DuPont – A Cost Initiative Could Be Substantial

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 2nd, 2014

DuPont – A Cost Initiative Could Be Substantial

  • DuPont is not an over-spender, when compared to other large cap Industrial and Material Companies, nor is it out of line with other large R&D spenders. However, we estimate that there is plenty of room for lower costs and would like to see DuPont target as much as $1.0bn of cost reduction over the next few years.
  • The Performance Chemicals (PC) spin should result in a one-time cost cut/headcount cut, which could be substantial. The PC business will want a cost structure competitive with peers and legacy DD will not want to bear any stranded costs either.
  • We would expect a onetime cost cutting program to be announced by the company this year and we would expect it to be a minimum of $250 million and possibly much higher. If you assumed that SG&A at DD is proportional to revenues (which it is likely not), you would need cut $400 million out of SG&A for the PC business to have the same SG&A/sales ratio as TROX.
  • We would like to see an on-going cost control program like we see at PX, with the company targeting an efficiency improvement each year both in corporate overheads and at the production/product management level. This would be the path to $1.0bn of cost reduction within a 3-4 year time frame. DD should follow the lead of PX and CAT – Exhibit 1
  • Given cost leadership in the Performance Chemicals businesses, we would not expect the company to give back too much of any costs gains to customers. Cost reductions at the higher costs producers would impact DD more significantly.
  • In the residual DuPont, further focus on “value in use” pricing rather than cost based pricing should also allow any cost reductions to be kept. Overall $1bn of retained cost cutting would generate $0.75 of earnings – $15 per share of value above our “normal” value of $74/share.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

In a recent presentation, DuPont CEO Ellen Kuhlman talked about an overhaul of management processes and ultimately costs. She indicated that this was a natural progression as the company thinks about its new structure, following a series of divestments and acquisitions and culminating in the expected spin of the Performance Chemicals business sometime next year. However, she did not put any sort of financial framework around the initiative indicating that the company would come back later in the year with estimated cost reductions. So what could it mean?

It is likely that all of the portfolio changes of the last decade leave the company with some stranded costs and also some structures/work practices that made more sense in the old DuPont than they do in the new DuPont. As the company works to eliminate stranded costs and set up a lean and appropriate management structure for the Performance Chemicals business it makes good sense to look at the residual DuPont through a similar lens.

We see two approaches – benchmark and innovate.

The benchmarking approach would be to look at how other companies – with business platforms approximating to the new DuPont – spend money at the corporate level but also at the production management level. In our view DuPont has two buckets of costs to go after – the most obvious is the SG&A pool – currently around $5.6bn, and the second would be encompassed in cost of goods sold around production and plant management and optimization. The likely problem here is that it could be hard to find appropriate companies to benchmark against. DuPont is not a traditional chemical company anymore.

Innovation is potentially harder, but possibly more lucrative. It would involve a blank sheet of paper and taking the approach of “how would we optimally manage this group of businesses if we were starting from scratch, taking into account the changes in information technology etc.” This approach is all about asking the right questions, such as:

  • What is the right level of data needed to manage a business/plant/R&D program on a day to day basis – and how do you get it and display it in the most efficient and cost effective manner?
  • How many layers of oversight do you really need if the data is readily available and presented in a form that is easy to understand?
  • How do you optimally interact with customers given changing technology and mobile communication?

The new tech companies operate very differently than even the old tech ones did – are there lessons to be learned. It is likely that companies like DD have pockets of this sort of progress already in terms of business and customer management and so may have internal models on a small scale.

DuPont’s SG&A is not wildly out of line for a company with a heavy R&D based strategy, but there are examples of R&D driven companies with lower percentages of SG&A as a % of sales. More importantly, there are a number of companies that show a declining trend in SG&A as a proportion of sales while DD does not. If we take a basket of better performers* over the last 15-18 years we get an average improvement in SG&A to sales of around 38 basis points per year, in some with most of the emphasis on raising revenue and not raising SG&A and in others with more of an emphasis on cutting SG&A costs. For DD this would equate to a cost reduction of roughly $130 million per year – 10 cents per share after tax.

(*IP, UTX, RKT, ECL, SNA, PX)

Benchmarking SG&A – Could DD Save $1bn? (Our Number, Not Theirs)

DuPont currently spends around $5.6bn on SG&A, so the question is whether the company could save 18%. This is not an unreasonable target, but it would set DD apart from others.

Higher R&D spenders are generally higher SG&A spenders and the chart in Exhibit 2 includes most of the larger cap names in the Industrials and materials group. DD is below the trend line with 66% R&D spend and 175% SG&A as a percent of normal earnings for 2013. If we look at Ag, Pharma and Tech, DD is not out of line either when we measure SG&A as a multiple of R&D – Exhibit 3. (See appendix for a list of constituents in Ex 3).

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Within each of these groups there are highs and lows – MON is slightly lower than DD within Ag, Roche well below DD and Intel well below all at 1.8x. If DD were to set a target of 2x R&D – it would have an SG&A target of $4.3 billion – a reduction of $1.3bn. This is likely the upper limit but would be a great achievement and would add around $1.0 per share to earnings of the existing DuPont.

We would expect changes to come in two ways – the first is likely to be a step change coincident with the Performance Chemicals spin. If DuPont is going through the separation process properly, there should be conversations going on along the lines of:

Performance Chemicals – “I don’t want/need all of that cost going forward”

Residual DuPont – “Neither do I”

If the company is really focused on avoiding “stranded costs” this should result in a significant headcount reduction announcement later in the year. It is impossible to judge how large at this point, but we would not be surprised to see as much as $250-350 million of costs targeted (possibly more) – probably biased initially towards Performance Chemicals. This could be a headcount reduction close to 1000 people across the company.

Second, we should expect to see a continuous improvement program, such as the one suggested in the overview. Examples of companies that have done this well are summarized in the next 4 exhibits. UTX is the only conglomerate with an improving trend. PX had 18,500 employees the year it was spun out of Union Carbide and $140,000 of sales per employee. Today the company has 27,000 employees, but $430,000 of sales per employee. DuPont and others have also seen meaningful improvements in revenue per employee, but PX has seen a greater rate of improvement and this helps drive the SG&A improvement.

Exhibit 4

Exhibit 5

 

Exhibit 6

Exhibit 7

Source: Capital IQ, SSR Analysis

Other Cost Opportunities

The more nebulous bucket of costs resides within cost of goods sold and revolves around how DD runs its day to day production and other operations. The company cannot do much about raw material purchases, except like everyone else find ways to use less raw materials and/or cheaper ones. However, the cost structure above raw materials can be addressed.

DD had cost of goods sold of $24 billion in 2013. Targeting only a 0.5-1.0% improvement a year (in absolute terms or relative to revenues) would also add meaningfully to earnings.

How Much Do You Keep?

Historically, companies have not kept what they have saved. Addressing costs is something that all competitors in all industries do either consistently or periodically and this lowers the cost curve and ultimately lowers pricing, so there is always some give back to the customers. Some companies use lower costs as a way to try to gain market share and this can result in giving much of the cost cut back quickly. However, in this case we would expect DuPont to keep most of what it cuts.

The Performance Chemicals business consists of products in a number of commodity markets – where all competitors are focused on costs all of the time. While the price for TiO2 is volatile, over time it has fallen relative to raw material costs as producers have lowered their costs of conversion. While DD has a sizeable cost advantage here, the company will lose margin if it does not keep pace with or stay ahead of the higher cost producers in terms of addressing costs. Here it is a little easier for DD to benchmark: Tronox has a SG&A to sales of roughly 10% versus the current DuPont average of 16%. As DD addresses costs here unilaterally we would not expect much to be given back to the customer – it is the cost action of those at the top of the curve that matters more.

The “new” DuPont is all about value added products, priced more on “value in use” than cost of production. As DuPont cuts costs in these businesses the company should be able to keep most of it. An exception would be where lower cost in a new product line or technology opens up a new market for the company, but here volume should outweigh any price decline.

Appendix

 

©2014, 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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