DuPont and Chemours – Strategically Challenged

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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

July 8th, 2015

DuPont and Chemours – Strategically Challenged

  • DuPont has underperformed the S&P500 by more than 15% year to date, adjusting for the CC spin, and is off almost $20 per share from the March peak when Trian looked like it might win the proxy. DuPont has also underperformed the chemical sector and all of its peers.
  • Chemours has declined more than 30% since it began “when issued” trading in mid-June. This has not been a good year for DuPont and in our view this is not the market; this is of the company’s own making.
  • There is value in DuPont, but we believe it is lost in a series of poor strategic decisions and a culture relying too much on internal reassurance and not enough on taking the occasional view over the parapet. Fighting with Trian was a mistake; separating Chemours might not have been a mistake, but spinning it off with a poisonous capital structure clearly was.
  • We think that the next mistake will come in Ag, where DD appears to be rooted in what could be outdated thinking and may miss a critical round of industry consolidation as a consequence. DD has a lot to offer in Ag consolidation – some good chemicals, some very good traditional seeds and the Pioneer sales and marketing engine.
  • Overwhelming all of this is too much unproductive R&D and structural costs that remain way too high. This high structural cost may be the only lifeline for CC as continued weakness in TiO2 could quickly put the company’s debt covenants at risk without aggressive cost reduction.
  • DD is a very attractive stock if you believe that some of the actions suggested by Trian are still possible, and on this basis we would stand by our $85 per share value (adjusted down from $90 because of the CC spin). Both DD and CC likely have further negative revisions to deal with this year and CC in particular could get a lot cheaper yet as a result.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

At the risk of beating a dead horse, or for the three people out there who do not know our position on DuPont, we are tackling the subject one more time and this time focusing on the strategic miss-steps the company is making. We believe that there is real value in DuPont and that the only thing standing in the way of unlocking that value is the leadership. We think there are five recent examples of poor management decisions at DuPont – all of which are probably caused by the same underlying problem – a lack of flexible thinking (or intransigence):

  • Misreading/miscommunicating the issues with TiO2 in 2012
  • The fight with Trian
  • The spin out of Chemours
    • The capital structure of Chemours
    • A spin versus a split
  • The continual unproductive spend on R&D
  • The lack of progress and huge expense in the seed portfolio

At the root of the problem, in our view, is an unwillingness to change a decision once made, perhaps because of some misplaced view that changing direction is a sign of weakness. The company should have settled with Trian early (as Dow did with Third Point) and got on with day to day business, rather than waste months and millions waging a campaign which distracted so many from their day job, including the CEO. As shown in Exhibit 2, APD and DOW have fared better since settling, though you have to adjust the DOW picture for the commodity collapse in late 2014, which coincided with the Third Point settlement.

Exhibit 2

Source: Capital IQ, SSR Analysis

The decision to separate Chemours was probably a good one, but market conditions changed so significantly during the process, that by refusing to change the debt and dividend “promises” DuPont has left Chemours management with almost no degrees of freedom. The company cannot afford the debt load or the dividend and in a continually weak TiO2 market is only one significant TiO2 price cut from possibly breaching its debt covenants, and perhaps setting DD up for more formal criticism.

See our recent piece on Ag Musical Chairs for our thoughts on where the Ag business might go. DuPont may have its head in the sand here – we hope that it does not – because a series of consolidation moves that exclude DuPont could weaken DuPont’s market position, despite the strong Pioneer franchise.

While, in recent interviews, the CEO has talked about the growth opportunity at the new “science based” DuPont, we remain very concerned that the growth (while clearly there) is not sufficient to cover the very high SG&A and R&D spend as well as the capital spend – i.e. the returns are not high enough.

The frustrating part about all of this is that DuPont could be both a great growth story and a great stock, and Trian’s Nelson Peltz was focused on the two primary things that matter; getting an appropriate return on R&D and capital spend and cutting costs. Current DuPont leadership is paying lip service to the cost issue, as the company has done in the past, and sees no problem with its R&D program.

While we like the potential at DuPont, we are becoming more concerned that the road to the finish line will contain twists and turns. We struggle to see anything but a poor Q2 and negative guidance, adjusted for the one time effect of the Chemours spin. We do not think the stock will work under current leadership. Chemours, by contrast, is in much worse shape and needs to go after cost reductions very quickly. The stock may not yet have found a bottom.

DuPont – Strategically Adrift?

“The Board is not holding management accountable for consistently poor operating performance and lacks the skills needed to make DuPont great again.” Trian

“The reason the company can’t hit its numbers is because of a very bloated, expensive, bureaucratic holding company that is choking the underlying business…We will be a positive agent of change. We’ll make DuPont great again.” Trian

Trian has been focused on what is best described in Exhibit 3 – chronic over promising and under-delivering. The chart would suggest that DuPont should screen aggressively in our “Optimism” work, but it does not because we measure negative annual surprises as a measure of optimism whereas DuPont generally pulls estimates down through negative guidance and then occasionally beats the lower number. But DuPont is clearly too optimistic or unrealistic about its businesses and this optimism drives overspending because the return expectation is higher than it should be. This appears in the R&D spend and in acquisition, with innovation not driving the anticipated growth and big moves like Danisco disappointing versus expectations.

Exhibit 3

Source: Capital IQ and SSR Analysis; includes Chemours (pre spin)

Optimism or overconfidence was clearly in the air when the decision was made to spin out Chemours. DuPont was optimistic that the TiO2 cycle would have turned by now and also optimistic that legacy DuPont business would be doing better. The Chemours capital structure should have evolved as the process evolved, but instead, DD stuck with the initial guidance, apparently more concerned with trying to make legacy DD look better against disappointing results rather than give CC a fighting chance.

DuPont’s sometimes hostile approach to outside opinion (as seen in the time consuming, costly and distracting battle with Trian) has us worried that group think, whether a large group or a small group, drives strategic decisions with very little attention paid to alternatives or risk. The result is the very disappointing operating performance of the last few years relative to expectations, and there is no real indication that the company plans to make any changes. While DuPont is talking about cost reduction, we think the company is scratching the surface and that the targets set out by Trian are more reasonable.

On the R&D/“Science” side of things we think investors are growing weary of the anecdotes; where Kevlar is finding greater use, what new seed or chemical is in the pipeline, progress on probiotics, etc. We need numbers – what is being invested and what returns are being generated. The revision trends in Exhibit 3 suggest that returns are woefully inadequate, regardless of the rhetoric.

DuPont’s recent underperformance has the stock slightly cheap on our normalized framework – Exhibit 4 – but not cheap enough to buy the stock based on value alone. The stock suddenly has a high skepticism index as a result of the underperformance – Exhibit 5 – suggesting a mismatch between value and return on capital. The flaw in the analysis and the reason not to get too excited is that the return on capital analysis captures forward earnings and so the recent points in Exhibit 6 are picking up 2016 estimates. Based on the revisions in Exhibit 3, it would be a brave investor to assume that 2016 estimates are robust.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

DuPont is fairly valued today without some changes in strategy and direction to better leverage R&D (or spend less) and to reduce costs. We think these changes will come because we think that investors will demand the changes. We are confident that DuPont could be worth 40% more than it is today with the right focus and the right strategy, but both are missing in our view today.

Chemours – Strategically Challenged

As we have gone through the last couple of years, leading up to the Chemours spin, one fundamental issue has taken the spotlight – the TiO2 business has shown no improvement, and has in fact deteriorated. We always believed that DuPont’s two year runway to the separation had less to do with the length of time needed to break out financials and more to do with hope that both legacy DD (mainly Ag) and CC businesses would have turned a corner by the time the spin took place.

TiO2 is getting worse not better caused by three coincident trends:

  1. Weaker global growth and weaker China growth; not helped by a dramatic slowdown in China of residential construction
  2. Continued capacity additions – with CC adding 200,000 tons next year (3% of the global market), in addition to more capacity in China, albeit at a slower pace than in the past
  3. Determined efforts on the part of TiO2 users, particularly in the paint space to use either substitutes for TiO2 of lower quality (lower cost) TiO2

Chemours has been impacted as much by the third point as by anything else, as when a customer adjusts formulation such that it can use the lower priced sulfate products (often from China), DuPont is faced with either losing the volume or making a significant price concession. We understand from customers that DuPont has probably seen more price compression in 2015 than others because of this issue. This is also something that is not going away, as it is likely that more sulfate substitution is possible. As the proportion of the market that has no choice but to use higher quality TiO2 shrinks, DuPont’s average price will fall relative to the market average.

Here is where DuPont has done Chemours the biggest disservice in our view. As the lowest cost producer for TiO2, Chemours should be unafraid of lower pricing and its inevitable consequence of weeding out the weaker players and operations around the world (Huntsman is closing a facility in France this year and there have been some smaller closures in China). For the TiO2 market to improve sooner rather than later, prices may need to fall again to shake out some more capacity – DuPont could afford this; Chemours cannot. By saddling the company with excessive and high priced debt (priced at a level which suggests a possible ratings agency downgrade – already!) and a huge initial dividend obligation, Chemours is fighting a battle, in which it should be dominant, but in which it currently has both hands tied behind its back.

The company will likely free one hand – at least partly – by cutting its dividend at its first opportunity, but is still very disadvantaged. Even after losing 30% of its value since it began trading, the stock still looks expensive to us (Exhibit 7) and the management team has to focus on what it can control to improve EBITDA and returns on capital. The only way to make this work, absent an unlikely near-term TiO2 recovery, is to go after the cost base aggressively – much more so than has already been suggested.

Exhibit 7

In Exhibit 7 we might be a little unfair on CC in one aspect as its dominant cost position in TiO2 should give the company a higher return on capital so using the industry average may be a penalty. Using current return on capital would push earnings above $1.00 and normal value slightly higher than where the stock trades today. However, we cannot ignore the capital structure, which is far from normal and should probably adjust

the multiple down to reflect the balance sheet condition and the risk of a dividend cut and a rating downgrade and possibly a covenant breach. While we believe that the likely dividend cut is priced in we still believe that guidance could be a surprise and could trigger a ratings agency review. We think there could be as much as another 20-25% downside in CC before it finds a floor.

©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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