DuPont – Sifting Through The Noise We Saw What We Wanted to See
Our positive stance on DuPont has been driven by two factors; valuation, and the belief that there is a real growth story in the core business. Valuation support remains but it is much less of a factor today than it was a year ago as the stock is only 5-6% below our measure of fair value – we estimate that “normal relative value” for DD is around $71 per share. However, our measure of fair value is based on DD continuing to operate and behave in the same way it has for years and clearly that is not the story that the company is telling today.
The exit of the Performance Chemicals business, according to the company, should leave a large core portfolio of differentiated platforms with very strong growth – driven by R&D advancements and leading to premium pricing. This is the third quarter in a row where we have seen evidence of that, with most of the core segments (excluding Agriculture this quarter) showing operating earnings gains versus the prior year. Ag was weaker because of the Latin American pull through of demand into Q4 2013 – across the two quarters Ag was positive.
The investment controversy here is whether DuPont is on either of the return on capital paths shown in the first Exhibit. The more muted recovery is what is driving our earnings/valuation model and creates our current fair value of $71 per share. We struggle to get more positive if this is indeed the right path, because even though returns are growing, there will be a negative step change in this chart when the performance chemicals business is divested as it has a higher return on capital than the company as a whole.
Upside in the stock will only likely come from a demonstration of faster and more consistent growth and a return on capital trend that approaches the more aggressive arrow in the Exhibit. In other words, the 12% return on capital generated by forward 12 month consensus earnings is on trend or close to trend rather than 200 basis points above trend. Even with a step down, post divestment, a growth trend like this would likely result in a multiple expansion possibly along the lines of what we have seen for PPG – shown in the second Exhibit. PPG’s relative multiple has doubled from 2008 to today. DuPont’s relative multiple was not as discounted as PPG’s historically – third Exhibit – but is around 20% lower than PPG’s today. Note that the analysis is based on “normalized earnings” and while PPG is expected to earn around 20% above our view of normal in 2014, DD is expected to earn 30% above normal so the comparison is not unreasonable. Forward estimates do not have PPG growing earnings significantly faster than DD for the next three years; the higher multiple is an indication that investors have more confidence in PPG’s trajectory today than they do in DuPont’s.
A 20% jump in relative multiple for DD would put a value of around $85 per share on the stock today.