Chemicals: Complexity Hitting Home – But Volatile Distraction is the Focus
In recent research we have discussed the problems of a too complex portfolio, in detail with regard to the difficulties investors have in understanding and valuing a complex story and in passing about the management challenge of trying to drive different (business appropriate strategies) on the same platform. We have noted the underperformance of the more complex companies in our Industrial and Materials coverage – as highlighted in the chart.
An added problem of complexity, even if investors get it and even if you can manage it, is that valuation is almost always driven by the lowest “quality” business in the mix and not the highest. Quality here does not mean good or bad, from an investor perspective it means growth, returns on capital and volatility. DuPont has recognized that, while profitable and a good generator of free cash, its performance chemicals business (20-25% of the portfolio) is a major distraction from the underlying and future story at the company. The volatility of the business obscures what is otherwise an interesting and developing stable growth story emerging from the bioscience research platform. See our research on this subject.
Today, Dow Chemical is talking about “options” for the more volatile and less value added parts of its portfolio. It is the same issue – if these businesses are not part of the “integrated and low cost” focus that the company has adopted, they will inevitably distract from it. Consequently, in our view Dow is taking the right approach – the key question is how much of the portfolio is in this category and how best do you execute any separation.
To be clear, there is nothing wrong with a cyclical, commodity based, business. It has a place in the market and it has a pool of natural buyers, some of which are value driven investment funds and some of which are private equity companies. What DuPont and Dow are addressing is the disproportional drag effect that these businesses can have on a better overall story.
Both DOW and DD trade below what we would consider to be fair relative value – DD more so than DOW – but both are in that group of relatively cheap large cap industrial companies with broad exposure to global economic growth and facing declining expectations for that growth. Both will benefit this year from lower costs (DOW has a more aggressive cost reduction program and more exposure to cheap US natural gas), new product introduction (DD more than DOW) and very good agricultural businesses. Both have risk of negative revisions for the second half of the year, but we are not sure that this will be a big influence.