DowDuPont Trough Earnings – Risk/Reward Stacked to the Upside

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 2, 2016

DowDuPont Trough Earnings – Risk/Reward Stacked to the Upside

  • The tepid early market reaction to the DOW/DD merger news is likely a function of a number of factors, one of which is the macro environment and how low earnings could go
    • On a pro-forma basis the company had 2015 recurring/clean earnings of $2.60 per share
    • Pre-synergies, and other cost actions, using 2015 as a base, we believe that an appropriate trough/worst case number for the pro-forma entity is $1.21 per share, throwing in everything that could go wrong – polyethylene being the largest driver
  • Using Dow’s history as a proxy, we would expect a trough multiple of around 30-35x trough earnings, generating a value of $36-42 per current Dow share and $46-54 per current DD share
    • $1.21 per share would be less than 50% of current “normal”
    • Dow has traded at a multiple range of 25-45x earnings when they have been more than 50% below normal
  • Pro-Forma earnings for 2015 have to be adjusted to reflect the Dow/Olin deal and the annualized benefits of other Dow M&A moves as well as 2015 DD cost cuts
    • This adds around 10 cents per pro-forma share
  • DD cost cutting, DOW cost cutting, synergies and new Dow investments, including the combination with Dow Corning, add meaningfully to a pro-forma trough
    • Cost cutting and deal synergies will likely reduce structural costs by as much as $5.0bn – $1.20 per share
    • New Dow investments are suggested by Dow to add as much as $2bn in EBITDA – if we haircut by 40% and tax adjust we get another $0.35 per share
    • Dow Corning could be as much as another $0.25 per share
  • Adjusted net “trough” earnings then becomes $3.13 per pro-forma share – with a low-end trough multiple we generate $62.50 per DOW share and $80.25 per DD share

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

While the rumor of the Dow-DuPont merger caused significant upside for both stocks, since the announcement the underperformance has been significant, down 12% in absolute terms and 9% relative to the S&P500. Until the last week, the pair had not only underperformed the market, but also the sector and proxies in the base chemical group and agriculture group. While some of the recent rally may have been driven by clarity around management transition at Dow, some has also been due to better results (especially from Dow) and more clarity on cost cutting.

The underperformance is largely driven by concerns about the macro and the markets in which the companies operate as well as how long we might have to wait for the transformation. In this piece we focus on the macro and try and put some boundaries around how low earnings could go if the wheels fell off every wagon. We look at three buckets of potential further disappointments: agriculture, polyethylene and China. We base our analysis on reported recurring 2015 numbers and generate a trough estimate from that base for the pro-forma entity before all of the cost and other growth initiatives that the companies have discussed.

  • Polyethylene: This is the big one, as the pro-forma DowDuPont will have around 8 pounds of polyethylene per share and today global margins are as much as 15 cents per pound above normal and 10 cents above normal when you adjust for the current oil/natural gas spread

    • Note that exposure and risk for LYB and WLK is much higher than it is for DowDuPont
  • Agriculture: This is already a weak market in an industry down-cycle but we look at historic margin swings and generate some possible additional downside
  • China: Both companies sell into China and both are exposed to some degree to products that China has overbuilt and where we see a change in global market structure and lower margins – this is a less significant risk than the other two in our view since DD divested TiO2 and Dow divested chlor-alkali

    • This is a bigger risk for WLK because of its PVC business, and possible even larger with the addition of the Axiall business

Both companies have seen some serious earnings collapses in past cycles as illustrated in Exhibit 2. For Dow a one standard deviation move in earnings is around 50%, while for DuPont it is around 30%. For the combined entity we are assuming that we can simply average the two. Consequently, a 50-60% decline in earnings (1.5 standard deviations) is the right way to think about a normal cyclical trough, and a worst case – 2009 for Dow and several times for DD – would be an 80% decline.

Exhibit 2


Source: Capital IQ and SSR Analysis

When we look at the businesses in the light of the three risks identified above, we come up with trough pro-forma earnings of $1.21 per share, using 2015 as a base and including none of the current DD cost cutting or synergies or Dow investments, etc. If we simply look at our “normalized” models and aggregate normal earnings for Dow and DuPont, adjusting for the share count change at DuPont implied in the merger, we arrive at $2.75 per share. The normalized work on trough earnings suggests $1.10-1.35 per share, so we are in the same ballpark coming from the top and the bottom.

We estimate that there is as much as $2.00 per pro-forma share of cost cutting and new earnings to add back to this – generating around $3.10 of adjusted pro-forma trough earnings.

Using Dow as a proxy we have a long-term history of earnings multiples at different points in the cycle – Exhibit 3. We think it would be very reasonable to put a 20x multiple on this pro-forma trough EPS number – again this generates $62.50 per share for the pro-forma DowDuPont, and Dow today, $80.25 for DuPont today.

Exhibit 3

Source: Capital IQ and SSR Analysis

Trough Earnings Analysis

Polyethylene

Polyethylene is the largest commodity risk for DowDuPont as it is the one commodity market where there is still significant margin, despite the collapse in oil prices. In recent work we looked at the possible risks in polyethylene, which are much greater for LYB and WLK, though mostly priced into the stocks (though not reflected in earnings estimates).

We expect polyethylene margins globally to fall by 10 cents per pound in 2016 versus 2015, given the market balance and the current oil and natural gas markets. As we think about “trough” earnings for DowDuPont we should probably be a bit more negative than this – especially given where margins are today relative to history – Exhibit 4. If we lost 15 cents of margin we would be back to an historic average rather than an historic low. With 8 pounds of polyethylene per share at pro-forma DowDuPont, and assuming 90% operating rates the company would lose $2.5 billion of EBITDA versus 2015 – roughly 80 cents per share after tax.

Exhibit 4

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Source: Capital IQ, IHS, and SSR Analysis

Agriculture

The combined ag business of Dow and DuPont show pro-forma operating EBITDA margins consistently above 20% since 2001 (the earliest date of consistent data). The sharp drop in margins in 2015 came as the top line declined 11%. Even assuming a further 10% revenue drop in 2016, the historical regression equation (R2 = 91%) implies a 16% EBITDA decline – $450 million in absolute terms, implying a margin of 20.6%.

If we get even more negative and assume a 15% top line decline for ’16, this equates to a $650 million EBITDA hit and margins just below 20%.

Taking the worst case of $650 million of lost EBITDA and assuming a 27% tax rate we reduce our 2015 pro-forma earnings by 20 cents per share.

Exhibit 5

Source: Capital IQ, Company Reports, and SSR Analysis

Assumptions around China and Currency

Whether the slowdown in China is driving currency or simply driving demand and pricing, it has been highlighted as a problem by almost everyone and as we think about possible trough earnings for the combined entity we should add the possible impact of further weakness, whether it presents as weaker demand or weaker currencies. Both companies have highlighted potential currency headwinds for 2016 and we have chosen to assume the worst case for each as our low estimate, which cuts around 24 cents of earnings on a pro-forma basis.

Back to the Relative versus the Absolute

While we think that the Dow/DuPont deal offers real upside in any number of economic scenarios. We are convinced that it offers the greatest protection in the worst scenarios – as the companies have so many earnings levers to pull that are simply not available to others in the sector. If you have a “doomsday” scenario in mind the more obvious hedged position is long Dow/DuPont and short Lyondell. If Westlake can win its bid for Axiall, Westlake also adds earnings levers and is already discounting more of trouble in 2016 than Lyondell – see recent research.

©2016, 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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