Dow and DuPont – Neither Growth nor Cost Cutting Stories – Yet

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 27th, 2015

Dow and DuPont – Neither Growth nor Cost Cutting Stories – Yet

  • Despite the great PR engines at both companies, neither DOW nor DD is exhibiting either a cost focused strategy or a growth strategy – at least not yet. Activists are directed at this “neither fish nor fowl” problem and we share the view that neither company is set up to address both opportunities simultaneously.
  • The potential is easier to see at DOW than at DD because LYB is a great proxy for what commodity DOW could look like. LYB has less ethylene and derivative capacity in the North America than Dow, yet made more in 2014 in the US in this segment than DOW did globally.
  • Both companies talk about a growth/value added portfolio but both are spending more to develop and market that portfolio than they are seeing in value created. EBITDA per employee is very low in both cases, and much lower than pure play proxies – adding weight to the Trian argument that you probably cannot optimize such a complex portfolio as DD.
  • Many of the companies we screen as overly complex coincidently fall in out “optimist” bucket, suggesting that the complex portfolios are hard to manage in a consistent manner and under deliver as a result. The argument for “de-cluttering” both portfolios is very high.
  • Monsanto is the best example here – the path to focus took more than a decade and multiple divestments and acquisitions. Despite this, MON remains a complex company and the better stock performance was driven by very strong consistent earnings growth, something that neither DOW nor DD has achieved.
  • If the activists achieve REAL change of focus at either company there is upside in both – with the commodity cyclical risk still much higher at DOW than DD. Because of the cyclical risk we have a preference for DD today, and we summarize the work we did on costs in a prior piece of research (updated for 2014 data) in Exhibit 1

Exhibit 1


Source: Capital IQ, Company Reports, SSR Analysis

Overview

At SSR we shy away from writing up quarterly earnings – we do not want to be part of the tidal wave of post earnings write-ups and frankly we are not sure we would add any value 80% of the time. In this case we are not writing about quarterly earnings we are writing about attitude and opportunity. Dow and DuPont have a lot of similarities right now:

  • Activist shareholders, either trying to change a board of directors or having succeeded
    • CEO’s under a lot of pressure to deliver as a result
    • More of an influence on corporate positioning and communications than there should be today, particularly if it comes at the expense of running the business well and making smart longer-term decisions.
  • Large undervalued agriculture businesses (more undervalued for Dow than DD today)
  • They both talk about growth programs
  • They both talk about cost cutting
  • They are both divesting slow growth, cyclical, businesses – which we could argue might be better off either remaining within the portfolios or being part of a larger divestment.
  • They are both spending lots of money trying to reinvent themselves against a history of poor capital allocation decisions

The major difference that we can see is that Dow is probably paying more attention to the activist than DD. Instead DD appears to be spending a great deal of shareholder money fighting what looks like a political campaign to defeat a proxy opponent who, from where we sit, makes a lot of sense, has had great vision and great success with other companies, and who is not calling for a complete change of the management team.

In this piece we want to focus on what the businesses and strategies are, and are not, in our view.

They are not growth strategies (or at least not effective ones). Growth companies beat flat or rising estimates not declining ones – Exhibit 2. Having one or a few parts of your business growing while the overall does not, will not create the multiple expansion that accompanies real growth today. One way to address the growth and multiple issue is to divest the boat anchors – in both cases we think the divestment plans only go part way to solving the problem and that a more significant split would create much more shareholder value – here we side with some of the activist thinking.

Exhibit 2

Source: Capital IQ, SSR Analysis

Neither are they cost cutting strategies – if you want to see cost cutting at its best look at CAT, AA, APD (recently) or any US E&P company with its back to the wall today. In our view both companies are paying more lip service to cost cutting than real attention and here we side very clearly with the activists again. While the cost targets indicated might look large in absolute terms – anything with a billion in it will always attract attention – they remain low relative to the real opportunities in our view. We have written about what we believe is possible at both companies (
DD
and
DOW
) and in both cases it is a multiple of what has been targeted so far. We would also argue that both companies are selling/spinning business that they could possibly have fixed and made more efficient with the right strategy and the right approach to cost controls. While they might ultimately be the wrong fit for both, they could possibly be much “fitter” and more valuable divestment than they are today.

On the growth front, both companies continue to invest; in capital projects, M&A and R&D despite no clear indication that these endeavors have driven positive returns in the past or will do so in the future. Both companies appear in the guilty columns in our optimism work, which highlights a history of capital allocation with unrealistic return estimates. DD a couple of years ago talked about a metric that was being developed internally to correctly measure return on R&D investment – accounting for the R&D spent, the capital spent and the cannibalization that a new product might bring to other products. The company has gone very quiet on this initiative suggesting that either they were unable to do the math in a simple repeatable way, or they could, but did not like the results.

On a more positive note, the divestment might begin to address the other problem that plagues both companies, complexity. We look at it from a relative multiple perspective and show that the market is increasingly less interested in complex stories – Exhibit 3. Sadly for both companies, the planned divestments will not take them out of the “most complex quartile”, while the more significant splits suggested by the activists might.

Exhibit 3

Source: Capital IQ, SSR Analysis

However, neither company is particularly expensive (Exhibit 4) and while Dow is currently earnings slightly more than what we would calculate as normal, DD is earning slightly less than normal. In both cases you could take the view that you are not buying at a stretched valuation and you have the possible upside of the impact of a change of strategy along the lines that the activists are suggesting.

The risks however are not insignificant for both. For Dow it is the commodity cycle – given the ethylene cost advantage in the US we would have expected Dow to make much more money over the last couple of years than it has managed, suggesting that more margin compression would take earnings well below what we would consider “normal”. DuPont has a similar problem with TiO2, which would not matter if the company was not planning the spin of Chemours. Chemours needs to stand on its own from the middle of the year and the suggested cash demands look quite high relative to possible EBITDA if TiO2 remains where it is today.

Exhibit 4

Source: Capital IQ, SSR Analysis

On balance, we prefer DD, despite the fact that the activist impact at DOW is likely further along. We like the more limited volatility at DD since they divested the cyclical commodities and energy businesses which plagued performance in the 1990s. However, although Exhibit 5 does not show this lower volatility at DD since 2010, we go back to our view that DOW should have been making more money with the cyclical expansion of US ethylene margins over the last few years – and should have seen more of a cyclical upswing. We also think that the cost/focus opportunity at DD mat be greater than at DOW. DD is relatively less expensive (Exhibit 6) in our framework, but only marginally and not by a level that is statistically significant.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Cost Opportunities – It’s a lot about Facing Up To Reality

If we take and very simple view (more simple than either company would think fair) and assume there are only two business models; commodity and Ag, we have LYB as a proxy for a commodity business and MON as a proxy for an Ag business. While these are probably best in class these days – they are still the benchmarks.

In Exhibit 7 we show 2014 EBITDA per employee for DD, DOW, MON and LYB. DOW and DD are underperforming their proxies significantly and if you assume that they are not in their commodity and Ag segments you end up (by difference) with very low levels of EBITDA per employee in the rest of the businesses – well below what a comparable specialty company would have. Any way you look at it, both DOW and DD have too many people.

Exhibit 7

Source: Capital IQ, SSR Analysis

We would argue that there is very little in the DOW portfolio that should not be run as low cost commodity business, with much more emphasis on how to run the business more leanly than on how to try and upgrade the portfolio through incremental R&D. In almost every business line there are products on the margin that are adding significant value to the commoditized starting point:

  • There are some grades of polyethylene and elastomers that have high value and associated high pricing, but most of the portfolio competes head to head with many others
  • There are some niche markets in polyurethanes, epoxies and acrylics, but the company has talked frequently about the low margin nature of the base materials, and competitors around the world are showing minimal margins.

These portfolios are too big to think that you can upgrade enough to make a difference and the boundaries become confusing – what is and is not a value added business – what should have R&D and tech service reports and what should be made in as generic a form as is possible, for the lowest cost possible and sold in the biggest bucket possible (or even better – biggest pipeline).

For both DOW and DD the non-commodity (or soon to be commodity) platforms are Ag plus something; for DOW that something is small, for DD it is larger. In the Exhibit 7 below we show an analysis of what the Dow Commodity business could look like, assuming that only Ag and what used to be called Electronic and Functional materials are not in this category. This update has required some interpretation from us for 2014, given that Dow has again changed its reporting structure in 2014.

Exhibit 8

Source: Capital IQ, Company Reports, SSR Analysis

Even though Dow has closed the gap a little in 2014, the company could be leaving as much as $2bn of EBITDA on the table in the more commodity business – which is around $1.20 per share of earnings.

Dow has the added upside of an undervalued Ag business – at least within the Dow portfolio. In Exhibit 8 we compare the four major Ag businesses from a revenue growth and margin perspective. The DOW business has the lowest margins but it does have the highest growth and even though we would not expect the business to be valued at the current MON EV/EBITDA multiple of around 14x, it should be worth more than the current DOW multiple of 9.5x. The risk, or course for Dow is that the business ex Ag may see a lower multiple. Investors would only see upside if DOW sold Ag and went after the cost base in the rest of the portfolio.

Exhibit 9
Source: Capital IQ, SSR Analysis

It makes more sense for DOW to sell its Ag business today than DD as when we do a sum of the parts analysis for DD today we get a value lower that the current value. The performance chemicals business is probably best compared to HUN, though the better margin in DD’s TiO2 business would probably justify a multiple premium to HUN. Taking all of these valuation proxies we come up with a simplistic break-up value as shown in Exhibit 10. With generous multiple assumptions we arrive at a value that is barely higher than the current value and well within the error margin of the analysis. Break-up does not get you there, it is all about costs.

Exhibit 10

Both Continue to Under-Earn on Their Capital – Better Decisions are Discussed by Both, but Are They Real?

DuPont’s return on capital trend looks better than Dow’s but surprisingly is the more volatile longer-term. Both have seen much lower volatility in the last 5 years, but as indicated above we would have expected Dow to be much more volatile on the upside since 2011 given the base chemical feedstock advantage in North America – Exhibit 11

Exhibit 11

Source: Capital IQ, SSR Analysis

But plenty of capital has been wasted as shown in Exhibits 12 and 13 and it can be argued that the improvements for both in 2014 are in part a function of the share price appreciation, in part as a function of the activist involvement. In past research we have compared these charts with companies like PX and PPG, both of which have been much better stewards of capital.

Exhibit 12

Source: Capital IQ, SSR Analysis

 

Exhibit 13

Source: Capital IQ, SSR Analysis

Neither Looks Good On Our Proprietary Matrix Framework

©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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