The DWDP Disbelief/Disconnect – Holding Back The Stock

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 4th, 2017

The DWDP Disbelief/Disconnect – Holding Back The Stock

  • While DWDP appears to be the most loved stock (sell-side) in materials, there is disconnect between the overall sentiment and the numbers behind it, causing the stock to pause.
    • Target prices do not suggest enough upside – nor do they support the unanimous positive recommendations – upside of around 10% (higher today with another revision) does not inspire much confidence. Investors need to see a path to $100 over 18-24 months.
    • While clearly connected – estimates for 2018 and 2019 are too conservative – significantly so in our view. The stock is already at a high multiple of 2018 estimates and the lack of leverage makes the EV/EBITBA ratio look inflated.
  • While we have seen peak multiples for DuPont a little higher (of forward earnings) than the stock is showing today, there is no logic in a peak valuation methodology multiple today unless you believe that this is as good as it gets economically.
    • It is likely that sell side and buy side alike are struggling to model the combined company and are focused on trying to model the spins – hard without proposed capital structures and capital allocation objectives for each.
      • Will the Ag business have high debt? Significant synergies and high and stable cash flows shows should allow the business to pay down debt reasonably quickly.
      • Will the Specialty business have a relatively clean balance sheet – allowing capacity for significant M&A?
  • We modeled the combined business in September – this is all you can do at this point. We have significantly higher 2018 and 2019 earnings than consensus. We are taking for granted that the split ADDS value versus the combination. Earnings come from:
    • Synergies – as much as $0.60 cents in 2018 and $1.00 in 2019.
    • Global economic growth and DWDP’s considerable leverage – we have not changed the assumption since September in Exhibit 1 – but data is more positive.
    • New capacity – no change in view since September.
    • We have changed the tax assumption from the analysis published in September.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We repeat some of our September analysis in this report to show what we think is the disconnect in DWDP’s stock today. Sell side sentiment does not align with sell side numbers, suggesting that analysts want to like the story, but are struggling to model the combined business, either because they are trying to step through to the split or because they are missing one or more of the many levers that are in play right now, from synergies, to new investments coming on line, to leverage to the improving global economy.

It is also possible that estimates continue to reflect concern over the ethylene business in 2018 and 2019. There is another disconnect here on two fronts:

  1. Estimates for LYB and WLK are anticipating some ethylene weakness but the stock prices are currently looking through those estimates – DWDP not following suit in our view.
  2. DWDP has the most global and feedstock flexible ethylene footprint and stands to make more consistent returns on this business in a volatile ethylene market or volatile ethylene feedstock market than any of its ethylene peers, with the possible exception of Exxon.

We have modelled the business with and without an ethylene cycle in 2019 and we get an earnings forecast and suggested stock price progression as summarized in Exhibit 2. This analysis is what drives our target price of $100 per share. As the global economy improves, we become increasingly more comfortable with these numbers and increasingly more confident that ethylene will have a very strong 2019 – with the positive trend in margins beginning in 2H 2018.

Exhibit 2

Source: Capital IQ and SSR Analysis

In the analysis below we walk through some of the discussion points raised by current consensus expectations and then look at a couple of different approaches to valuation – looking at peak earnings and peak multiples with and without synergies. Our approach is conservative throughout, but limited by the barriers to creating pro-forma models for the spin companies (lack of balance sheet guidance).

We add the likely multiple effect of reducing the complexity of the companies through the splits – something we have covered a length in prior research. The table in Exhibit 3 shows the summary of the valuation targets than can be generated and helps reinforce our continued interest in the story.

Aside from possible revisions and target price momentum, we do not see much of a catalyst before Q4 earnings and perhaps some better 2018 guidance but believe that 2018 could be a very good year for the stock.

Exhibit 3

Source: Capital IQ and SSR Analysis

The Sentiment Disconnect

Interestingly there is not much of a correlation between sell side sentiment and upside to target price, either for the Chemicals group – Exhibit 4, or for large cap Industrials, Exhibit 5. DWDP has one of the higher upsides to target price and is the right side of a very weak correlation line in both cases. We are surprised that the correlation is not better and would certainly own DWDP over ASH and over HON based on the charts. In a market that has seen 19% growth in 2017, none of the upside targets below, except OLN look that interesting.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

If instead we look at recommendation versus forward PE (Exhibit 6) you might expect a better correlation as analyst look for bargains – cheap stocks – this is not the case and again DWDP does not look that compelling – within chemicals we would be more drawn towards HUN and EMN, but on the basis that you should generally buy stocks when sentiment is at its weakest, LYB, FUL and MOS stand out (especially LYB.

Within large cap industrials DWDP is still not compelling, but MMM is s stand-out concern – very negative sell-side sentiment and a very high multiple.

It all comes down to estimates for DWDP for 2018 being too low.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

What is Fair Value – A Conservative Approach

If there are no synergies that fall to the bottom line, but if we are heading towards an earnings peak (driven by a strong economic cycle), history would suggest peak earnings of around $4.95 per share – Exhibit 8. The combined entity has averaged an 18.5x market multiple of peak earnings in prior peaks – 18.5 x $4.95 = $92 per share.

Exhibit 8

Source: Capital IQ and SSR Analysis

With synergies, as summarized in Exhibit 1, we get a step change in recurring (normal) earnings of close to $1.00 per share and normal return on capital jumps to 10.8% from 8.7% – Exhibit 9. This would be additive to any peak as well as any normal earnings number. Peak moves to around $5.90 per share and valuation to around $110 per share on the same basis as above. We believe that a more focused company with the new investments as a tailwind and aggressive cost moves at legacy DuPont ongoing can do better than the numbers above, and in Exhibit 1 we have 2019 estimates slightly higher than $6.00 on a combined company basis, including the impact of share buyback.

Then we get the added benefit of the Split.

Exhibit 9

Source: Capital IQ and SSR Analysis

The Split – Upside in Multiple from a Reduction in Complexity

Whether the split companies can be run better, whether they allocate capital better, whether they have unique and more value-added M&A opportunities, as a result of being separate will all remain to be seen, but you would have to think so. What we do know is that the move will reduce complexity – see prior researchand Exhibit 10. This assumes that the companies report based on the structure presented in the Q3 results.

Exhibit 10

Source: Capital IQ and SSR Analysis

Our work on complexity is summarized in Exhibit 11. We would expect the split companies to all get at least a 1.5 multiple point improvement because they are easier to model and because they should have strategies that are easier to understand and execute. A 1.5 multiple expansion on earnings of $6.00 per share (2019) is 12% upside on the current share price. This is a lever that has not been included in the analysis behind Exhibit 2 as we kept the multiple assumption flat in the combined company model.

Exhibit 11

Source: Capital IQ and SSR Analysis

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