Weekly Findings – October 28th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

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October 28th, 2018

Weekly Findings – October 28th, 2018

Thought for the week: “PPG – DuPont All Over Again and an Embarrassed Board of Directors Likely – But There Is Still Time to Rethink”

  • Chart of the Week – Active Strategies
  • PPG – Again – The DuPont Playbook is Out
  • Q2 – That was as good as it got!
  • DWDP – The Sum of The Parts Argument Becomes A Stretch
  • Weekly Winners & Losers

Chart of the Week

Note; In all of our weekly summaries and most of our regular published research we include only a fraction of the data we have accumulated over the years and we also provide somewhat generic conclusions – targeting the “average investor”, if such a thing exists. We also assume that every reader is well versed in many of our thematics around “optimism”, “skepticism”, “complexity” and others. We are always happy to tailor research specifically for individual clients and have done more of this in recent years. Please let me know how we can be of help.

  • Chart of the Week

In the chart of the week we show the performance of five companies from the day an activist declared a position – for a maximum of 2 years from that point – not all have 2 years of history yet. The point is to contrast the early performance of those companies where there was direct and effective engagement with the activist and those where there was confrontation. We have kept the analysis to companies we cover and understand both at an industry and company level. We could probably find a dozen examples of other companies that fit in both groups.

The collaborators are:

  • APD – following discussions with Pershing, then CEO John McGlade agreed to step down and a search for a replacement was begun – APD also allowed Pershing to nominate new Directors and one of those Directors, Seifi Ghasemi, eventually took the CEO role.
  • DOW – Andrew Liveris engaged collaboratively with Third Point almost immediately and allowed three new Directors to be appointed. The strategy and messaging became less ambitious – something which had plagued the company previously. Andrew kept his job.
    • Note that the decline in DOW stock 6-9 months after the Third Point entry was all about oil price declines and was a sector move.
  • RPM – terms were agreed with Elliot before it was public that the shareholder was involved – a new management structure was created immediately – thus far the CEO has kept his job.
    • There is not much stock history here as the deal is recent, but RPM has outperformed a collapsing sector and sub-sector

The antagonists are:

  • DuPont – Too well documented, and discussed in the PPG section below – CEO eventually lost her job, but the stock was punished as soon as it was clear that Trian could fail.
  • GE – Trian now has a board seat but was initially unwelcome – two CEOs have subsequently lost their jobs and the stock is yet to recover.

In every case the companies involved were mismanaged prior to intervention. Consistently destroying shareholder value and very guilty of business/management optimism, one of our core analytical tools. We measure Optimism by looking at company’s ability to predict its own earnings over the long-term (short term analysis to too easily influenced by exogenous events). Optimistic companies are destroyers of value relative to their more conservative peers, and the chart below is taken from work we published earlier this year based on a methodology we have been using for the last 6 years. In the work that we did last year on what makes a good company, RPM makes the good company cut on one metric and the combined DWDP makes the cut on one bad company metric – otherwise none of the above appear in either group and neither does PPG.

These are both complex pieces of analysis and we are updating both at this time – with the good company work expected first. In the chart below we show the stock price performance for the top-quality quintile of companies identified in the “good company” analysis at this time last year with their lowest quintile peers. The chart shows two lines for the top group to exclude (in the lower case) three of the twenty who biased the analysis because of very low absolute starting share prices.

We cover PPG in more detail below but the message here is as follows – if you have an underperforming company and activist engagement you are probably going to win if you own the stock. If there is collaboration with the activist, you will likely win steadily. If there is confrontation, expect volatility. While the opening salvoes have been fired on the PPG front, it is probably still too early to determine which path will be followed.

  • PPG – Again – The DuPont Playbook Is Out

In 2014 we wrote this short piece on DuPont. It talked about how Trian’s strategy for DuPont was likely right and that the stock had rallied in anticipation of the strategy (possible leadership change and probable break-up). At that time Trian was getting aggressive push back from the DuPont Board and we identified downside to the stock if the Trian strategy was the right path but if Trian gave up because of lack of engagement.

This all sounds strangely familiar if you are reading the PPG related press this week. PPG’s stock is not rallying (see weekly winners below) because the board is showing its support for Mr. McGarry; it is rallying because Trian likely has the right plan and there is hope that Trian will be successful.

Trian is not alone in thinking that changes are needed at PPG – we have become increasingly vocal on the point since earlier this year when we published on the first earnings miss and identified and alarming trend towards “optimism”, which has become worse since that time. Optimistic companies (PPG shown in chart below) underperform, (chart in prior section) and PPG has underperformed (excluding the period since the Trian ownership announcement). Optimism is almost only ever corrected with regime change – Trian with DuPont and hopefully with GE – Pershing with Air Products – Third Point with Dow (while the CEO did not leave, the company adopted a more conservative strategy suggested under pressure from Third Point).

But here is where the problems start – in the case of APD and DOW both CEO’s “went quietly”! They agreed to change, and the stocks were good investments from the beginning. In the case of DuPont, the gloves came off, the “debate” became a major distraction for a CEO and a Board which already had shown that internal communication lines were poor and consequently the ball was dropped ever further, managerially and operationally, and major earnings misses drove the stock lower – especially when it looked like Trian’s persistence would not get the result wanted.

Last week there was a Forbes article which talked about the need for Company Directors to stand up to activists – I take issue with the article and see it as very self-serving for those who contributed and missing the key point. Boards of Directors should stand up to activists ONLY if they are doing their jobs properly and can show that empirically. In our 30 years of coverage of the chemical sector and 6 years covering the broader Industrials and Materials space it is our view that the sub-group of boards of directors not doing their job properly is quite large. The issues outlined by Trian and the chart below show that PPG’s Board is likely not doing its job properly – the Forbes article is linked below. There is a major difference between an activist looking to make a quick return at the expense of a longer-term opportunity for a company and one which spots long-term value-destructive behavior and tries to correct it. Where there has been long-term value destructive behavior the Board is at fault – DuPont and GE are clear examples and it looks like PPG may be in the same boat, although to be fair to PPG, it is only 3-4 years or poor performance, so far, whereas for GE and DuPont it was more than a decade.

https://www.forbes.com/sites/rogertrapp/2018/10/22/independent-directors-need-to-stand-up-to-activists/#36312c8b26b0

As we have indicated a couple of times – we were ultimately right with our recommendation on DuPont, but the stock collapsed before it outperformed, because of the distraction of the proxy fight, Trian’s ultimate loss of that fight and the earnings misses which continued. This volatility risk also exists for PPG in our view, unless the Board has a change of view quickly.

Link to Trian’s white paper.

Link to broader PPG piece written earlier this month

  • Q2 – That was As Good As It Got!

At this point last quarter, we published the chart below – showing revenue and EPS beats and misses for those that had reported by the last full week of July. At the time (link) we questioned whether this (Q2) was the peak – as good as it was going to get. The issue being the risk that trade uncertainty would cause a dent in either economic growth or confidence or both. Contrasting the first chart below with the second, it looks like Q2 might well have been the peak. The bias in Q3 is still positive, but not as much as for Q2, which was incrementally better than Q1.

The more important chart – and the one we really focus on each quarter is the year-on-year growth chart (third chart below). Note, that so far in Q3 only half of the companies we have in this analysis have reported and consequently the data set is not complete. That said, the number of revenue declines is surprising in what is generally a more raw material cost driven inflationary environment. Most of the declines are in the metals or metal users space. It is unlikely that the full set of data will give us a better picture as we have yet to include a number of companies that have already offered negative guidance.

With the benefit of hindsight, we should have been more aggressive with our view of the peak in growth in July and been far more vocal about our caution with respect to that idea – the fourth chart shows sector performance (expressed through SPDR performance) over the three months. Initial Q4 guidance suggests that Q4 may look similar to Q3 with respect to the third chart.

  • DWDP – Even the Sum Of The Parts Is Not Working

We have been big supporters of the DWDP idea since the onset, but the stock is clearly not showing broad confidence, and the idea is worth revisiting using a sum of the parts approach – as ultimately separation is the plan. Using proxies for the various DWDP businesses and assuming a bigger break-up than just three companies, we struggle to do better than the current price, unless the Ag business trades at a much higher multiple of EBITDA than Ag businesses have in the past. Part of the problem is that LYB is likely the proxy that everyone has in their heads today for the New Dow and, despite its now 4.5% yield, it is only trading at and enterprise value of 5.5x EBITDA. With DWDP at 8.0x and New Dow almost 60% of the EBITDA it is not complex math – the balance has to have a value of 10.25x EBITDA. The company could get more value in a tax-free exit of Electronics – sharing synergies in some sort of merger and might be able to do the same with Nutrition, but it still does not generate much upside and still demands a high multiple from Ag. In the first chart below we show part of the problem – all the comps are down – it is not just DWDP that is unpopular. In the second chart we show EV/EBITDA ranges for all the comps – at the top end of the ranges we get more upside for DWDP but it is important to note that many of the higher multiples are associated with trough EBITDA – this is particularly true for FMC – which structurally today looks nothing like the FMC included in the history. From this analysis you could argue that the commodity group is below average EV/EBITDA, but everything else looks fairly valued. Note that the most direct comp for DWDP today – BASF – already trades at a much lower multiple – but part of that is the current Europe discount versus the US and part is the recent earnings miss and guidance – we still have DWDP earnings ahead of us.

Taking the multiples on the chart above we have constructed a table of possible valuations for DWDP (below) and the answers do not look that attractive. To get meaningful upside from today you need to assume that the DWDP components are given multiples higher than their peers. Any overall segment multiple increase would likely benefit everyone else in the analysis above as well as DWDP and some of the more levered names might see more equity improvement – as shown in the table below, DWDP is mostly Equity – with very low debt as a proportion of total capital – we have lowered net debt in this analysis to reflect what we expect to be higher cash at the end of Q3.

Our thesis on DWDP has been hurt by the overall sector sell off, which is out of DWDP’s control, but more concerning is that the company is likely to fall well short of our EBITDA estimate this year, which was closer to $20bn. With the much touted “higher valued added” products and “solutions” offerings, DWDP should be making more money than this – especially when you consider the cost cutting initiatives both from synergies and at many of the specific businesses. While DWDP is not giving explicit guidance, the company has low-balled expectations for this year and beaten them thus far, but consistently tempered expectations.

For this story to work – and for the stock to be worth owning (versus others) we need to see the following:

  • More accelerated earnings growth – relative to others in businesses where commodity prices are volatile and out of the company’s control.
  • Probably a break-up of DuPont – with Electronics and Nutrition divested in ways which allow DWDP shareholders to benefit from expected merger synergies – i.e. higher EBITDA multiples than shown below.

In the meantime, you run the risk that there is initial selling pressure on both the materials company and Corteva as they are spun out.

Please see last week’s piece for our thought on communication shortfalls at the company.

  • Weekly Winners and Losers

©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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