DuPont Can Be A Bad Stock: If Trian is Right, But Gives Up

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Graham Copley / Nick Lipinski

203.901.1629 / 203.989.0412

gcopley@/nlipinski@ssrllc.com

October 2nd, 2014

DuPont Can Be A Bad Stock: If Trian is Right, But Gives Up

  • Trian’s focus on breaking up DuPont is, in our view, more driven by creating platforms that can run with lower costs than the expectation of higher immediate break-up value. We do not see much of a sum of the parts premium today without some heroic growth assumptions.
  • In earlier work on DD we concluded that a fair price was probably in the low 70s; the stock remains cheap on our Normalized framework but does have a high Skepticism Index suggesting that investors do not have faith in forward estimates. Negative revisions are likely if costs rise ahead of the Performance Chemicals spin and if Ag falls short of expectations.
  • DD’s discussed cost reductions of $1 billion, are likely to be a fraction of what could be achieved with the right focus. In our view, as much as $2.40 per share (net) out of DD’s current cost base could be achieved over a three year period, with the right focus and with the right corporate structures. It is going to be difficult for the company to generate growth in its current form that would create as much shareholder value, and impossible to persuade investors today that it could be so.
    • This will likely be the core of Trian’s attack, and is likely to be backed by more data than DuPont’s defense of the status quo – unless DuPont has very good R&D productivity data that is it willing to share.
  • If DD can grow earnings by 8% per annum over the next 3 years, while taking $2.40 per share of costs out of the company, we get a 2017 EPS of 7.66 per share assuming no buy-back. Applying the current multiple to 2017 estimated earnings generates a share price of $100 per share. This assumes no better value for the company in pieces rather than as a whole.
  • To get to the doubling of value suggested by Trian you would need to assume that the overall multiple would increase to reflect the faster growth and simpler structure.
  • DuPont could still change the debate by making a strategic move in Ag, which we have discussed in the recent past.

Exhibit 1


Source: Capital IQ, Corporate Reports and SSR Analysis

Overview

For investors to lose money in DuPont from here (particularly on a relative basis) two things need to happen. First, Trian needs to lose – i.e. not win over shareholders, not win a proxy fight and not drive any change. Second, Trian’s current criticisms of the company need to be largely correct. If Trian is wrong and if DuPont can, as it suggests, generate above industry average growth and improving margins through its greater innovation led business model, then investors will win whether Trian gains support or not. The overall value of the company will expand whether or not it is broken up, but probably more so if the same level of growth can be achieved with a more efficient cost base.

If Trian is right about the growth prospects, the high costs and the overall structure of the company, and if corporate goals fall short, then the only way investors win from here is if DuPont is broken up and run more efficiently. Continuous negative revisions will sap investor confidence, but equally important, overestimation at the company level will likely lead to a misallocation of capital (both capital spending and R&D investment) and progressively lower returns on capital.

Simply looking at the two main issues – growth and costs – suggests to us that the course suggested by Trian might be the right one.

Growth vs Cost: DuPont is delivering good growth in the business segments that it plans to retain – post the performance chemicals spin – with the exception of the recent slowdown in the Ag business. However is it enough growth to justify the significant expense? For the last 12 months DuPont has spent $7.7billion dollars on R&D and SG&A – 22% of sales. This is almost $6 per share on a net basis, and the key question is whether DuPont can generate more shareholder value over the next 3-4 years by the growth it drives from this investment/high cost structure, or by reducing costs by as much as half this number. If a different focus at DD could take $3.0 billion out of costs ($2.40 per share, net) within 3 years, the “do nothing” scenario needs to generate around 13% annual EPS growth to achieve the same earnings in 2017, assuming no growth in net income in the cost cutting scenario. The growth story needs to look even better when you take into account the likelihood that the business would still show earnings growth in a lower cost environment and what DuPont could do with the additional cash flow. Assuming DD could net a cumulative $4.5 billion of additional cash over a 3-4 year period, and assuming an $80 share price, the company could buy back roughly 5% of the outstanding shares.

A lower cost, focused portfolio, approach could create enough shareholder return in the next 3 to 4 year period such that the current DuPont, untouched, would need to grow earnings as much as 20% per annum to generate the same shareholder return. This is highly unlikely. More importantly, it is almost impossible for DuPont to assert such possible performance and receive any benefit of the doubt ahead of time.

DuPont has talked about the power of its R&D platform and process and the exciting opportunities at the interface of bio-based science, agriculture, nutrition and materials. This broad focus is causing the company to spend extensively on R&D and product development and customer problem solving. It sounds great, but only IS great if it can generate a return on investment that enhances DD’s shareholder return. There is no real evidence of this to date and given the cost and focus alternative outlined above, it is highly unlikely that DuPont can make this work within a time frame that matters – if they could it would likely be working and evident already but it is not.

There are very few pharmaceutical companies that make an acceptable return on R&D and none has been able to do so on a sustained basis. Furthermore, the market appears to penalize industrial companies for high R&D spending – it expects a positive return on R&D spend from the drug companies and nothing from Industrial and Material companies.

Our view is that Trian is mostly focused on costs, but recognizes that the cost issue probably cannot be addressed without a more simplified corporate structure and business mix.

Near-term, DuPont is likely to struggle with 2H 2014 earnings because of continued weakness in the agriculture space and this weakness is likely to be picked up on by Trian as support for its proposal.

DuPont has three broad options in our view:

  1. Ignore the questions and advice from Trian
    1. If the company can show very strong earnings growth from its core portfolio quickly and start to publish some very strong R&D return data, it should prevail – shareholders do OK
    2. If not, it is likely going to be a fight and probably an ugly one unless Trian can get significant shareholder support quickly. Shareholders eventually do OK as long as Trian gets support and does not give up.
  2. Distract Trian by doing a large scale Ag deal – we think the obvious deal is with DOW – combining businesses and spinning out a portion. Shareholders do OK but probably not as well as in 1.a or 3.
  3. Proactively work with Trian to achieve a version of Trian’s plan – Shareholders do OK.

Costs are High and Rising

Running large companies and broad product lines is all about leveraging costs – high incremental margins expanding returns as the cost leverage plays out. Our best, but probably easiest example of this in the chemical space is Praxair – Exhibit 2, where we show PX’s SG&A to sales ratio since the company was spun out of Union Carbide. During that period the company has seen revenues grow by almost 5x, while SG&A costs have risen by 3.2x. If we look at DuPont, we need to look at both SG&A and R&D (R&D is small for PX), and we get a different picture – Exhibit 3.

Exhibit 2


Source: Capital IQ and SSR Analysis

Exhibit 3


Source: Capital IQ and SSR Analysis

SG&A to sales for DuPont has barely moved from 2003 levels despite the fact that sales are up 30% over the period. SG&A has increased lock-step with sales. However, more significant is the recent major change is in R&D spending which has gone from just under 5% of sales in 2003 to 6% in 2013, while sales have risen 30%. Even in periods of healthy growth, cost discipline is lacking.

It is almost impossible to find good comps for DD on the R&D side, we have addressed the broad issue of R&D returns in the past , and will update this shortly in a separate piece. While we also try to find good proxies for DD on the SG&A side we can perhaps look at CAT (Exhibit 4), which has done a very good job of focusing on all aspects of costs in recent years, both before and after the Global Financial Crisis and before and after the Bucyrus acquisition. CAT’s trend line is down and today SG&A to sales would be around 13% if sales were at more normal levels in the mining sector. For DD to get to a 13% ratio it would need to cut $1bn from SG&A and while the current cost cutting plan does target that number, it is targeting more than the SG&A line.

Exhibit 4


Source: Capital IQ and SSR Analysis

As we think about cost cutting, and as we created reasonable targets by business for Exhibit 1 we assumed that half of the cost cutting opportunity was at the SG&A level and the other half on cost of goods sold and R&D. If we use HUN as a proxy for Performance Chemicals – SG&A to sales of just below 10% – it is not much of a stretch to assume that $250-300 million of SG&A costs can be reduced here at DD, given that this business is, in part, the focus of the announced cost reduction plan. We have assumed that $600 million of costs can be taken out of this business. This is equivalent to around 9% of revenues.

While Ag and Nutrition is a much bigger business, we do not see as large an opportunity here in SG&A, but a larger opportunity in R&D and other costs. Overall we are assuming an $850 million cost reduction – around 5.5% of revenues.

The bigger absolute opportunities in our view come in the rest of the business and in the corporate overhead line – more than $1 billion in the residual business and a further $500 million in corporate.

We would break this down – See Exhibit 1:

  • $1.5-1.75 billion SG&A
  • $0.25-0.75 billion R&D
  • $1.0-1.5 billion cost of goods sold/other

Break-Up Value – More about Managing Costs than Break-up.

We believe that Trian’s focus on breaking up DuPont is more of a means to an end, which is an overall set of businesses with a lower cost base. A break-up analysis of DD today does not yield much of a premium, given that the stock today is trading at 15.1x forward earnings. The current best in class large cap specialty chemical company today in our view is PPG with a 17.3 forward multiple, but with an earnings chart that is very impressive – Exhibit 5. DuPont ex Ag and ex Performance Chemicals does not deserve this sort of multiple, but perhaps a 5% discount to PPG – taking a generous approach.

Exhibit 5


Source: Capital IQ and SSR Analysis

Monsanto is trading at 18.5x 2015 estimates. DuPont has seen higher revenue growth in Ag than Monsanto in recent years – Exhibit 6, but has much lower returns. It would be hard to argue for the same multiple as MON unless returns can be improved – perhaps through cost cutting. It is also assumed that growth will

slow at DD once Rynaxypyr comes off patent. We are assuming a 10% multiple discount to MON, which may be generous.

As we have suggested in prior research, the Ag business may be worth more if it is combined with another companies Ag business and partly spun out – we have used Dow as an illustrative partner. The combined business has strong growth but low margins – pointing to high cost issues raised in critiques of both companies.

Exhibit 6


Source: Capital IQ and SSR Analysis

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 7. 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 7


Source: Capital IQ and SSR Analysis

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