Weekly Findings – June 3rd, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
June 3rd, 2018
- Chart of the Week – Relatively Cheaper Plastic
- More Cost Determination from DWDP
- Air Products and Air Liquide Should Stay Out Of The Competition for PX/LIN Assets
- Weekly Winners & Losers
Tariffs on Steel and Aluminum will likely lead to higher prices of both products in the US because of the net import market balance – US production may increase, but ultimately prices will be set by imports – increased because of tariffs. Could this help competing products at the margin, where the US has a surplus of those competing products – the most obvious being durable plastics such as PVC, High Density Polyethylene and other engineering and specialty plastics? If an automaker is looking at a 20% increase in the price of steel, is he or she more likely to look at a design that incorporates more plastics, maybe, especially if the US is awash with cheap chemical feedstocks and surpluses of most polymers.
Given the “to and fro” nature of the current administration’s approach to trade, and the likelihood that everyone will kiss and make up in the end, radical design changes in vehicles and other durables are unlikely, but if you are a producer of durable plastics – now is a good time to be pushing your domestic (made in the US) advantage, which looks just as interesting on a longer time frame (chart below) as it does over the last three years.
If the trade unhappiness escalates, the downside is that the US is a large net exporter of plastics and this would likely be a target for retaliation. As the chart shows, exports are trending back up as US chemical investment is trending up. Given export net backs, US polymer producers can afford to be quite price competitive as they attempt to create new areas of growth.
We are unconvinced that any of the current trade dynamics will be permanent, but should they last, companies such as DWDP (specifically new DuPont), EMN, FUL, POL and KRA could see marginal benefit. As could the PVC producers (replacing more steel pipe) – WLK. LYB could see benefits in HDPE and through some of the SHLM compounding end markets.
Last week we wrote on some “New Dow” comments about cost focus in the context of trying to catch Lyondell as the low-cost producer of polyethylene and other commodities. This last week Ed Breen spoke at a conference and talked equally aggressively about the cost opportunities at what will be the New DuPont and Corteva (the new Ag company). Most of the synergies that DWDP has identified sit within these businesses rather than in the New Dow, so it is reassuring to hear that it is a focus and that progress is being made.
We are particularly happy to hear that Mr. Breen is focused on R&D productivity and effectiveness – something we have written about for years. In our opinion, DuPont has not seen either an adequate or a consistent return on its R&D for decades – occasionally coming up with a blockbuster, but that blockbuster not making up for other wasted initiatives. Back in 2015, we wrote a focused piece on R&D at DuPont and the charts which follow are taken directly from that piece – the first shows DuPont cumulative spending and returns from 2000 through 2014 – during that period the company spent almost $24 billion on R&D – a cost which contributed to overall value destruction of almost $27 billion. If you look at where the money was spent – second exhibit (2013 data, but a representative split pre-merger) – you can see the challenge of the Ag business. The opportunity at Corteva is not only to cut unnecessary costs, but to streamline and focus R&D in the manner Mr. Breen is suggesting. We do not believe that the Ag Chemicals business generally is going to be a high growth–high innovation market going forward, but Corteva will have a synergy and cost cutting opportunity that other reshaped players may also have, without the high cost of an M&A premium.
Also at that time we looked at patent application and patent application costs. The chart below shows the 5-year historic return on capital on a monthly trend basis against the average cost of a patent for DuPont and others. The chart looks poor for both DuPont and Dow, but with the new direction and leadership, this is an opportunity rather than something that should be looked at negatively today. While the market may take the view that “talk is cheap” the stock has reacted somewhat positively to both the New Dow and Mr. Breen’s comments. However, we believe that the story remains very undervalued at around 9x forward EBITDA – given that there is likely as much as 15-20% upside to EBITDA from synergies and further focused cost reduction, without any end-market improvements.
The European Commission announcement this week that it has supplied Praxair and Linde with its list of competitive concerns with respect to the proposed merger is no surprise, and it is highly unlikely that the content of the report is a surprise to either company. Both PX and LIN know what has to be sold with likely 95% accuracy at this point. This is why they have been entertaining bids for the assets for months – either as a one transaction solution or piecemeal.
It is likely that both Air Products and Air Liquide have been looking at the expected divestments and trying to figure out which assets they want and what the regulators would allow. We are unconvinced that there are good/value creating opportunities for either company in this process. We think they are likely wasting their time. The regulators are clearly looking to maintain a level of competition in the business and are far more likely to approve a deal which creates a new player – either by selling the whole thing to private equity or the whole thing to a smaller player in Europe or Asia – possibly with help from private equity.
Given the multiple that Carlyle paid for Akzo Chemicals, it is clear that there is lots of private equity money out there looking for something to do – plenty of others were involved in the Akzo auction and all were willing to outbid any strategic who might have had a synergy story to tell.
Our expectation would be that if APD or AL were able to pull some select assets out of the whole, it might delay the deal, something neither PX nor LIN want, making it even more likely that they would have to overpay – both to outbid the private equity players and to convince PX and LIN that the added execution and timing risk was worth it.
As we noted when the deal was first announced, APD still has the option of trying to buy LIN away from PX – but this would need to be an all cash, or mostly cash, offer at a premium and would consequently be quite dilutive – at least initially. APD does have the management skills today to integrate such a large deal (this was probably not the case a couple of years ago) and would likely not require as much to be divested to get a deal approved. Given the multiples – as shown in the chart below – this is not a crazy option for Linde or for APD, with PX having a lot to lose if the deal was derailed based on the first chart.
We think that the risk of an APD bid for the whole Linde business is very low at this point. We still like the PX/Linde deal and likely still have the highest earnings estimates for the combined company a couple of years post close – see our prior research. For those who can invest in more than one gas company, Air Liquide looks like the steady, less risky, story as the company pays down debt from the Airgas deal and continues to drive synergies.