Dow vs. DuPont – Dawn Of Real Values!

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 30th, 2015

Dow vs. DuPont – Dawn Of Real Values!

  • Dow Chemical and DuPont both have meaningful upside if refocused management pull the right levers and really focus on shareholder value.
    • Recommendations complicated by possible timing of events and likely management fortitude. DuPont likely offers more potential value, but Dow’s path to success looks easier.
    • We would own both but see more ways to win with Dow more quickly today.
  • The greatest short-term benefit that would accrue to both companies is a merger of their Ag businesses, incorporating an aggressive cost cutting initiative.
    • If managed correctly this might lead to a $60-65 billion enterprise value for the combined Ag business – or ~50% of current combined level for the two companies.
    • Individual Ag deals (but not with each other) could also unlock value, just not as much.
  • Greatest longer term benefit could be created from a complete merger of the two companies, ultimately leading to a three way split – Ag, Specialty Chemicals and Commodity Chemicals.
  • The Current oil/gas pricing environment is more favorable to Dow, supporting near term earnings.
    • Any declines in oil relative to natural gas would however be detrimental to Dow.
    • Continued strength of the US dollar will be less impactful to DD vs DOW.
  • Valuation measures predicated on normal earnings power currently favor DuPont but its intransigence to aggressive cost cutting, poor R&D returns, and lack of strategic focus are headwinds to this being realized.
    • The Chemours spin-off is a further concern for DuPont.
  • Risks to both stories are M&A, as both companies have a history of poorly timed and value destructive acquisitions – we believe that new management focus at both companies reduces this risk.
    •  DOW’s divestment strategies suggest a much greater focus on value creation.

Exhibit 1

Overview

While both companies have destroyed significant shareholder value over the last 20 years through poorly timed or value destructive acquisitions as well as R&D spending that has under-delivered, both have seen significant shareholder pressure over the last 18 months and management/strategy change is apparent. Perhaps now we can judge the companies on value and opportunities rather than being distracted by the risks of potential value destruction. So, if we assume shareholder friendly strategies from both, which would you rather own? Exhibit 2 gives a qualitative view of some of the issues and where we think investors would rather be positioned to exploit or protect against each.

Exhibit 2

Dow is over-earning versus trend, but this makes sense given the US base chemical feedstock advantage – the question is whether the company is over-earning enough. DuPont is under-earnings versus trend, despite some US feedstock benefit. Both companies face headwinds and slower growth in their Ag businesses. Dow is discounting some improvements and success in valuation today; DuPont’ share price, while off its recent lows, reflects the below trend earnings and suggests not much belief that things can get better. The valuation discount between the two companies is very close to an extreme and shows more confidence in Dow than DuPont. Our skepticism work shows no disconnect in value – Dow is over-earning but valuation reflects it; DuPont under-earning and this is also reflected in value.

If you had a blank sheet of paper and the benefit of looking at best in class proxies, such as LYB and MON, you would quickly conclude that both companies have far too many employees. DuPont more so than Dow in our view. Given recent changes and recent announcements we would assume that DuPont is going after the cost opportunity more aggressively than Dow. Our fear here is that DuPont goes down the break-up path too quickly and that the cost opportunity accrues to the buyers or the break-up companies rather than DuPont shareholders today.

Dow has by far the greater fundamental/investment tailwind in our view, with the Sadara investment likely to pay off within a year and all of the new capacity coming on in the US Gulf. Neither will look as good if crude prices continue to weaken and/or US Natural gas prices start to rally, but an oil/natural gas scenario that penalizes Dow (and others building in the US) looks like a less likely event at this point. If Dow could combine these investments with a more “best in class” commodity margin mindset on the non-manufacturing cost side of the equation, the benefits could be much higher.

Both companies have divested “boat anchor” businesses this year with Dow executing by far the better deal and DuPont at risk from the Chemours exit given the precarious position of Chemours today. The other strategic issue that both have to face today is what to do with their respective Agriculture businesses. We believe that they should do something together. While this is likely to create more upside for Dow than DuPont on day one, we have refreshed our analysis here and believe that we had previously underestimated the opportunity by only looking at potential synergies, ignoring already high cost structures. A combined business, well run and with the right cost focus could have a $65bn enterprise value – 85% of DOW’s current EV and approximately DD’s current EV.

Dow’s future looks brighter today than it has for some time, and simply keeping a steady hand on the tiller should be good enough for Dow to deliver, all things being equal on the energy front.

The DuPont path is much less clear, but the stock is less expensive on an historic “normalized” view. That said, the interim CEO said all the right things on the conference call and suggested that both costs and break-up would be in the cross hairs – the right focus at DuPont could generate huge upside.

A more radical option is for DuPont is to close ranks with Dow more imaginatively than just in Ag. The possible combination and then perhaps appropriate separation into three companies (Ag, commodity and specialty) could drive a great deal of value, particularly if combined with a real cost focus.

In our recent research on DD we arrived at a value range for the stock of $65 to $91 based on the effectiveness of the cost cutting alone, without any benefit of a clever Ag deal. For Dow, the cost cutting is not as great an opportunity as for DD, but the Ag deal could be significant; just the cost opportunity gets us to a “normal” value of $60 per share – the Ag deal could add another $6-8 per share.

With several issues at play here we analyze each one separately below.

 

Agricultural Chemicals – The Near-Term Major Value Opportunity

We have grossly underestimated the Ag opportunity between DOW and DD in our prior work as we have only focused on possible synergies and not of right sizing the individual footprints in line with “best” or “better” in class proxies. We have concluded in pages of prior research that both DOW and DD have too high cost bases today and that one of the major opportunities for both companies is on the cost front. The individual Ag businesses suffer from inflated costs just as the broader companies do and we see as great an opportunity in getting to an appropriate cost structure as we do from dragging synergies out of a combination.

In Exhibit 3, we show COGS, R&D and SG&A to sales ratios for DD Ag, DOW Ag, MON and Syngenta (we have had to make some estimates for DD and DOW, but both companies give enough data such that we think we are on the right track). If we use MON as a proxy for DD and Syngenta as a proxy for DOW, we get the cost opportunities outlined in Exhibit 4 and we have then taken a stab at synergies of a combined business to arrive at what we think the combined EBITDA potential might be – arriving at a number north of $6bn.

Exhibit 3

Source: Company Presentations, Capital IQ, SSR Analysis

Exhibit 4

Source: Company Presentations, Capital IQ, SSR Analysis

If we assume a merger as the right path for these businesses, based on operating income or EBITDA we would give DOW around 25% of the venture and DuPont 75%, though the shares could change with debt allocation. With the potential of more than $6.5bn of EBITDA, and using MON’s multiple as a guide we can generate an enterprise value in excess of $65bn – $16bn for Dow and $49bn for DuPont, so very value-added for both companies, much more so for DOW given current earnings multiples.

As a reminder, this analysis differs from what we have done in the past because we have looked at the absolute level of costs in each stand-alone business today and assumed that these can be improved before the addition of any synergies from the combination.

The charts below (Exhibits 5 through 8) summarize the business mix of a combined Ag business and show why the fit is good and probably better than either company could achieve with others.

 

Exhibit 5 Exhibit 6

Source: Company Presentations, SSR Analysis Source: Company Presentations, SSR Analysis

Exhibit 7 Exhibit 8

 

Source: Company Presentations, SSR Analysis Source: Company Presentations, SSR Analysis

But Maybe The Biggest Deal Is The Best

Contained within Dow and DuPont are potentially three very large and very interesting companies – as discussed above, an Ag Chemicals business; a commodity company and a specialty company. While there could and should be some debate about which pieces fit in the last two portfolios, our best guess is shown in Exhibit 9. The history of both companies should tell both management teams that the right answer is to put any business you are not sure about in the commodity bucket, because if you are not sure, that is where they are headed!

In Exhibit 10 we look at the recent performance of each of the larger segments and in Exhibit 11 we summarize the revenues of what we think each of the “three new companies” could be. As we think about the commodity piece, it would be larger than Lyondell and could probably be run more profitably than Lyondell with the right focus – LYB has a current enterprise value of $46bn – the Dow/DD piece would be 8% larger on revenues and we assume a 10% premium for a DOW/DD business run well, because of asset quality and integration – so $54bn.

The Specialty business is a little harder to benchmark, but we can probably put some boundaries around it – with PPG as a reasonable low end and Ecolab a reasonable top end. Based on revenues we would have 142% of PPG and 155% of ECL – $44.5bn at the low end and $65bn at the top end.

This gives an enterprise value (including $65bn for Ag) range of $163.5bn at the low end and $184bn at the top end. The current EV of Dow + DuPont is $138bn. The low end of the potential is 18% upside and the top end is 33%, without thinking about the cost opportunity too aggressively at the specialty company.

It is unclear how a deal like this would work – probably DD buys DOW in an all stock deal as a starting point – and while both sets of shareholders would likely benefit – DOW is the more obvious way to play it.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Cost Opportunities Are Large At Both – But More Important for DD

Both Dow and DuPont have headcount numbers that could probably be reduced by 15-20% – this is roughly 8-10,000 employees for DOW and a similar number for DuPont (Ex-Chemours). There are clearly longer term objectives, but they should be objectives none the less. For too long both companies have tried to grow into their cost base and it has not worked. In the meantime, their more focused competitors have taken out costs in an attempt to compete with better technology and generally better assets at DOW and DD and have closed the gap. Great examples are in TiO2 (now in Chemours) and polyethylene, where companies like LYB run similar businesses to Dow with half the employees – Exhibit 12.

Both companies are first quartile when it comes to engineering and manufacturing excellence and the asset base is generally excellent. The cost issues are mostly headcount, with likely too many levels of management and too many people trying to “up-sell” what are essentially commodity products through R&D and technical service and marketing.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Company Presentations, Capital IQ, SSR Analysis

DOW More Levered to the US Gas Advantage

DuPont buys ethane, natural gas and power in the US to the tune of around $0.9bn – Exhibit 14 – and clearly the US cost advantage has been a benefit over the last few years, given that most of this purchase is in the US. However, DuPont’s exposure is dwarfed by Dow, with its ethylene exposure and manufacturing density in the US Gulf and Alberta – Dow spends close to a billion dollars a year in North America on ethane alone at current prices. The US gas benefit is part of the reason why Dow has not seen the same degree of negative revisions this year as DuPont, but only part, given that both have extensive non US exposure and have both been exposed to weaker non US demand and exchange rate based headwinds.

Clearly Dow is the bigger earnings winner if oil prices rise relative because it will not only help the economics in the US but also help the economics in Sadara as it will raise global pricing. Dow is adding propylene and ethylene capacity in the US in the 2016-2018 period and while we are less convinced that the propylene units will make an adequate return, the ethylene investment should do well, even at the current oil and natural gas price; and very well if oil rises.

Exhibit 14

Source: Company Presentations, SSR Analysis

We Are Where We Are Because of Value Destruction (Beware a Large Non-Ag Deal)

If you add up how much DOW and DD have spent (invested) versus how much value they have returned to shareholders over the last 15 years, you can understand why both companies have been the focus of activist shareholders – Exhibit 15. Whether bad timing (DOW) or bad execution (DD) or just too expensive – acquisitions have not helped either company. Divestments have been mixed, although what Dow has done recently has been impressive, but it is evident that stranded costs have built up and added to an overall inflated cost base at both companies.

Exhibit 15

Source: Capital IQ, SSR Analysis

Current valuation favors DD, which is driven by the company’s sub-trend earnings. DOW is reflecting some of its recent improvements, and looks historically expensive relative to DD. The valuation divergence between the two companies is near an all-time extreme – Exhibit 16.

Exhibit 16

Source: Capital IQ, SSR Analysis

On our skepticism work we see no major disconnect in valuation. Dow is over-earning but valuation reflects it; DuPont under-earnings and this is also reflected in value. The most

recent peak in Exhibit 17 was the benefit of the doubt given to DD through the Trian battle and subsequent loss of value.

Exhibit 17

Source: Capital IQ, SSR Analysis

Over the last year and a half we have seen DOW embrace change – perhaps most or at least partly suggested by more involved shareholders, while DD chose to fight change (personified by Trian). Based on current valuation and the fate of senior management, fighting was not the right path. DOW has spent 18 months focused on value creation and change and DD has spent the last 18 months taking its eye off the business ball. Valuation reflects the chosen path today, but does give DD some benefit of the doubt that things will now change. In an environment of weaker global demand and a strengthening dollar, DOW’s actions have provided an offset. DD has had no offsets and consequently its revisions look terrible relative to DOW – Exhibit 18. It is our view that DOW would have had revisions that would have more closely resembled DD had it not been for the self-help exercises of the last 18 months. So the question is whether DuPont is worse or simply behind!

Exhibit 18

Source: Capital IQ, SSR Analysis

©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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