DuPont – The Uncomplicated Story and The What If?

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@ssrllc.com

January 25th, 2013

DuPont – The Uncomplicated Story and The What If?

 

  • Today, it is not perhaps necessary to understand the inner workings of DuPont to recognize the opportunity in the stock. Sometimes, we would argue the complexity of the story can get in the way of a more simple, but compelling valuation view.
  • DuPont is statistically cheap and no heroic assumptions are needed to spot the entry point that we see today. Miss-steps in the past have created similar dips in absolute and relative value and each time the stock has recovered well.
  • DuPont is not a particularly volatile stock and so large price gains are unlikely. A recovery from its current valuation low is probably worth 15-25% and you get paid a healthy dividend to wait.
  • Forward estimates are currently around $3.80; this compares to normal (mid-cycle) earnings of $3.60/share. Our valuation framework suggests a normal value of $58. Should internal or external factors push stronger earnings then the stock price could be expected to move to $70(one standard deviation above normal value)
  • This 64,000 foot view is quite compelling; however, if you move to 20,000 feet you could get quite excited and generate much higher values. Get into the weeds and there is always a risk that you get confused and/or distracted by the noise.
  • We present an argument that DD is most of the way through a portfolio transformation that would make the company look more like Eastman from a return on capital and growth perspective, and less like Dow Chemical. However, the next step in the process would need to be a big one.

Exhibit 1

Source: Capital IQ and SSR Analysis

Detail

DuPont is a large, multi product, multi market and multi technology company that has changed its spots quite considerably over time, sometimes dramatically (the Conoco acquisition and subsequent divestment and the Pioneer HiBred acquisition, would be good examples) and always evolutionary through the introduction of innovative products. It is complicated and product by product history is a poor guide mainly because the portfolio has evolved considerably and in some cases radically.

Throughout its history, however, a couple of constants – or near constants – remain.

  • Return on capital, which has a long-term mild negative slope to it and averages around 10%. Exhibit 2
  • Volatility around the trend or the average return on capital has been very high and remains high, suggesting that a large part of the business has a cyclical marketplace.
  • Anomalies in valuation around a trend line have been frequent and correct quickly. Exhibit 1

These have been true despite any number of portfolio changes any number of new high value add products introduced and a number of products commoditizing.

Exhibit 2

Source: Company Reports, Capital IQ and SSR Analysis

Looking only at factors like these it is fairly evident that the stock is attractively valued today and that some simple reversion to mean move is not only likely, but likely to happen quickly, as it has done in the past. Earnings expectations for this year reflect the high end of “normal” earnings we would expect from DuPont, despite negative revisions over the last few months as the margins and volumes for TiO2 have been dialed back.

With mid-cycle earnings in the $3.50-3.60 per share range and a consistent historic relative multiple of about 1.05x the S&P500 multiple, we arrive at a value in the high $50s per share – 20% from here, but the stock also has a very good dividend yield and ample cash flows to cover the dividend.

But, we could put on some slightly more rosy spectacles and get more excited. DuPont began a strategy in the late 1990s of exiting businesses that did not meet its growth and return goals. Examining the company’s return on capital chart more closely (Exhibit 2), an optimist would spot a point of inflection at around that time, from a very negative trend to a more positive trend – albeit just as volatile, which we will come back to.

Very few commodity/cyclical companies have managed to change the direction of their return on capital trend over the last 40 years, and they have either been in industries that have consolidated dramatically, following years of truly appalling returns (Rail, Paper, for example) or companies where an aggressive divestment strategy has taken place. You cannot acquire your way to a better business if you continue to own the pieces that drag down your growth or maintain your volatility.

The best example we can find of a business transformation that has worked in this way is Eastman Chemical. We do not have as much history as we have for DD, but if you look at the return on capital trend in Exhibit 3, there is a clear period of decline followed by an impressive recovery.

Exhibit 3

Source: Company Reports, Capital IQ and SSR Analysis

One significant difference between the two today appears to be volatility – and this perhaps explains the more obvious difference, which is in stock performance over the last few years – Exhibit 4. EMN has had a tremendous run and, while part of that has been a long string of positive earnings surprises, most of it is the belief that EMN’s portfolio now looks like it has much lower volatility and higher growth.

Exhibit 4

Source: Capital IQ and SSR Analysis

A Half Baked or Half Executed Plan?

Comparing the two companies, DuPont lags on growth and on volatility. DD spends 50-60% of net income on R&D, while EMN spends 25-30%. Both companies spend a little more than D&A on capital expenditures. On this basis you would expect DD to drive proportionally more new business from innovation and new capacity than EMN. If this is a true statement, DD is really held back by its legacy cyclical businesses – the ones that the company has so far chosen not to divest.

DuPont has done a lot to remove the more commoditized/volatile businesses from the portfolio, as well as those where it did not see enough growth potential. Since 2001, it has sold:

  • Performance Coatings
  • Fluoroproducts and specialty catalysts
  • Numerous more commodity Ag Chems
  • Protective Coatings
  • Polyester
  • Invista (Nylon)
  • Polyethylene Film
  • Pharma

Today, the volatility (and it is significant) sits mainly in the performance chemicals business, so the big question here is TiO2. The negative for DD is that despite its volatility, this segment has a higher average return on capital than the overall portfolio, a higher average operating margin and much higher free cash flow – so it is a source of funding. Given the nature of the business, it is going to be very difficult, if not impossible to exit in an earnings accretive manner should the company want to explore this option. However, that does not necessarily mean that it is the wrong thing to do.

©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.

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