Description

Description

Summary

A VIC write-up on pre-breakup DowDupont (DWDP) from February 2019 began with a comment that at $56.10 per share, the stock had become ~15% cheaper than it was at the time of the prior write-up from July 2018.  Now following the breakup, on a combined basis, OldCo DWDP has a market value of ~$48 per share or nearly an incremental 15% cheaper once again. Most interesting among the three new companies is DuPont (DD), a large cap special situation stock with a significant upside case that the market is ignoring.  DD is a collection of world-class specialty chemical businesses that trades at a significant discount to the sum of its parts. With management actively exploring transactions to simply the portfolio and unlock the value of its businesses, I see a clear path to 30+% upside.

Background / Context

Nearly four years ago in December 2015, Dow and DuPont agreed to merge, with a plan to optimize the businesses and realize $3b+ of synergies and then break-up into three more focused companies: 1) New DOW, a Basic Materials company, (2) CTVA, an Agriculture company and (3) new DD, a Specialty Chemical company.  A drawn-out regulatory review delayed the merger close until September 2017, leaving 2019 as of the year of the breakup into pure plays. DWDP spun-off DOW on April 1 and CTVA on June 1, leaving DuPont as RemainCo and changing the ticker to DD. For reference, the DWDP equivalent price is (DD + DWDP + CTVA) / 3.  During the long period between announcement and breakup, a common market narrative was that the buying opportunity would come upon the spins themselves, when investors could decide which pieces they wanted to hold. Meaningful upside hasn’t materialized for any of the three companies, and DD closed today at a price nearly identical to the level at which it ended when-issued trading, with the S&P 500 up ~14% over that period.  So a natural question is “why has this stock been such a meaningful under-performer?” I’ll discuss the reasons next.

Reasons for 2019 Underperformance

·         Macro risks.  The cyclical parts of the portfolio have suffered this year, most notably the Auto (15%) and Smart Phone (5%) end markets.  China is approximately 15% of sales.  To frame the impacts, consensus 2019 EBITDA is now 3.5% below the midpoint of standalone guidance that the company set in June.  However, this outcome is consistent with that of other companies with similar end market exposures (such as ITW and MMM, whose shares have fared better).

·         Complexity of the company.  I’ll discuss the businesses in more detail below.  But the portfolio is diverse and sprawling, and investors don’t yet have significant history with the segments, which originate from DuPont, Dow and other acquisition targets.  I also sense that with complicated transactions (likely Reverse Morris Trust transactions, RMTs) a core component of management commentary and attention, investors are waiting for clarity on the specific transactions or fear that they won’t realize value soon enough, as these transactions would take around a year to close.

·         PFOA/PFAS.  A prominent investor pitched MMM and Chemours (CC) at the May 2019 Ira Sohn Conference as shorts on PFAS liability exposures.  Weeks later, former DD (2015) spin CC sued DD for relief under the Separation Agreement that has given DD a full indemnification.  And then during recent weeks, Dark Waters, a movie “inspired by” true events that casts DD as a villain over PFOA contamination and cover-up, has been released nationally.  These issues have now migrated into the mainstream debates on this stock. The issues are complex and have been discussed in detail in the message boards for two CC pitches this year.  But I’ll note some key points: 1) Dark Waters relates to a case that DD and CC settled in 2017 for $670mm (split 50/50), so the link to higher liabilities isn’t clear; (2) DD does in fact have an unlimited indemnification from CC, and CC re-affirmed the Separation Agreement in 2017; (3) the liabilities themselves sit at CTVA, and DD/CTVA have a sharing mechanism in place to split outsize liabilities with CTVA ~70%/~30%; and (4) the link of legacy DD to liabilities related to PFOS or the fire-fighting foam (FFF) that MMM produced is unclear at worst and non-existent at best.  Without meaningful FFF exposure, the total exposure of legacy DD (so DD, CTVA and CC) in aggregate is likely to be no higher than low single digit $ billions, as compared to the $48 billion DD market cap. So a liability that seems heavily priced into the stock could very well end up being immaterial or even non-existent.

·         Story fatigue.  Given the multiple false starts of the broader DWDP story, I think that many investors have simply given up.

Summing up, the market seems to be focusing on the negative and noise here, overlooking the quality of the businesses and ability of the company to unlock significant upside in the short-term.

Company Overview

DD consists of four core businesses, each with the margin profile of best-in-class specialty materials businesses and exposure to favorable secular growth areas such as health & wellness, digital revolution and connectivity, advanced mobility, medical & pharma, personal protection and sustainability.  DD also has a small non-core segment of more cyclical businesses that it is current marketing for sale.

Below is a summary of the DD portfolio (sales mix and EBITDA margin based on 2019E, subsegment mix based on YTD September 2019 sales).  Note that Safety & Construction isn’t as cyclical as the name suggests, as only 30% of the business is construction. Again, most of the cyclicality this year has asserted itself within Electronics & Imaging and Transportation & Industrial segments.

·         Electronics & Imaging (E&I)

o   16% of Sales

o   33% EBITDA margin

o   Subsegment mix

§  44% Semiconductor Technologies

§  33% Interconnect Solutions

§  13% Advanced Printing

§  9% Display Technologies

·         Nutrition & Biosciences (N&B)

o   29% of sales

o   24% EBITDA margin

o   Subsegment Mix

§  48% Food & Beverage

§  38% Health & Biosciences

§  14% Pharma Solutions

·         Transportation & Industrial (T&I)

o   23% of sales

o   27% EBITDA margin

o   Subsegment Mix

§  47% Mobility Solutions

§  30% Healthcare & Specialty

§  23% Industrial & Consumer

·         Safety & Construction (S&C)

o   24% of sales

o   28% EBITDA margin

o   Subsegment Mix

§  49% Safety Solutions

§  30% Shelter Solutions

§  21% Water solutions

·         Non-core

o   8% of sales

o   Mid-teens EBITDA margin ex-JV income

Transaction Potential

Executive Chairman (former CEO) Ed Breen and the rest of senior management have been transparent that the company is open to any transactions that are value-enhancing.  Building on Breen’s history at Tyco and his commentary at DD, he focuses on transactions that generate significant synergies and minimize tax leakage. Though the company hasn’t formally put any core businesses up for sale, N&B is likely the top priority, given peer multiples in the 16-21x 2020 EBITDA range, heavy and credible reporting on the matter (with Ireland’s Kerry Group the reported front-runner) and the lowest levels of synergy with the rest of the DD portfolio.  Bloomberg also reported in early November that DD is evaluating alternatives for its Transportation & Industrial segment, with Celanese a potential counter-party. To illustrative management’s seriousness and activity level around its strategic review, below are some comments from Ed Breen from for the October 31 earnings call.

“I want to emphasize that we are well aware of the value creation potential inherent in this portfolio. We are actively pursuing strategic portfolio transactions that will drive increased shareholder returns and sustainable long-term growth.”

“Obviously, the team is extremely busy on looking at some transformational moves and I would just say, we're in seven day a week work mode right now, if I could say it that way and really looking at that heavily to move a couple of things.”

“Well, no, the Chemours suit will have no bearing on any strategic actions we take on the portfolio. And look, I can't talk timing, but let me just go back to the comment I made a few minutes ago, where Marc [CEO], Jean [CFO], me, we're all -- we're in seven day a week mode right now. It feels like back when we were doing stuff of talking to Dow and getting things going. So we're busy, we know what we want to do and we're pursuing.”

“The PFOA has not been an issue in things that we're looking at and working on. So I'll just -- I will leave it at that, it doesn't concern me. And just from a multiple standpoint, it's hard to answer that, but I'd just say, broadly multiples are very good. When you're looking at transactions right now, and by the way, just to give you one, I think, multiples in the N&B type sector are kind of at all time highs right now. And I think a lot of that is just a steady business, a steady industry, which kind of recession-proof, people are going to eat, and they command multiples of around kind of 20x. The real premium companies, which I think we are the premium company in the space. So multiples are not an issue in what we're working on.”

Valuation

DD currently trades at 11x 2020E EBITDA and 15x 2020E earnings.  2020E FCF conversion should be close to 100%.

In a conservative sum-of-parts valuation, I get ~$74 per share (14% upside), based on the following assumptions (all EBITDA multiples):

·         No full-segment transactions

·         E&I 12x, discount to ENTG/CCMP

·         N&B 15x, discount to IFF/GIVN SW/KYG ID/SY1 GY

·         T&I 10x, low end of specialty chemical peers

·         S&C 12x, discount to Multi-Industrials

·         Non-core 8.5x

In an upside sum-of-parts valuation, I get ~$86 per share (32% upside), based on the following assumptions:

·         E&I at 13x, in line with ENTG/CCMP

·         N&B 17x, based on a mark to market valuation in an RMT

·         T&I 12.5x, based on a mark to market valuation in an RMT

·         S&C 13x, more in line with Multi-Industrials

·         Non-core 8.5x

Note that should my N&B transaction multiple materialize (assuming no other transactions), the DD RemainCo would be trading ~8.8x EBITDA.  Each 1x on the Remainco Multiple would be worth nearly $6 per share or 9% to the stock.

Risks

·         Further macroeconomic deterioration

·         Lack of portfolio transformation progress

·         Continued overhang or adverse PFOA/PFAS developments, including a potential ruling in favor of CC

Catalyst

Large-scale portfolio transaction announcements

Greater market appetite for cyclical laggards