Chemical Catalysts – Why Are Activists Interested and What Are the Challenges/Opportunities

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 30th, 2014

Chemical Catalysts – Why Are Activists Interested and What Are the Challenges/Opportunities?

  • Several large cap Chemical companies (notably DD, APD and most recently DOW) have all come under activist interest in the past few months.
  • The activists appear to have picked the right targets, and the issues are several.
  • DOW and DD are hampered by the complexity of their business portfolios.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Several large cap Chemical companies have become the focus of activist interest in the past few months – DuPont, Air Product, and, most recently, Dow Chemical.

Third Point was not sufficiently convinced by Dow’s announced plan to spin or sell its chlorine business and would like to see the company split its specialty and commodity businesses. Pershing Square announced its stake in Air Products in late July – the leadership change that they sought is partially underway but there are significant (perhaps immutable) obstacles to the goal of mirroring returns and growth at peer rival Praxair. DuPont’s resident activist, Trian, has less well articulated objectives, while DuPont itself is looking to spin out its TiO2 business and continue on an “integrated science” path with the remaining units.

There are clearly reasons why these companies have been targeted by these activist investors. Exhibits 2-4 show APD, DOW and DD trail their industry peers across a variety of metrics.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Complexity

This is an issue that is particularly relevant for Dow and DuPont.
In prior research
our analysis showed that highly complex companies (from both a geographic and business segment perspective) have been chronic underperformers – we reproduce a chart from that piece in Exhibit 5. DOW and DD are among the most complex companies, not only within the Chemicals space, but within all Industrials and Materials (the two most complex companies in our view).

Not only do these highly complex companies habitually underperform, they have steadily become more and more unloved. Exhibit 5 shows the consistently declining multiples afforded to companies with high complexity. Over this time frame investors have clearly shifted their favor towards the straightforward stories, affording the more simple companies a higher premium – Exhibit 6.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

To this end, the separation/split/spin ideas floated by the companies themselves and their respective activist investors could unlock gains by virtue of greater business clarity. Our view is that a prospective DD TiO2 split, while significant, might not be enough – the story here remains complex. Dow’s chlorine exit seems a poor fix. We see this as doing little to address the larger issue of complexity, and indeed, the end result may be an even more convoluted arrangement.

Cost Cutting

All three companies have high costs relative to their approximate peers, in multiple areas.

Charts?

R&D

R&D is of particular concern for Dow and DuPont. Both spend heavily on R&D, and while a strong case can be made for this to continue in their Ag businesses, based on growth and returns, spending elsewhere has a very poor return. This of course is not an issue that is unique to DOW and DD – if R&D was effective in the Chemical space the best fit line in Exhibit 7 would slope in the other direction.

Exhibit 7

Source: Capital IQ and SSR Analysis

DuPont, at least, is perhaps beginning to see the results of its high R&D expenditures. While DuPont’s return on capital history interestingly shows greater volatility than Dow’s, a 10-12 year recovering uptrend is evident at DD – Exhibit 8. The same cannot be said for DOW – Exhibit 9.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

What Is The Right Model?

In Dow’s case, we do not believe that a Value Added Brand Management strategy and a Lean Cost Driven Commodity Driven strategy can exist optimally under one roof, and current returns support our skepticism.

For DuPont today, the question is does the company have the right management/structure to run an innovation rich, brand driven, “value in use” strategy. The share price would indicate the answer is no.

Separately, if, like APD, the bulk of your growth comes from reinvestment of free cash flow in new capital spending, you had better be very good at managing the design and construction process. There is likelier an easier fix here than what is needed at DOW and DD, but performance confirms that APD is struggling to compete with PX, ARG, Linde and Air Liquide as it lags these competitors in the project management and cost arena.

The Mistakes

All three companies have made the mistake of fighting or denying commoditization, and continue to do so.

Lack of Consistent Strategic Direction

The recent history of initiatives at the targeted companies shows a string of entries and exits, with conflicting and often confusing focuses.
DOW – Shale Breeze

While its commodity chemical peers have seen great leaps in profitability in the wake of the “shale gale”, Dow has barely felt a breeze. In fact, its ROC has actually declined slightly – Exhibit _. To some extent the company is benefitting from a margin and cash flow standpoint (within the Performance Materials segment) but there is obviously an offset elsewhere.

Exhibit

Source: Capital IQ and SSR Analysis

All in all, we are not convinced that a break-up of DOW today yields any additional value without aggressive cost cutting. While separation would still be a component of our ideal plan for the company, we believe there is a better path than the one suggested by Third Point. We expect this to be a battle between activist and target – the rhetoric bandied about could drive the stock incrementally high, but we would not chase it here and would be taking profits at this point.

DD – Positive

The current DuPont is beset by the complexity of its businesses. Investors remain skeptical about the company’s current strategy, particularly how the material and agriculture units belong together – overall DD simply struggles to articulate a strategy that investors understand. The company’s claim that it will take 18 months to spin out the Chemicals business is further cause for skepticism – we ourselves would like to see this done sooner. We have previously suggested that the stock can move above $80 per share (perhaps as high as $90) post-execution, and with good growth prospects in the legacy business. We also suspect that the TiO2 divestment is not the only deal being considered, and think it likely that DuPont is looking at acquisitions in the Ag and Nutrition sectors.

APD – On the Fence (For Now)

Air Products must face the practical reality that it cannot become rival Praxair. This is no longer an opportunity as the assets have been built and acquisitions have been made. But APD can see upside by refocusing and reworking the business model from multiple angles, adopting best practices from competitors and driving returns up. We view the leadership change as key to unlocking this upside, and a new CEO will need to be willing to make meaningful changes to bring costs and capital allocation decisions under more focus. That being said, the stock today looks fairly valued, and could just as easily trade down with the wrong CEO appointment as it could trade up with the right one. It is important to stress that the Air Products story is not about a break up; rather, it is about making a good company in a great business better.

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