DuPont – Aggrivating; But Unlikely to Change Without Action

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 23, 2014

DuPont – Ag-rivating; But Unlikely to Change Without Action

  • DuPont is being penalized because of the normal behavior of what is arguably its best business – Agriculture. The business has some volatility driven by weather and crop prices, but at DuPont (and likely at DOW) this adds to the unwanted noise of a complex company despite overall very strong growth and returns.
  • In the company conference call with clients today, Dow Chemical CEO Andrew Liveris talked about a likely further round of consolidation in Ag Chemicals and Seeds and seemed to telegraph a willingness to engage in discussions. We think that this is an avenue DuPont should pursue, as we do not buy the argument that the future is all about seeds, and think that a balanced seed/chemicals portfolio makes more sense.
    • The Ag growth at both Dow and DuPont over the last several years, which has exceeded others in the industry, has been dominated by chemicals innovations.
  • A sensible next step for a combined business, or a stand-alone option for DD, would be to IPO the business – with DD or DD/DOW retaining majority ownership. Owners would benefit from an appropriate multiple for the growth, margins and returns of the business.
  • An initial JV would give both companies the opportunity to share cost savings, which we think would be substantial as the business was streamlined to run with an appropriate cost structure. Pro-forma margins are well below those of Monsanto and Syngenta, suggesting upside from the right focus.
  • DuPont has some good things going on, and a busy dance card right now given the planned exit of Performance Chemicals and the major cost initiative. However, this should be on the dance card also – DOW is equally busy but clearly willing to talk about Ag to other participants.
  • While we see upside in both companies – valuation supports DD over DOW.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

DuPont is working diligently to exit the business which has been seen to be a source of unpredictability and volatility for the company – Performance Chemicals – but almost immediately we are drawn to the other source of unpredictability and volatility, Agriculture. DuPont has now guided down both Q2 and Q3 2014 because of broad agricultural trends this year over which it has no control – swings in corn and soybean pricing and weather leading to planting patterns and demand for DuPont products that would have been impossible to predict correctly 6 months ago. DuPont is not alone here; all companies selling in to the Ag space are hostage to annual consumption uncertainty, although DOW appears to have weathered the storm better than others this time around.

To be fair to DuPont, Monsanto and others, the volatility seen in these businesses is significantly lower than we see in commodity or intermediate chemicals, where swings in volume can be accompanied by more destructive swings in prices.

However, the market hates uncertainty and punishes earnings misses – likely presenting DuPont with a dilemma. Having made the decision to remove the historic “bad actor” from the mix, does the company find that investors now spend a disproportionate amount of time focused on a business that, while not Mickey Rourke, is not turning out to be Tom Hanks either.

The Ag business has very strong growth and strong average margins and this has been DuPont’s logic for retaining the business. Ag pure plays like Monsanto and Syngenta have translated this growth into much higher earnings multiples, despite the volatility in earnings, caused by the very clear seasonality in the business as well as the vagaries of weather and acres planted. Both Dow and DuPont are likely penalized by a different view, which is that the unpredictability of the Ag businesses simply adds to a story that is already too complex to understand, or more importantly model, for most.

If DuPont continues to operate its Ag business as is, we will continue to see earnings uncertainty and volatility – earnings pulled or pushed from one quarter to another and impacted by factors outside of DuPont’s control. Even with performance chemicals out of the mix, there is a risk that the remaining company still earns a complexity discount and that DuPont does not see a value for the Ag business that reflects what is paid for pure plays.

In our view, DuPont has a number of options here to release the value and perhaps get away from the current discount;

  • Wait – do nothing and hope that the relative growth of Ag makes it a big enough part of the portfolio to drive valuation on its own.
  • Sell the business – the multiple it would get could allow DuPont to buy back stock or buy lower multiple businesses in an accretive way
  • Spin out part of the Ag business (IPO) – retain the majority stake – hope that the Ag business gets a premium multiple and this reflects in DD valuation
  • Combine business with Dow Chemical’s Ag business – then IPO a piece of that business. Solving similar problems for both companies.
    • DD and DOW get the potential benefit of the higher multiple
    • Both get the benefit of cost related synergies from the business combination
    • The market cap of the combined business would be substantial
    • Both companies would then have exit/consolidate options going forward

While we see upside in both Dow and DuPont if the companies can execute on current stated strategies, valuation pushes us strongly towards DuPont as the way to play a joint initiative in Ag – Exhibit 2.

Exhibit 2

Source: Capital IQ, SSR Analysis

Earnings and Volatility – The Ag Dilemma

Looking at the data in Exhibit 3 we note a couple of things. First the decline in revenue in Performance Chemicals from 2011 to 2012; second the relative stable and growing trends in everything else, and third the well understood seasonal volatility in Agriculture. When we look at the data on an annual basis, so taking out the seasonality – Exhibits 4 and 5, we see the strong growth in Ag.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Return on assets in the Ag business is very high and has been growing consistently – Exhibit 6, and together with the revenue growth highlights the value of the business outside the seasonal volatility.

Exhibit 6

Source: Capital IQ, Company Reports, SSR Analysis

The other factor that we looked at was how much the overall volatility of DuPont’s portfolio has changed over time and as shown in Exhibit 7, the portfolio changes that began in the late 1990’s have materially changed the shape of the company for the better from a shareholder perspective.

Exhibit 7

Source: Capital IQ, SSR Analysis

What we take away from this analysis is that DuPont is likely unfairly treated from an Ag perspective, given that seasonal volatility is less worrisome at the pure plays, and that the overall portfolio has improved dramatically over the last 10 or so years with the earnings growth and returns improvements in Ag a major part of the story.

The Drivers of AG

Ag is a volatile business – albeit a growth business. If we look at corn and soy acres planted in the US, Exhibits 8 and 9, both growth and volatility are evident. A one standard deviation event for corn planting is around 10% of acres planted – for soy it is higher at 12-13%. The acres are only one variable as pricing has an incremental impact on what farmers will pay for to maximize yield – they will generally pay for higher yielding seeds and pesticides, but may use more or less pesticide depending on the expected value of the crop and or weather.

Managing that volatility as a seed or chemical producer is very difficult, as you control none of the drivers and have limited influence over decision making. Where you can control the business is through share gains driven by innovation, pricing etc.

Exhibit 8

Source: USDA

Exhibit 9

Source: USDA

Consolidation – DD/DOW Agriculture

It was very clear from Dow Chemical’s earnings call this morning that CEO Andrew Liveris sees a further round of consolidation in the agricultural chemicals and seeds space, and appears willing to be a participant. Dow and DuPont suffer from the same issue – rapidly growing Ag businesses which look undervalued in a broad chemicals portfolio.

We have written at length about business complexity , and the discount that is applied to complex companies today across the broad industrials and materials sectors – see prior research and Exhibit 10. In a recent CNBC interview, Nelson Peltz highlighted complexity as one of the subjects of discussion between his investment firm and DuPont.

Exhibit 10

Source: Capital IQ, SSR Analysis

While Ag adds to the growth and the earnings and the returns at both Dow and DuPont, it also adds to the complexity, making the companies harder to model and harder to understand. The risk is that when Monsanto guides down because of a seasonal or weather factor, the market sees this as the normal course of business in Ag. When it happens at DuPont it is seen as another earnings miss in a complex portfolio.

Both Dow and DuPont would benefit from getting a fair market value for their Ag businesses – the question is how best to achieve this. Below we expand on the bullet points in the overview.

Wait – do nothing and hope that the relative growth of Ag makes it a big enough part of the portfolio to drive valuation on its own.

  • If we use the average segment revenue growth rates for the last 3 years and extrapolate – assuming a performance chemicals exit – DuPont’s Ag business would be 50% of revenues by 2017.
    • This assumes that the very strong recent revenue growth for Ag – largely driven by Rynaxypyr – can continue.
    • It also assumes that other businesses do not accelerate growth and that DD does not make acquisitions outside Ag – both of these seem unlikely given company discussions and presentations.
    • It also assumes that investors would start to value DD as an Ag company once the company hits 50% of revenues from Ag – maybe the hurdle is 60% or 75% – we do not know.
  • This is a strategy – but probably not the best way forward.

Sell the business – the multiple it would get would allow DuPont to buy back stock or buy lower multiple businesses in an accretive way

  • Today Monsanto trades at 22.6x 2014 expected earnings and DD at 16.2x, but with depressed earnings in performance chemicals.
  • If DD could find a buyer who could extract synergies, it is possible that a sale could approach a Monsanto multiple, but without the synergies we would expect a discount but still a valuation above 20x.
  • The issue would be taxes. This business likely has an enterprise value of more than $25bn (possibly as high as $35bn) and has a net asset base of less than $6bn. A straight sale would leave DuPont with a huge tax bill and materially change the economics of any sale.

Spin out part of the Ag business (IPO) – retain the majority stake – hope that the Ag business gets a premium multiple and this reflects in DD valuation

  • With $11.7 billion of sales and almost $2.9bn or EBITDA, DuPont Ag would make an interesting independent company and would compare with Monsanto and Syngenta both with revenue of around $15 billion.
  • By spinning out part of the Ag business it would have its own value – driven by its growth and margins and that anchor value should be reflected in DuPont’s value.
  • At the same time you would uncomplicate the DuPont story to a degree.
  • The reason not to do this is you believe that the rest of the portfolio can match the growth rate and margin structure of Ag over time – but even then you would likely face the complexity discount.

Combine business with Dow Chemical’s Ag business – then IPO a piece of that business. Solving similar problems for both companies.

  • We think this is by far the most interesting option for the reasons outlined below:
    • Both DD and DOW get the potential benefit of the higher multiple.
    • Both get the benefit of cost related synergies from the business combination – there is real opportunity to improve the operating margin of the combined business.
    • The market cap of the combined business would be substantial – as high as $50bn.
    • Both companies would then have exit/consolidate options going forward.
    • DuPont would own more than Dow – very rough estimate – 25% public 45-48% DuPont, 27-30% Dow.
    • Tax efficient – could possibly divest completely through a Morris Trust transaction
    • See supporting charts – Exhibits 11-14.

Exhibit 11

Source: Capital IQ, Company Reports, SSR Analysis

Exhibit 12

Source: Capital IQ, Company Reports, SSR Analysis

Exhibit 13

Source: Capital IQ, Company Reports, SSR Analysis

Exhibit 14

Source: Capital IQ, Company Reports, SSR Analysis

 

 

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