Questions for DWDP

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 11th 2018

Questions for DWDP

  • The luster around the DWDP merger and split appears to be fading – the stock has underperformed the S&P500 since November of 2017 and significantly in 2018, despite lots of confident talk from the company and some earnings beats.
    • The earnings beats have generally been accompanied by negative guidance and consequently have not resulted in strong performance from the stock.
  • The separations are what everyone is waiting for and lack of data on capital structures makes each impossible to model today. Some important questions come to mind:
    • With US ethylene/polyethylene margins falling, LYB’s relative strength vs WLK is likely almost a 4% yield – versus WLK at 1%. What does DOW think about dividends?
    • With the much weaker US ethylene market, will DOW push ahead with expansions?
    • If Aramco buys SABIC – does DOW still want to pay up to get 50% of Sadara?
    • What is the right comp for Corteva and what is the outlook? Not that interesting?
    • What is the right leadership team and strategy for new DuPont? Break-up?
  • Earnings have grown over the last year – pro-forma run rate annualized EBITDA is up $2.8 billion at Q2 2018. Adding the cost initiatives pre-merger and the synergies given in the Q2 call, suggests unimpressive incremental margins on new revenues; below company average.
    • Other companies – without synergy opportunities – are seeing EBITDA gains in 2018, although likely not much, if any, in the US commodity space. DWDP should be seeing something more from the significant Capex from 2015-2017 in our view.
  • Are we back to the same old DOW and DuPont? The sell-side love affair with the story would suggest no. Performance and relative multiple (Exhibit 1) might suggest otherwise.
    • We still like the story but earnings must grow faster for it to work as it is unlikely that multiples will expand without a much more articulate and interesting dialogue from management than we have seen to date – prefer BASF and HUN.

Exhibit1

Source: Capital IQ and SSR Analysis

Details

DWDP has underperformed the market since the merger – Exhibit 2 – as well as our US chemical index – Exhibit 3. However, while DWDP is up 5% since the merger in absolute terms, BASF (the only real peer for the combined company) is down 7% over the same period. (The DAX has underperformed the S&P, but BASF has underperformed the DAX).

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Earnings have been good – Exhibit 4 shows rolling 4 quarter segmented EBITDA – but not so good in the context of the cost initiatives, both those conducted by the two companies prior to the merger and the synergies since the merger. In Q2 2018 the company claimed that the company had achieved $375 million of synergies in the quarter. Adjusting for seasonal movements in the Ag business, it looks like the company had a good quarter in addition to the synergies, but when looked at on an annual basis – using the rolling quarterly data in Exhibit 4 – there is an EBITDA gain of $2.8 billion (four quarters to Q2 2018 versus four quarters to Q2 2017 pro-forma). $900 million of this is synergies from the merger. Dow and DuPont were working on significant cost initiatives in the build up to the merger and it is highly unlikely that they were all in place by August 31st 2017, and consequently influence the year on year EBITDA delta above, perhaps by as much as another $500 million. If you adjust the EBITDA gain to exclude the cost cutting and synergies, you get a 17% incremental EBITDA on new sales – well below the company average of 20% in 2017.

Exhibit 4

Source: Capital IQ and SSR Analysis

The results discussed above are with a strong ethylene/polyethylene market in 2H 2017 and 1H 2018. This is not the case today as summarized in Exhibits 5 and 6. Consensus has EBITDA estimates down in Q3, following guidance in July, but still showing a year on year gain of more than $500 million – likely accounting for synergy gains and contributions from Sadara, but possibly overestimating Dow Material Science earnings in the US and possibly Ag which has been disappointing all year.

Exhibit 5

Source: Bloomberg, Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

What is the Break-Up Value? Is There Any Value In A Break-Up?

We showed the chart in Exhibit 7 in our piece on polyurethanes this week and it is another concern for DWDP as all the peers are cheaper! The new DOW will more than likely trade at a discount to the current DWDP and can only use LYB as a proxy if it is willing to pay a significant dividend. Can DOW afford its announced capex plan, the Sadara investment and a high dividend?

We do not have a business or stock proxy for Corteva anymore. FMC trades at a premium EBITDA multiple to DWDP, but this is likely distorted by Lithium for the time being. Bayer trades at a premium multiple to DWDP and at a premium to some of its pharma competitors. It is possible that Corteva will have a premium multiple to current DWDP but given recent EBITDA trends – Exhibit 4 – it is questionable – it is also the smallest piece.

Then there is the BASF comp – a comp for DWDP today and for the new DuPont, and not a comp that you want, at least not today. DWDP needs to win through earnings growth as it is hard to make a multiple expansion story today. So far, every better DWDP quarter has been met with cautious/negative guidance – if this continues the stock has limited upside and if earnings crack (because of weaker basic chemicals) there is, at a minimum, relative downside. The chart below might suggest that DWDP sticks together as a conglomerate and abandons the spins. There may be additional value if the break-up includes breaking up DuPont.

Exhibit 7

Source: Capital IQ and SSR Analysis

DWDP does not look expensive on our normalized framework, but this is not because the company is materially under-earnings – in fact, despite the significant increase in capital, return on capital for the larger company is close to trend – Exhibit 8 – albeit a declining trend and one that management would want to reverse as a consequence of this combination and separation process. There is clearly upside in the stock if aggregate returns can move back towards 10%, without a decline in the capital base, but given the long value destruction histories of both companies it is unlikely that investors will give them the benefit of the doubt – maybe if Ed stays and the spins are postponed?

Exhibit 8

Source: Capital IQ and SSR Analysis

DWDP looks very inexpensive on our normal framework, but this because the market multiple is high and companies like DWDP do not follow a higher valued broader market typically, as can be seen in Exhibit 9. The anomaly in the chart is Dow’s underperformance following the financial crisis and the market multiple crash that followed. This was the result of Dow’s brush with insolvency following the Rohm and Haas deal and failure to complete the basic chemicals sale to the Kuwaitis.

Exhibit 9

Source: Capital IQ and SSR Analysis

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