DWDP – Dead Horse, Meet Whip!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 2nd, 2018

DWDP – Dead Horse, Meet Whip!

  • We feel like we are flogging a horse that is looking increasingly dead when we talk about DWDP today, and with close to 28 years of doing this you would think we would know a dead horse when we see one.
    • The stock just goes down – good industry news – goes down – bad industry news – down!
  • We have, in the past, blamed the street for apathy with respect to earnings estimates, as, while every other major chemical company in the world has seen positive revisions since September 17 – most of which have been beaten in Q1 2018 so far – no revisions for DWDP!
  • But if we believe the working thesis behind our very powerful “optimism” analysis, the blame here lies much more with DWDP management who have effectively been radio silent on expectations – except for a very confusing guidance comment in January.
    • The sell side follows guidance – and the guidance here has been very poor.
  • It is understandable that there would be some confusion with respect to earnings, given likely charges, changes in tax rates, and possibly more important, changes in depreciation rules and how DWDP will treat amortization of goodwill before the splits.
    • BUT, EBITDA should grow and should grow well in 2018, because of the better business environment, Dow’s capital investments AND synergies.
    • DWDP should blow through EBITDA estimates that are largely unchanged from the day the merger took place – Exhibit 1.
  • DWDP’s EBITDA estimate for Q1 is $4.8bn and if the company cannot do significantly better, is might be time to ask questions about why the merger made sense.
    • Separately, investors are likely to remain nervous if significant cash flow growth is not met with a plan to return more of that cash to them. Both Dow and DuPont had terrible acquisition track records and none of the SpinCos needs a war chest.
  • The stock is attractively valued – close to its 52-week low – but others in the sector are also cheap and DWDP management needs to disclose a lot more this quarter to look different.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

The chemicals sector and the broader Industrials and Materials sectors are clearly out of favor in 2018. As we have written in recent work – the earnings and revenue momentum is very strong – estimates are being beaten at a higher rate than normal – recommendations are moving more incrementally positive and the stocks are still selling off.

In such situations one tends to turn to the special situations – the stories that have more to them than simply industry fundamentals and the broader macro/investment environment. In the Chemical space we have two such large deal special situations still in development – the DWDP restructuring and separation and the PX/Linde merger. The market likes the latter much more – Exhibit 2 – and while we would agree with the ranking, we think the penalty for DWDP is too steep. We choose September 1st, 2017 as a base because that is the date of the DWDP merger. Both PX and DWDP had previously outperformed from the date of their respective deal announcements through this date. PX has outperformed DWDP by 23% since that time – the PX/Linde deal is yet to get approval, and both companies should be beneficiaries of the stronger global economy – so where is the disconnect?

Exhibit 2

Source: Capital IQ and SSR Analysis

It is not terribly helpful to draw more comparisons between the two sets of businesses because chemicals/plastics and industrial gases are very different. Looking at DWDP specifically there is clearly a disconnect as seen in the charts below. In Exhibit 3 we show EPS revisions or lack thereof for DWDP. We would stress that we think EPS may be misleading for DWDP this year for a couple of reasons that are not simply related one one-time deal charges:

  • The purchase accounting leaves DWDP with a huge slug of goodwill on the balance sheet – how this is amortized and how it cuts into earnings is unclear – but it will not impact EBITDA.
  • The new tax laws allow for more accelerated depreciation on US capital investments – whether this can be applied to some or all of the money that Dow has spent so far on the Gulf Coast we do not know, but if the company can accelerate depreciation it should – this could also cut into EPS – but it will not impact EBITDA.

Every DWDP peer has seen positive EBITDA revisions since September, but not DWDP – Exhibit 4. Most of those companies, including DWDP had very strong 4th quarters – Exhibit 5.

Most of the stocks have had poor performance year to date – Exhibit 6 – suggesting a lack of interest in what are improving industry trends, but DWDP has been treated more harshly than the rest in our view, because of its other levers to drive value. Simply beating expectations on Thursday will likely not be enough to re-engage interest – DWDP needs some or all of the following:

  • A very strong EBITDA number – especially if earnings are impacted by new/elected D&A charges. The number should reflect and be presented to show gains from a better business environment, new investments and synergies to date.
  • We need an update on synergy progress and a revised quantum.
    • It would also be good to get an update on the non-synergy cost reduction opportunities that still likely exist at the legacy DuPont businesses.
  • Use of cash – the company should increase the buyback to exploit the cheap stock. If they don’t, we can assume that one or two of the businesses want to spin out with very flexible balance sheets – this would be a red flag given that neither company has good acquisition DNA.
  • We need some guidance on possible capital structures and dividend policies for the spin companies – management should have this worked out by now.
  • Leadership – who is going to run the Ag business and the Specialty business and what are Ed Breen’s plans. Some reassurance that Ed is staying the course would be welcome.

This remains a very interesting story and could be a very good investment – today on offer at a bargain price – but we need some more data.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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. Sources: Capital IQ, Bloomberg, Government Publications.

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