The DuPont Vote – Short Term Noise – Change is Coming Either Way

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 13th, 2015

The DuPont Vote – Short Term Noise – Change is Coming Either Way

  • While all eyes will be focused on the shareholder vote today, we are not sure that the longer-term story will be much different regardless of who wins. The complexity of DuPont and the misplaced optimism that the company displays have been highlighted over the last few months and change is inevitable.
  • Comments on the Chemours debt road show (admittedly heard second hand) seem to confirm, or at least hint towards, the cost cutting opportunity at the parent company, as outlined by Trian. Furthermore, the Monsanto move to acquire Syngenta, highlights a significant and probably appropriate change in Ag Chemical/Seed strategy which DuPont has likely missed; instead choosing to waste time and energy fighting with Trian.
  • We think that a leadership change at DuPont is highly likely, regardless of the vote outcome, and that there will be some meaningful changes to strategy to address both costs and focus. In prior research we have highlighted how much cost we think can be taken out of the company and believe that this can add as much to EPS growth over the next three to four years as the underlying business growth. We see a minimum value for DuPont on this basis of $90 per share and could easily come up with higher scenarios.
  • One such scenario comes from the value that MON is willing to give to Syngenta, on the basis of combined business opportunities and potential synergies. We could argue that a DD Ag combination with Syngenta could generate more growth and at least as much synergy, suggesting that the price offered for Syngenta so far puts a very high value on DD’s business. 15x Ag EBITDA for DD generates a value of $35bn and adds at least 10% to DD’s current value, before we include the cost opportunities.
  • While the consensus view appears to be that a win for the DD board slate will take the stock down, we are not sure it matters in the medium term. We would own DuPont and we would look at any lower value opportunity to buy the stock more aggressively.

Exhibit 1

Source: Capital IQ, SSR Analysis

Complexity Index calculated by dividing the number of reporting segments by the share of overall business in the US

Analysis assumes expansion of reporting segments by 1 for DD spin off or separated companies

Overview

DuPont is a complex company that has for many years been far too optimistic about its potential. Expectations have been driven by an inflated view of R&D productivity and the result has been missed expectation; not on a quarter by quarter earnings miss basis, but on steep negative revisions on expectations 6 to 18 months out. Two years ago the consensus expectation for GAAP earnings for 2015 was $6.00 per share – today it is $3.75, which remains higher than recent guidance. The optimism has resulted in an inflated cost base because the expectation was always that returns and earnings would rise to justify the expense.

As we wrote in our recent piece on Eastman, optimists tend to lose their grip on what the real competitive strengths of the portfolio are and the necessary focus to ensure that those strengths are maintained. Dow and DuPont have both been focused almost exclusively on the growth piece of the story in each case and have largely ignored the cost side – DuPont more so than Dow in our view – while competitors have caught up and in some cases passed them. The erosion of the industry’s cost structure, which neither company has led, or in some cases even taken part, has undermined base margins such that any “upgrading” victory that either company has experienced has been drowned out by what has gone on at the other end of the chain. Their optimism has stemmed from their hopes of innovation, and while both companies are now addressing cost, they have some serious ground to make up.

While Trian has backed away from its view that DuPont needs to be broken up to realize the cost and appropriate business strategy goals, recent evidence would suggest that this approach is probably right. Trian has made much of the streamlining of Axalta since DuPont sold the automotive coatings business to Carlyle, and it would appear that Chemours is talking about the cost cutting opportunity it has in discussions with potential debt investors. These are all cost opportunities that the parent was unable or unwilling to address prior to the sale or spin. Our recently published cost opportunity estimate is summarized below in Exhibit 2. Whether this can be achieved without a break-up beyond Chemours remains to be seen

Exhibit 2

Source: Capital IQ, SSR Analysis

The possible reshaping of the global agricultural chemical and seed industry will likely force DuPont to take further steps to focus and possibly separate businesses further. DuPont has some very attractive elements to its Ag portfolio but likely needs to be a participant in any broader consolidation and is probably too late and too distracted today to cut into the MON/Syngenta dance.

DuPont has not had a bad last five years and much of what the company talks about in terms of growth is correct. However, the focus is on businesses that have been either drowned out by the deterioration of the Chemours portfolio or the downturn in Ag, and the company could have done much better with an appropriate focus on costs and on where to best allocate R&D dollars.

The opportunity for the company is significant, and at this point it probably requires a fresh set of eyes in the C-suite.

Spinning out Chemours does not Solve the Complexity Issue – May not Mute the Optimism

In the report we published this week, we identified DD as the most complex company in the Industrials and Materials sector – Exhibit 3. We also pointed out that DD was one of many optimists in that group, as defined in our recent work on business optimism. It is not clear to us which is the chicken and which is the egg here. Do optimists think they can run complex companies and generate great returns, or are complex companies so difficult to understand that management teams often overestimate possible returns or (more likely) miss businesses that are commoditizing and take their eye off the cost structure.

Exhibit 3

Source: Capital IQ, SSR Analysis

Complex companies do not appear to gain the lower earnings volatility and lower cyclicality that they might expect versus their less complex peers – Exhibit 4 – but they do perform more poorly.

Exhibit 4

Source: Capital IQ, SSR Analysis

As shown in Exhibit 1, spinning out Chemours will reduce the complexity at DD and is a step in the right direction. However, it is not far enough to make a difference in our view, and if complexity is the cause of optimism and optimism drives inappropriate allocation of capital (including R&D spend) we can expect the behavior to continue.

The original proposed Trian split to create a “growth co” and a “cyclical co” would create companies that are far less complex and would likely result in a more appropriate focus on cost and appropriate growth investment. More important for the growth company would be a multiple that would allow the company to raise capital/equity on a level playing field with likely partners/targets. DuPont today could not join the bidding for Syngenta without significant dilution. A DuPont Ag/nutrition company would probably be able to enter the ring better matched.

©2015, 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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