DuPont – Betting the Farm – But Perhaps a Need to Crop the Portfolio?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 13th, 2013

DuPont – Betting the Farm – But Perhaps a Need to Crop the Portfolio?

  • DuPont is working on some very interesting and potentially very lucrative science. In its recent analyst day the company did a good job of explaining the discovery opportunity at the interface between three core science avenues: agriculture, bioscience and materials science.
  • Moreover, its Danisco acquisition has introduced the company to hundreds of new customers, many with interest at the intersections of the sciences. Cross selling opportunities to Danisco customers were probably underestimated by the company at the time of the acquisition and are probably still underestimated in consensus numbers today.
  • However, it is clear from the valuation of the stock that investors do not see the science creating an adequate return on investment. Either that or they are so distracted by the cyclicality of non-core businesses that they have missed the growth opportunity. Or both.
  • In our view, DuPont should act to fix both issues – focusing the portfolio in markets and products where the full weight of the science can be leveraged, and providing investors with a handful of new metrics to measure progress within the R&D pipeline. These metrics should focus on fully built up returns on cash spent rather than revenues.
  • Despite a good absolute start to the year, the stock is not expensive on a relative basis and is an outlier on the inexpensive side among both Chemical companies and large cap industrials. With a high dividend yield, you are paid to wait, as long as there is something worth waiting for.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

It is not our habit, nor our intent to “report” on company earnings or company events, but we are going to make an exception following the DuPont investor day this month. We do this for two reasons: first because
we wrote favorably on DuPont at the beginning of the year
and the stock has done well, so it is probably time to address what to do now. However, second and more important, DuPont’s strategy and future touches on themes that we have tackled in the last 6 months and consequently we feel we can add some perspective and perhaps ask some important questions.

The title of this piece, while a bit glib, gets to the heart of the matter; DuPont is going “all-in” (almost) on a strategy of innovation, driven as much by the interface between materials and agricultural science as by the more discrete sciences alone. The story sounds great; different from anything else we are hearing and is fairly believable, but this is a track that the company has been on for several years and the market remains unconvinced. There are, in our opinion two issues:

The first is that the whole platform does not fit with the strategy, unlike, for example Monsanto, Sherwin Williams and perhaps today PPG. The negative focus is on TiO2, not because of the great technology or the great margin advantage that DuPont enjoys, but because of the volatility of the business and its ability to distract from any core message – as seen in 2012. While TiO2 is the main negative focus, the more skeptical at the recent meeting might reflect on how similar the Kevlar story today sounds to the Lycra story as told by DuPont in 2000.

The second issue is not unique to DuPont; it is an issue that many companies struggle with. It is how to communicate with investors with regard to the success of the R&D strategy and its progress. At the DuPont analyst day, the CFO rightly asserted that nothing was more important at DuPont than the return on investment in R&D and innovation more broadly. The only objective metric (as opposed to subjective examples) offered today talks about revenues generated from products four years old or younger. It is a metric used by others and is, in every case, not helpful. Firstly, the “new sales” always include sales cannibalized from old products, so real growth is unclear. Second; sales is not a measure of returns and it does not help the investor get comfortable that the primary goal is being achieved – i.e. increased and/or acceptable return on investment. If we look at a handful of chemical companies for which we have long dated history we can show a correlation between return on capital growth and total shareholder return – Exhibit 2. In our January research we suggested that DuPont might have seen a turn in its ROC trend since 2000, but the picture remains very volatile – see Exhibit 4 later in the report.

How DuPont addresses the first issue is a matter of much speculation, and it is likely that at the margin meeting attendees were expecting some guidance or message of intent to divest the TiO2 business. From our perspective we would not have expected DuPont to say anything different at the meeting regardless of which way they are moving on TiO2 or any other business.

Exhibit 2

Source: Capital IQ and SSR Analysis

The second issue can be addressed in a couple of ways; wait, or change the way you report. If the strategy is valid, waiting will work, as eventually sales will grow fast enough and margins will expand quickly enough to convince investors that the pipeline has value. The issue is how long you have to wait and given the less predictable/controllable parts of the portfolio, the risk is that you have to wait a while until their impact becomes less important. The alternative is to provide investors with some well thought through metrics that can be updated consistently and regularly to show progress from the innovation pipeline, not just at the top line but also at the return on full investment level.

So what to do with the stock today? When we wrote positively on DuPont in January it was more of a valuation call. While the stock has subsequently done well, so has the market, and today it is still 10% below what we would consider to be mid-cycle value. It looks even more attractive when compared with the chemical sector overall, which is in aggregate expensive, even pulled down by the market cap weighted discount in DuPont.

But – DuPont is spending the largest part of its discretionary cash in an area that investors struggle to value. Today the stock would be higher if the R&D expense was $1.0 billion lower and dividend payments $1.0 billion higher, but if the strategy is right this change would lead to a much lower share price 5 years from now than by sticking with the strategy. DuPont can do two things proactively to change sentiment; exit the commodity pieces that do not fit with the “innovation” path, and/or provide investors with focused data. If you believe either of these are likely you should stick with it as the valuation is not high, the upside could be significant and the dividend continues to offer support. Otherwise you will probably be more relaxed elsewhere.

Why is R&D so difficult?

We have written extensively on this subject and refer you to the work we published earlier this year
. Essentially, R&D is hard because all the easy stuff has already been done. We have solutions for most problems in the agriculture, consumer packaging, construction, health, food, industrial and all other industries. Some of these solutions are not very elegant, almost all can be improved upon and in some limited cases there is opportunity for radical change, but there are several smaller pots of gold rather than one large one, and plenty of companies chasing the prizes. It is very easy to waste an awful lot of money in R&D if you are not disciplined and it is also very easy to let costs escalate peripheral to the R&D budget as you add customer service and other incremental SG&A.

Generally, investors do not give companies the benefit of the doubt for R&D spend in the Industrials and Materials sector, as shown in Exhibit 3. If you look at the three broad buckets of discretionary spending that are available to a company – Capital Spending, R&D and Dividends – increasing the proportion of free cash going to dividends is the only strategy with a positive correlation with stock performance in these sectors.

Exhibit 3

Source: Capital IQ and SSR Analysis

Portfolio Composition and Perception, A Tale Of Two Strategies.

DuPont makes some compelling arguments about the strength of its TiO2 business and what it delivers to the company in terms of cash flow and return on capital. In fact the company is investing in a major expansion of its facility in Mexico. At the same time, DuPont readily admits that the business is volatile, but is positively inclined towards it because of its high free cash flow and dominant market position.

If we look at DuPont and PPG side by side, today we see two companies with similar returns on capital relative to normal, both recovering from the economic volatility of the prior three or four years – Exhibit 4.

Exhibit 4

Source: Capital IQ and SSR Analysis

In early 2012, both companies had good core businesses, but both had significant cyclical components to their portfolios. Using our Skepticism Index as a guide, the market had more faith in DD at the beginning of 2012 than it does today – in that valuation anticipated only a small decline in return on capital. PPG also had some degree of skepticism in its value, albeit not much. As the chart in Exhibit 5 shows, things changed significantly during the course of the year. PPG sold its cyclical chlor-alkali business and DD’s TiO2 business had a major wobble. The result was a dramatic shift in relative investor sentiment. The skepticism index for DD rocketed and for PPG it collapsed. PPG outperformed DD by 56% in 2012 and while DD has clawed about 10% of that back so far in 2013, PPG continues to keep pace with the market.

Exhibit 5

Source: Capital IQ and SSR Analysis

Note: Our Skepticism Index measures alignment between current returns on investment and current value. A positive number suggests that either a stock is inexpensive or there is an expectation that returns on capital will fall. A negative number implies that the stock price is anticipating an increase in returns on capital from current levels.

PPG’s sale was dilutive to earnings – as much as a 15% decline was reflected in consensus earnings estimates for 2013 and 2014 once the economics of the deal were disclosed. PPG’s return on capital is not materially different to DD’s today, nor is it meaningfully further from trend as was shown in Exhibit

4. Consensus estimates have PPG growing earnings from 2012 to 2014 by a total 14%. For DD the same measure is 31%. Despite this, the average analyst rates PPG a buy while the average analyst rates DD a hold.

The movement in PPG’s stock and the overall sentiment is to a large degree the value of certainty and clarity. PPG’s multiple expansion has dwarfed any dilution from the sale of the chlor-alkali business. The company is now focused in areas where it has technology, density and more limited competition. Furthermore the higher multiple gives the company more strategic leeway.

At SSR, we are (constructive) skeptics at heart, but today we would bet that the technology engine within DD, if managed well, has significantly more diverse growth potential than the engine at PPG, suggesting that the valuation upside from sizing and focusing the company appropriately could be dramatic.

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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.

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