can produce the positive returns on full investment – R&D plus capital, plus any associate M&A – as the company suggests, we should see positive earnings surprises, or robust enough earnings to create confidence in 2015 estimates. We would use the return on capital trajectory as a guide and remain positive on the story.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

DuPont is putting up the numbers – or at least it is putting up the numbers where it matters, in the businesses which will remain after the spin/split of the performance chemicals business sometime next year. The remaining businesses have for the most part delivered good growth over the last three quarters, and as we have discussed in prior research overall return on capital is on an upward slope and high today, despite the weakness in the TiO2 market – Exhibit 2.

Exhibit 2

Source: Capital IQ, SSR Analysis

If consensus estimates are correct the combined DuPont will make close to $5.00 in earnings in 2015, up from around 3.30 in 2012.

However, the investment community has generally been unhappy with DuPont, and we would argue that, despite the run of the last 12 months, remain unhappy. They don’t like;

  • the new reporting practice of excluding pension costs,
  • and, the apparent lack of market awareness when the TiO2 business went south in 2012,
  • and they don’t like the complexity of the portfolio generally and the nutrition and biosciences businesses specifically
    • because for the most part they do not understand them

In our view, it is clear that they do not like the stock based on the price. While consensus estimates may stand close to $5.00 per share, the price of the stock would suggest that this estimate is unattainable. If we normalize the S&P earnings over many cycles – 40 years – and do the same for DuPont, DuPont has managed a premium to the market multiple of around 10% – Exhibit 3. Even if we take the trend rather than the average, the current relative multiple would be around 1.06.

The market is trading at around 17.75x 12 month forward earnings today (a slightly higher multiple if you use “normal” earnings). DuPont’s 12 month forward earnings are around $4.60 today, so without the historic premium and just using the market multiple you get a value above $80 per share and with the historic premium, north of $85 per share.

Exhibit 3

Source: Capital IQ, SSR Analysis

The most likely reason why the stock is still well short of this valuation range is that the investment community does not believe the consensus estimate. Historically that has probably been the right view to take, as looking forward 2 years consensus has been too bullish on DuPont much more frequently than it has been too bearish – Exhibit 4. The average overestimation has been 16% including all the years and 28% if you just take the negative years.

Exhibit 4

Source: Capital IQ, SSR Analysis

If we apply the smaller of the two haircuts to the 12 month forward consensus number of $4.60 we get $3.86 and on that basis the target would be much closer to where the stock is today – $68-73 per share. The top end of this range is also the value we generates using “normalized earnings” for both DD and the S&P500 and a normal relative valuation between the index and the stock.

Even as DuPont has outperformed the market over the last 16 month – i.e. played some catch up – its skepticism index has increased. While the stock has appreciated, it has not appreciated as much as its earnings revisions might support. In Exhibit 5 we show how the components of our skepticism index have moved for DuPont over the last 14 months.

Exhibit 5

Source: Capital IQ, SSR Analysis

DuPont Needs To Beat the Numbers – Consistently

The stock is fairly valued – or close to fair value – if you take history as a guide and expect an average haircut to 2015 estimates. DuPont experienced meaningful positive revisions over the last 13 years in only two years – 2010 and 2011. For DuPont to rise into the $85 to $90 per share range – whether as one company or as two (assuming the separation of performance chemicals) one of two things need to happen:

  • We wait and the company delivers on 2014 and 2015 estimates – on this basis we will probably see $85 by the second half of 2015
  • The company beats on expectations – consistently, such that 2014 and 2015 estimates move higher – in which case we could see the higher valuation this year.

So far we are not seeing positive revisions for 2014 – Exhibit 6 – but we are seeing some relative stability.

Exhibit 6

Source: Capital IQ, SSR Analysis

Without some upside surprises to earnings, which would give investors confidence that the consensus estimates are possible, or even beatable, the stock is not going to do very much.

We have seen Dow Chemical make some improvements in its earnings due to some cost initiatives over the last year. DuPont may have some similar levers, but in the near term has a cost headwind as the company incurs the expenses associated with separating the performance chemicals business.

©2014, 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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