Description

DowDupont and its ensuing spinoff parade will provide the material for Chapter 3 of You Can Be A Stock Market Genius, 2nd Edition. The current risk / reward setup is asymmetric, at 15% downside (15x 2018 street earnings) and 85% upside (22x 2019 owner earnings). Looking forward from 2019, investors should begin to underwrite the then multiple public companies separately, leading to an even more favorable valuation. Given this dynamic and the low implied volatility being priced into DWDP options, I recommend buying the January 2020 $90 leaps for $2.50.

Following the recently completed all stock merger of Dow and Dupont that produced an underleveraged balance sheet, DWDP offers value hiding in plain sight with a sequence of pending catalysts over the next two years, including two or more spinoffs resulting in three (Agriculture; Materials Science; Specialty Products) or more (Specialty Products may create additional spinoffs itself) public equities that each may become M&A targets or acquirors. Largely forced and from a position of weakness, recent spinoffs and divestitures exiting Dow and Dupont while under prior managements have created immense value for their new shareholders:

These results bode well for the likely success of the future spins, especially considering current CEO Ed Breen’s track record of value creation while at Tyco from 2002 to 2012 is already deserving of a chapter in YCBASMG. Over leveraged and on the verge of bankruptcy when he joined the company, Breen reduced excess corporate overhead and dismantled the industrial conglomerate via five spinoffs: Covidien (acquired by Medtronic), TE Connectivity, ADT, Tyco Flow Control (reverse morris trust transaction with Pentair), and Tyco Fire & Security (merged with Johnson Controls). In short, Breen has seen the current setup at DWDP before and knows how to execute the playbook for value creation.

Existing activists Trian and Third Point fought with legacy Dow and Dupont management teams for multiple years over bloated cost structures and poor capital allocation. Trian and Third Point were, respectively, successful in removing Dupont’s CEO and forcing Dow’s CEO Liveris (now DWDP Executive Chairman) to take a back seat to current CEO Ed Breen. They were also instrumental in pushing the companies to merge, and again aided shareholders this Spring by blocking Liveris’ attempt to reconstitute the portfolio of the Materials Science unit (which he will likely head). In short, these well heeled activists are heavily invested with their time and money and reputations to see DowDupont’s merger integration, synergy capture, and spinoffs result in a favorable outcome for shareholders.

The company currently trades for 18x 2018 stale consensus earnings of $4, but Third Point and Trian believe DWDP can earn $5.50 - $6 in a few years time. Assuming a 5% revenue growth CAGR (versus 9% guided organic growth for Q4 2017), successful synergy implementation, and a recent peak in the company’s capital investment cycle, the company is trading for 12x 2019 owner earnings. This valuation is too cheap for a portfolio of businesses that have dominant scale in their respective segments, have demonstrated the ability to pass through COGS inflation, have lock-in with many large customers due to process integration and facility adjacency, and consistently produce 20% returns on tangible capital. While there is cyclicality inherent to the businesses, if anything it should provide a multi year tailwind for the Agriculture and Materials Science segments, whose end markets are still depressed or just starting to rebound.

The above is a conservative snapshot of valuation and its related drivers for the consolidated company as the market may see them going into 2019. Summary financials for the three to be formed companies and their respective divisions are below:

Even inside of the to be created companies, individual divisions are growing at different rates and have different margin profiles. When further considering different end market drivers (some cyclical, some secular, some both), different geographic footprints, different capital intensities and resulting different ideal capital structures… its hard to believe the market has an accurate handle on what DWDP’s primary value drivers will be in a few years time.

Further segment financial disclosure and guidance provided by management between now and spinoff completion (management’s targeted range of February 2019 on the quick end and August 2019 on the slow end), including timing announcements for individual spins, form 10-12 filings, and related roadshows, will provide analysts with more clarity around implied segment valuations and should lead to the market revaluing DWDP on a sum of the parts basis. While some segments may trade at a lower multiple than the current consolidated multiple, others may trade at a premium to their own industry peer group due to an assumed takeout premium (as one example, in the Specialty Products segment where comps trade for 12x - 15x EBITDA, public peers Cabot Microelectronics and Versum may be merger partners for silicones or electronic specialties or both).

This opportunity exists due to 1) investor fatigue after years of previous managements’ over promising and under delivering, the ensuing shareholder activist fights for control, and the extended period of time for Dow and Dupont to complete their merger following announcement 2) the company and industry not being a recent sector of focus for distracted investors (myself included) who are busy playing themes of higher rates (banks), tax reform (small cap, US geography), terrorism (defense), FANG, cryptocurrencies, etc. 3) stale estimates and modeling from the sell side, who first received historical, comparable financial info recast by segment from DWDP management at the end of October and have not yet materially updated their analysis or outlook or SOTP as a swath of industry investor day presentations held their attention until the holiday season began and pushed the work to the beginning of 2018.

Catalyst

• Successful merger integration and related expense reductions
• Two or more spinoffs to occur over the next 24 months
• Announcements and filings on individual spincos' financial results, capitalization, management teams