DuPont – Getting Appropriate Value for the Growth Engine
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
July 26th, 2013
DuPont – Getting Appropriate Value for the Growth Engine
- DuPont’s announcement that it is looking at options for its performance chemicals business is in our view a statement of belief above all else. It is confirmation that the company believes that the “science” engine at DuPont can drive a faster growing and higher return business with limited cyclicality.
- It is very hard to place a value on the future DuPont, as no-one else is looking at the integrated science around materials, nutrition and agriculture the same way. Consequently the stock will likely be valued on performance rather than comps – although Monsanto is relevant.
- We would expect to see some sort of spin or stock swap for the Chemicals business based on our belief that a low tax base will hinder a straight sale. However, there are a variety of avenues that DD can explore and it sounded on the call as if they are beginning the process.
- In our view the opportunity at the company is to expose the direction change in returns on capital, evident in the Exhibit below and at the same time remove much of the volatility around the trend. It is likely that any separation would lower the overall return on capital, but should show more pronounced acceleration in growth.
- We present an unsophisticated and very back of the envelope view of possible valuation, based on relative multiples and derive a possible $90 target. This assumes that the divestment/separation can be achieved with no tax consequences and that the residual business grows quickly.
Source: Capital IQ and SSR Analysis
We took the view some time ago
that, if DuPont really had the novel growth engine that it describes at the interface between bioscience and materials, the company would eventually proactively move to divest those businesses that could not benefit from the engine. That time appears to have come. To be clear, this is a very bold move by the company, as it really has the company putting its money where its mouth is. By exiting performance chemicals, it will lose a business that contributed more cash per dollar of sales than the other business and the return on capital of the residual portfolio will likely be lower than the return on capital today – at least initially.
What management wants to demonstrate is the value added nature of the rest of the portfolio and how it is being transformed by the science engine. This should be a high growth portfolio that quickly accelerates both earnings and returns on capital (reflecting higher returns on the heavy R&D spend). The challenges are many, not least of which is identifying and executing the most shareholder friendly exit strategy (or strategies) for the chemicals businesses. Our analysis would suggest that there is a low tax base in this business, making a straight sale unlikely as it would not maximize shareholder value.
Assuming that the separation can be achieved and that the exited businesses create a value that is x% of the whole today, the next challenge will be driving the rest of the business and demonstrating its success such that investors give it more than (100-x)% in terms of value. In our view the residual business will need; above market growth of earnings, lower than market volatility of those earnings and a continued positive trajectory to return on capital. Progress to date would suggest that these are all possible, but we would still encourage the company to develop some more informative metrics around R&D returns in order to increase investor confidence.
We are more confident about the 2 to 3 year horizon than we are the 6-12 month horizon for value creation as we think there is a risk that investors do not give the residual company the benefit of the doubt and wait to see progress in growth and returns. Much will depend on how much history the company recreates for the residual company to give investors a more complete basis for their analysis.
For comparison, we look at two companies that have seen significant market perception change over the last several years because of significant portfolio moves – Eastman and PPG. Eastman made many of its most important divestments many years ago – in the first half of the last decade – but the market waited to see how the company would perform and we only saw a break-away in valuation when we saw a break-out in earnings, outside the historic cyclical ranges, as demonstrated by a prolonged period of depressed relative multiples – Exhibit 2. PPG was given the benefit of the doubt much more quickly once it signaled that it was exiting commodity chemicals. PPG is yet to demonstrate the improvements in return on capital that we think are likely, but valuation has broken out already: DD will likely fall somewhere between these two extremes.
Source: Capital IQ and SSR Analysis
Our initial suggestion of potential value is based on a very simplistic approach and assumes that there are no tax consequences of the separation. So please treat it in the illustrative manner for which it was intended:
- Our normalized value for DD today is around $64 per share
- Today the company is trading at the market multiple, though historically it has been higher (see Exhibit 2).
- The chemicals business is around 20% of the company and all things being equal would likely trade at a relative multiple of around 0.9x (worst case – it would be compared to commodity names but has much higher base earnings).
- The residual would likely trade at a worst case 1.15x relative multiple (PPG is at 1.25 today) – best case would be 1.50 initially; unless the EPS growth rate accelerates quickly (MON has a 10 year average relative multiple of 1.75).
- At the low end you would have a proportional multiple of around 1.1 – generating 10% upside from normal value – target price $70-72.
- At the high end you would get a proportional multiple of 1.38 – 38% upside from normal value $85-90 per share.
The Divestment Challenges – Lessons from PPG
PPG had an interest in divesting its chlor-alkali business for many years and it had been the subject of questions with investors from the time we were introduced to the company more than 20 years ago. As the portfolio became more special and value added in nature, the question became more of a focus. PPG always faced two problems; the first being the simple mathematic fact that the earnings from the chlor-alkali businesses were being given a higher multiple because of their inclusion within PPG than they would get in a more commodity (cyclical) portfolio, suggesting that any divestment would be dilutive to PPG. This was made worse by the second issue; a relatively low tax base. Consequently the divestment had “value destruction” written all over it. While a spin out may have been able to mitigate some, if not all, of the tax issues, the dilution barrier was substantial as the market did not need another small cyclical commodity company and the probable comps were not highly valued. Patience paid off and the RMT deal with Georgia Gulf was the best exit for PPG as it dealt with the tax issue and avoided the creation of a small commodity player. Interestingly, had PPG known the positive impact the move would have on the multiple of the core business it might have acted differently and sooner.
DuPont likely has the same tax issue, and while it is possible, it would be surprising to see another chemical company, or a PE company, make a bid that made sense for DuPont, particularly for the TiO2 business, which is the largest piece. Some sort of split or spin may make more sense, but this purely speculation. However, as a stand-alone company it would not be small, and it would have sufficient cash flow and earnings to suggest a valuation that would likely not be that dilutive to current DuPont.
Unlike PPG, there is not yet a consensus view that the performance chemicals business is really holding the company back. If this was the case we would see the relative multiple expand and the divestment of the chemicals business would, on the surface, look more dilutive than it does today. It is perhaps better for DuPont that this is the case as any dilution from the divestment would be small and would draw less criticism.
The real challenge is then to position the residual business correctly from a business segmentation perspective and from a published data perspective to give investors an accurate view of what is driving both growth and returns. The more illustrative history that the company can compile around these metrics the better, even if some of the prior year return on capital or margin data don’t look too good.
The Materials Opportunity
While the new DuPont will have Agriculture and Nutrition as two of its pillars, we wanted to frame the materials opportunity in this report. The most obvious illustration, in our view, is captured in the Coke advertisement for Dasani water shown in Exhibit 3. The 30% from plants claim in the add refers to the mono ethylene glycol (MEG) component of a PET molecule – in this case we believe manufactured from sugar based ethanol sourced from Brazil. The cost of including this component in the process is not insignificant to Coke as the supply lines are very inefficient and keeping the product segregated from traditionally manufactured PET is also not cheap (we are probably talking tens of millions of dollars of additional costs). For Coke, the advertizing benefit is clearly seen to be worth it, and clearly their hope is that as demand rises from other users the supply lines will become more efficient and costs will fall.
Source: Google Images
The opportunity that DuPont sees is the ability to take its leading edge bioscience research into this area more broadly. What large food retailer or broad consumer products manufacturer would not want to be able to say that an increasing amount of content of its products was coming from renewable resources:
- Auto makers – replacing traditional engineering plastics and fibers
- Food Packagers – like Coke
- Consumer Products – Packaging and the chemical contents of the product itself
- Fuel – what can we do beyond ethanol?
- Electronics – improved recycling or lower carbon footprint in both manufacturing and disposal.
- Textile makers
Coke has shown that it is willing to pay (a lot) in order to wear the “renewable” label. Others are following suit, but they are limited today by the technology available and the costs versus fossil fuel based products.
DuPont is unique – as the company rightly states – no-one else is looking at the opportunity across agriculture, nutrition and materials in the same integrated way. However, they face many and varied challenges:
- Much of the original research in the materials area is being performed at Universities or in small venture start-ups. Part of DD’s approach has to involve understanding what is going on outside the company and either partnering with or acquiring key enabling technology as it is developed.
- Some of the “holy grail” chemistry does not really exist today in a form that has any real route to commercialization. A molecule with an oxygen component in it appears to be an order of magnitude easier to synthesize from a plant base than one without, and aromatic
- rings (important for PET, polycarbonates, styrene based polymers and many others) are proving to be a real challenge.
- Part of the opportunity is likely to be finding substitute molecules or polymers that do the same job, but that can be manufactured through a bioscience route. A lot of work has been done by others on polylactic acid (PLA) in the past, but the progress has stalled.
The most difficult part of the strategy, however, may not be contained in one of the bullets above. It is likely to be how best to monetize any technology advance to ensure maximum return on investment; something that DD will need to be very disciplined about if it is going to succeed and generate the value it hopes to create. It is unlikely that this is a “one size fits all” answer. Different routes will make most sense for different avenues of discovery and development. Some will require partnerships with companies who are better placed to exploit the technology, some will involve technology licensing as a route to the best return, and some will most appropriately be held in house and fully exploited for sole benefit of DuPont.
It was encouraging recently to see DuPont indicate that it is looking for a partner for its corn waste based refinery process. This is a process where DD is investing $200 million to build a facility in the US, but where it is now looking for a partner better placed to build capacity and market the output around the world. DD would like to take a minority stake and extract value essentially from the sales of the technology and the processing know-how. In our view this demonstrates the flexibility of thinking needed to extract maximum value.
If DuPont really has what it thinks it has in terms of technology opportunity, and can drive the business in a way that extracts the maximum value for DuPont (highest return for the minimal cash and capital outlay) this could be the most interesting stock in the Industrials space for the rest of this decade and beyond. But, it is a big “if”. There are no obvious comps for what would be a new DuPont – it would not be a chemical company, nor would it be only an Ag company. Companies like Monsanto and some of the better specialty chemicals companies trade at 25x earnings today, and Monsanto’s share price today is 10x what it was 10 years ago. We would suggest that at current value, the company does not have a lot of relative downside, but the upside could be substantial.
©2013, 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.